How to tell if your country is in recession

GST collections are a reasonable proxy for overall end-user spending – the metric only excludes zero-rated and excluded items, such as raw groceries and pharmaceuticals and insurance products.

For the first fiscal quarter of the year (April 1 to June 30, 2023), the Government of Canada reported a 3.6% drop in GST collections in comparison to the previous year:

Personal income tax collections are higher (presumably reflecting on higher wages and gross employment) while corporate income tax collections are lower (most certainly a function of large corporation profitability in the oil and gas sector).

The key point of this post, however, is that it appears that spending is slowing. Are people running out of money to spend?

Perhaps the most shocking part of this report is that it shows the government is in a mild surplus position (when calculating revenues minus expenses) but rest assured, the year-end fiscal projection is still for a $40 billion deficit.

Negative amortization mortgages

Rising interest rates are going to break things, and this one in particular (Globe and Mail article on negative amortizing mortgages) is going to be interesting.

Snippets:

BMO disclosed that mortgages worth $32.8-billion were negatively amortizing in the third quarter ended July 31. That is the equivalent of 22 per cent of the bank’s Canadian residential loan book. For the second quarter ended April 30, the total was $28.4-billion, equivalent to 20 per cent of BMO’s loan book.

TD had mortgages worth $45.7-billion negatively amortizing in the third quarter, the equivalent of 18 per cent of its Canadian residential loan book. That was higher than the $39.6-billion, or 16 per cent of its loan book, in the fourth quarter of last year.

…

In this year’s third quarter, CIBC had mortgages worth $49.8-billion, the equivalent of 19 per cent of its Canadian residential loan book, in negative amortization. That was higher than the $44.2-billion, or 17 per cent of its portfolio, in the second quarter, according to its financial results.

It appears about 20% of mortgages presently are negatively amortizing. This is presumably due to the interest component of floating rate mortgages rising coupled with fixed payments being insufficient to pay the interest component. This would not apply to mortgages that have their payments vary with rising interest rates.

What will be even more interesting is when fixed rate mortgages renew. Five years ago the lowest rate you could get was 3.19%. Today this is 5.44%. By definition when people renew their mortgages they will continue amortizing their principal, but many of them will be facing increased payments. For example, somebody taking a $1,000,000 mortgage 5 years ago at 3.19% on a 25-year amortization would have a monthly payment of $4,830/month. If, after five years, they wish to renew the remaining principal (approx. $858k) at 5.44% with a 20-year amortization, that monthly payment goes up to $5,843/month. If they wish to keep their $4,830/month payment, the amortization on renewal goes to 29.6 years!

It is a valid point, however, that negative amortization is meaningless without the specific quantum involved. For instance, if your mortgage is negatively amortizing at 5% a year, while your property value is appreciating 10% a year, you are actually decreasing your loan-to-value ratio over time. This headline may be a little less ominous than it sounds without digging deeper into the data – which sadly was not provided.

The debt party will end very badly when real estate valuations collapse (if they ever do). Given the propensity of the Canadian government to functionally open their borders to anybody interested (especially in the form of student visas), the influx of population has provided an increasing level of demand for real estate on a very slowly rising supply base. As long as this remains the case, absent of any dramatic rise in unemployment, it appears unlikely there will be any deep downward catalysts on residential real estate valuations.

Canadian Fixed income review – end of August 2023

I’ve been reviewing the fixed income situation in Canada. Some observations:

1. The yield curve is still heavily inverted, and the inversion has gotten even wider over the past week. The half-year bond is at around 525bps and the 10 year is at 359bps as I write this. There is a general anticipation of the rise of the short-term interest rates stopping, but this anticipation has been present now for almost half a year. Time will tell.

2. There hasn’t been a new TSX debenture issue since Fiera Capital a couple months ago, and issuance this year has been very light. Previously you would typically see companies issue new debt and call existing debt with half a year to a year left of maturity, but now they are letting debt run to near-maturity – probably because the coupons they are paying today are less than what they can roll over for, coupled with everybody and their grandmothers waiting for rates to decrease!

3. Preferred share markets are very thin, but if you do not anticipate the 5yr government bond yield changing materially for a year, there are many high-credit names that are trading at 10% rate resets. There are too numerous to mention, but for example, pretty much all of TransCanada’s (TSX: TRP) are trading above 10% at the current 5-yr rate reset value. It becomes an interesting situation for an income investor whether they want to roll the dice with equity, get a 7.6% yield currently or to play the relatively safer preferred shares and clip about 300bps more out of it. There’s even one really trashy financial issuer that has a reset yield currently north of 15% which I’ve looked at, but I value my sanity over yield at the moment.

4. Risk-free cash continues to remain extremely competitive against much out there. The only way to rationalize more speculative equity investments out there is with implied growth or implied expectations of interest rates dropping. We are not going to get this interest rate drop as long as market participants are obviously stalling for it.

The “everybody wants to be a day trader” society

I keep having this amusing thought in my mind, “Everybody wants to become a day trader”. I noted this especially during the Covid-19 era which gave the lesson to a whole cohort of individuals that the way to riches was picking off Gamestop (NYSE: GME) and YOLO-ing to millions. Since then, there has been many people wanting to get into the investing world as their second “side gig”, instead of doing something that actually adds value to society.

I have written and spoke on a past episode of Late Night Finance the fictional world of an island of 100 people, being able to produce a mild surplus of food to satisfy their needs, and then what happens is that they all want to turn into day traders – producing food is difficult work, while clicking buttons in front of a computer is so much easier!

Here is a small amusing story.

When going to Costco (something that Charlie Munger and myself share in common high regard to our appreciation for this institution), I overheard an employee and presumably one of his friends (who wasn’t wearing any name tag) having a conversation near the vegetable section. While I was casually looking at produce, I couldn’t help but overhear some very interesting words such as “limit order” and “trades”. Naturally my ears piqued and I stopped there and became very interested in inspecting the fine micro-details of the avacadoes in front of me while I listened to the conversation. Essentially the friend was talking to the employee about how you should always use limit orders and was tapping away on his Wealthsimple app on his mobile phone to show some charts of various stocks. He clearly was giving a miniature lesson on trading to the employee.

This got me thinking about a few things.

1. Financial competition is everywhere. Technically all of you readers of mine are competition as well, but I am such a sleepy trader that I’m not much of a threat, unless if we decide to all pile into the Yellow Pages (TSX: Y) at the same time (speaking of which, a valuation of an EV of 2.8x annualized operating cash flow!).

2. Maybe there are still new entrants trying to get into “the game”. Tough to believe at this point.

3. How many people would stop working in order to make their fortunes trading stocks? Why bother slogging away at Costco making $20/hr when you can potentially make $20/minute YOLO-ing Tesla or whatever?

Statistically speaking, there has to be some cohort that has tried and by virtue of getting a bunch of coin tosses correct, have removed themselves from the labour force at least temporarily. Just like somebody going to the casino and winning at slot machines, it is entirely possible to win money at the stock market without any prior knowledge. I would claim the stock market offers better odds. When a society starts to see the way to riches as a result of zero-sum extraction as opposed to actually creating wealth (farming, building, cutting people’s hair or programming software), it is no wonder why we are seeing inflation – nobody’s producing supply because they’re too busy day-trading. You get enough of this cohort in society and not only does the zero-sum extraction become more difficult for the participants involved but the cost of everything else rises because of the labour pool removal.

Interest rates controlling the key to everything

Most of the financial world tries to anticipate what actions Jerome Powell and the Federal Reserve decide to make with monetary policy.

For the past year, markets have been trying to anticipate the so-called “pivot”, i.e. the point in time where the Federal Reserve will stop raising interest rates and eventually lower them. The thinking is that lower costs of capital will usher in a new era of demand and we can party like it is 2009 with a rush of quantitative easing.

One problem, however, is there is a deeply psychological component to the inflation going on. The inflation expectation itself is a determinant of real interest rates. I’ll give a very simple example.

Let’s say the nominal interest rate is 5% and inflation is 2%. The real rate of interest is +3%.

However, if you expect inflation to be +4%, the real rate goes down to +1%.

The higher the inflation expectation, the lower the real rate.

An extreme example would be if you anticipated your currency turning into Argentinian paper, with a 50% inflation. Your real rate of interest goes very negative, very quickly and you suddenly will have a very large incentive to spend everything you can today.

We fast forward to today, where you still have the chairman of the Fed saying that inflation is too high. In Canada, Tiff Macklem more or less said as much.

There is the makings of a chaotic system. While nominal interest rates are elevated and real interest rates are still quite positive in relation to past norms, the inflation expectation (the Bank of Canada has referred to this as “entrenched expectations”) continues to render the effective real rate down, if not negative. However, market participants are anticipating a halt in the increase of nominal interest rates and the Fed Funds Futures suggests that there will be 100bps in cuts by the end of next year.

It is precisely this expectation of lower interest rates that is preventing the nominal increase of interest rates to have their desired effect by central banks. As a result, demand is still high because inflation expectations remain high – practically speaking, the real rate of interest in the minds of a lot of people is negative. When the purchasing power of your cash continues to erode, why not spend?

The chaos factor is anticipating when there will be a turnaround in expectation. Psychological whims are fickle – much more so than nominal interest rates.

To use a science analogy, the economy is feeling like a super-saturated solution – one minor intrusion away from reverting into another state of matter. I can’t anticipate when this will occur. However, when it does, it will be relatively swift. I don’t want to use the word “crash” to describe it, but there is a possibility, albeit I would not rank it as probable at the moment.

What are some defences to this scenario? Holding cash is good, although my gut instinct says it is a crowded trade. The trade is crowded enough that it will probably buffer the impact of lower prices. A scenario I see more likely is the long-term (10 year) risk-free rate rising to a point that suppresses equity valuations like a wet blanket on a campfire. Although this is hardly a scientific sample, stable royalty income trusts such as the Keg (TSX: KEG.un) have recently exhibited some degree of price contraction, likely due to the yield competition with cash. Why bother holding risky units in a steakhouse chain when you can just hold onto (TSX: CASH.to)? Is that truly worth a 250bps equity premium? It even looks worse for A&W (TSX: AW.un), which is at a 50bps premium at the moment. Maybe I should be shorting it!

Finally, let us not discount the slow impact of quantitative tightening. In Canada, we have $23.9 billion in government treasuries maturing on September 1, and another $558 million in mortgage bonds maturing on September 15. This is about 7.75% of the Bank of Canada’s balance sheet of treasuries and mortgage bonds. Funds parked at the Bank of Canada by banks remain plentiful, however – nearly $157 billion is still parked at the BoC at last glance. Credit is still available – you just have to pay a lot more for it.