Category: Economics

Bank of Canada – holding interest rates

In a decision that surprised nobody, the Bank of Canada kept the interest rates steady at 5% and gave the usual cautionary language that they’re watching the situation carefully.

However, my post is about the press conference the Bank of Canada held a day later, titled “What population growth means for the economy and inflation“.

In the Bank of Canada’s page describing this December 7 press conference, they highlighted the following quote (bold emphasis my own):

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“Strong immigration since the start of 2022 has helped increase Canada’s workforce…. And the larger workforce has boosted the level of our potential output by 2% to 3% without adding to inflation. This is a significant improvement, especially considering Canada’s otherwise rapidly aging population.”

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Then just a little bit lower down, we have the following (again, bold emphasis my own):

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The impact on inflation

When newcomers move to Canada, they need to buy many necessities to help them get settled. This increases demand for goods and services, which can have an impact on inflation.

Not all newcomers affect the economy in the same way. For instance, because of their high tuition fees, international students typically add to consumption more than many other newcomers. Overall, though, the initial boost to spending from the recent rise in newcomers has had very little impact on inflation.

But newcomers also need housing, and that’s a different story. Canada has long had housing supply challenges for many reasons, including:

* zoning restrictions
* lengthy permitting processes
* a shortage of construction workers

The result is that new housing construction has not kept up with population growth for many years.

With these housing supply challenges, the recent increase in newcomers has added to the pressure on rent and housing prices. And this has affected inflation.

Ultimately, Canada needs more housing, and the recent focus by all levels of government to increase construction is a welcome development.

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I take amusement in the phrases “without adding to inflation”, “which can have an impact on inflation”, “has had very little impact on inflation”, “this has affected inflation” all bundled together – talk about covering your bases!

The Bank of Canada is just as much a political beast as our members of parliament are in Ottawa, but the way they express it is different in flavour. They are trying to telegraph something fairly obvious, in that the component of CPI that is contributing the most to inflation is related to real estate:

It does not take a Ph.D. in economics to determine that if you admit a million people into the country a year, and the increase in housing stock is well less than a million homes, that prices are going to rise.

That said, the year-over-year comps for mortgage rates (looking at 5-year and variable) is about to level off in 2024 and this component of CPI will abate. The Bank of Canada raised to 4.5% on January 25, 2023 before taking a pause and then raised to 4.75% on June 7, 2023 and 5.00% on July 12, 2023. Energy prices have dropped considerably year-to-year and this will also provide a tailwind to the economy.

It reminds me of a fictional economic scenario where a loaf of bread costs $1.00 and next year it goes to $2.00. Inflation is 100%, people panic, and then some action is taken. Next year, the load of bread costs $2.04 and then everybody cries victory that they have conquered inflation. This will likely be the result of some disastrous economic decisions made during the Covid crisis.

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.

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.

Strange times

This is a post without much direction.

Canadian Macro

Perhaps the largest surprise to occur in the past two weeks was the Bank of Canada deciding to resume interest rate increases. I generally believe that this is an attempt to shake up complacency in the marketplace and that we are approaching the point of diminishing returns. By increasing future implied interest rate expectations, however, is in itself a form of interest rate increase. So we continue to have the triple barreled approach – actual rising interest rates, threatened future interest rates, and quantitative easing. Interest rates started rising on March 2, 2022 and we are about 15 months into the program. As capital hurdle rates have increased and projects that otherwise would have been initiated stall out, we’re probably going to start seeing this slowdown occur pretty soon.

The yield curve remains heavily inverted – right now you can get a 1yr GoC yield of 5.07%, while 10yr is 3.40%, a 167bps difference.

GST/HST inputs, from fiscal 2021-2022 to 2022-2023 (table 2), only rose 2.7% year-to-year, which is a negative real growth in GST-able consumption. This does not bode well overall.

I look at the inflation inputs and it seems intuitive that cost increases will continue to rise above the 2% benchmark – especially on shelter. The interest rate environment (in addition to other roadblocks) is seriously constraining supply, yet demand continues to remain sky-high (one of the effects of letting in a whole bunch of people into the country, including students, which massively raises rental rates in cities).

Inefficient spending

One of the problems of using GDP is that it doesn’t account for unproductive expenditures vs. productive expenditures. If you paid somebody a million dollars to move a pile of dirt from one location to another, and then back again, you would have a million dollars added to the GDP, but the wealth of the country has gone nowhere. That money could have been used for something more productive. If you get enough of this inefficient spending, it starts to show itself in other components of the economy – namely demand for goods/services that clearly are not being supplied because you’ve tasked too many people with moving piles of dirt from one location to another and back again. Those people could have been employed in another activity, say road building, which is a more skillful (and productive) use of moving dirt from one location to another.

It is pretty much the reason why much government spending is inefficient – it gets directed to segments of the economy which are for political purposes rather than productive purposes. Do this enough, and you eventually get inflationary effects in the things that people really need.

A lot of what we have seen over the past 15 years or so can likely be attributed to the cumulative effects of this. While governments are the chief culprit, the private sector as well has significant bouts of inefficient capital allocation (e.g. look at the value destruction in the cannabis sector, or most cryptocurrency ventures, etc.). The “slack” of the misdirection of resources has been exhausted after Covid, and the cumulative impact is truly obvious – a lot of people are going to suffer as a result, and collectively our standard of living will be declining.

Nifty 50 re-lived

The nifty 50 were the top 50 stocks in the US stock market in the 1970’s. Today, the top 10 stocks of the S&P 500 consist of about 30% of the index and many comments have been made about the effect of these stocks on the overall index. In particular, the rebound in technology stocks since November 2022 has caught many fund managers by surprise, and it is to the point where essentially if you did not own them (Facebook/Meta, Nvidia, etc.), most closet index fund managers would have badly underperformed. Perhaps it is sour grapes from somebody like myself (where I am barely treading water for the year), but this just does not look healthy.

Safe returns

Cash (various ETFs) return about 5.08% at the moment. For yield-based investors this is a very high hurdle. For example, looking at A&W Income Fund (TSX: AW.UN) with its stated yield of 5.3% – while you do get a degree of inflation protection, how much can burger prices rise before you start seeing volume slowdowns (and it is volume, not profitability that counts for these types of royalty companies)? Cash is out-competing much of the market right now. With every rise in the short-term interest rate, the differential widens.

Everybody looks at the charts of long-term treasury bonds in the early 1980’s and said to themselves “if only I had gone all-in on those 30-year government bonds yielding 15%, I would have made out like gangbusters”. This is almost the equivalent of saying your ideal timing into the stock market is February 2009, or March 23, 2020. The problem with such statements, other than they are entirely “hindsight is 20/20”, is that in order to get those 15% yields, such a bond needs to trade at 10%, 12%, 14%, etc., before reaching that 15% point. Valuations that would seem attractive and bought before that 15% yield point will have unrealized losses, sometimes significant, at the crescendo event. This is usually the point where most leveraged players are forced to be cashed out at the violent price action.

Parking cash is boring, and likely will result in the loss of purchasing power over periods of time (the CPI is a terrible barometer for ‘real’ consumer inflation), but better to lose 5% of purchasing power instead of 40% in a market crash!

Implied volatility

The so-called ‘fear gauge’ (the 1-month lookahead volatility of the S&P 500) is getting down to 2019 lows:

I don’t know what to make of this. Markets price surprises and probably the biggest surprise is a rip to the upside, despite all of the doom-and-gloom that the macro situation would otherwise suggest – perhaps interest rates are going to rise even further than most expect?

Either way, I’m not going to be a market hero. I remain very defensively postured and I do not feel like I have much of an edge at the moment. When you had everybody losing their heads over Covid three years ago there was a ripe moment where the reality vs. psychology mismatch created huge opportunities. Today, the normalization of this reality vs. psychology has created much more efficient market pricing. I can’t compete in this environment which feels like trading random noise. Maybe the AIs have whittled away the differential between reality and psychology – but they are only as good as the data that gets fed into them, and markets tend to exhibit random patterns of chaos now and then which will throw off the computers. So I wait.

If you ever wonder why I can’t work in an institutional environment, it is due to having some radical thoughts like the last paragraph.