Economics – Page 10

Why Canada is getting into trouble

I try to avoid politics in this website other than how they interact with the financial markets (which is a material consideration – don’t face the headwinds of the central banks or federal governments – just ask Albertan oil and gas producers!), but this little interaction in Parliament should be a pretty good indication of the minds of our esteemed Ministry of Finance (MP Pierre Polievre has been a very effective finance critic for the opposition):

(You want the actual answers? Try here.)

I understand what the Minister of Finance is doing from a political angle – he is obviously being given specific advice to not say anything that is clippable in a negative light. So he won’t answer any real questions in Parliament. There are no consequences to not answering questions in Parliament other than public embarrassment, which didn’t seem to hurt the Liberals in the previous election (Trudeau’s blackface, etc.).

Although the USA is blowing more money out the door, one can make the claim that they still have the strongest military and still an extremely powerful economy that, when they actually care about it, can be nearly self-sufficient from a domestic perspective. As a result, they can take ridiculously huge monetary and fiscal actions and will still be in reasonably good shape (inflation would result when claims on currency start flowing in to purchase goods and services, but it would not be a country-ending event). Canada cannot make such a claim as our primary export is natural resources, and we rely on imports for significant amounts of goods. We still have a reasonably decent amount of domestic production, but it is nowhere as robust as the USA. As a result, at the same levels of debt (proportionate to our GDP and population) we are more brittle economically.

Fortunately, the federal entity has had a relatively low amount of debt to GDP, but this is going to change (upwards) very quickly. Our debt to GDP will rise about 15% this fiscal year alone. Canada is structurally unusual in that our sub-soverign entities (i.e. provinces) are relatively more powerful entities than other countries, and as such, to have a proper apples-to-apples comparison, provincial debt should be included with the overall burden – when taking this into light, Canada is slipping into fiscal territory where it should not be going. We’re still miles away from around 1993 where interest expenses on gross debt was a third of our revenues (it was about 7% in the previous year), but it doesn’t take much imagination where you start having a monetary crisis and interest rates skyrocket, and that’ll force some really terrible fiscal decisions to properly regain the confidence of the financial markets.

Unfortunately, by the time that the country has to pay the bills for what is happening today, the people causing the problems will be long gone. It makes Harper’s performance during the 2008-2009 economic crisis (which was in itself instigated by a minority parliament that was going to overthrow him from office if he didn’t spend like mad) look quite good by comparison.

The ultimate irony is if there is enough supply destruction in the US shale market (coupled with lack of capital plus the depletion of the top-tier sites), fossil fuel prices might rise enough to bail out Canada’s energy companies, which would have a positive effect on the country’s finances (and the Canadian dollar). This would be despite the current government doing everything it can to shut them down.

The future of monetary policy

We are all forced to be closet macroeconomists and for that, I’d suggest reading Ray Dalio’s primer on money, credit and debt:

More specifically, the ability of central banks to be stimulative ends when the central bank loses its ability to produce money and credit growth that pass through the economic system to produce real economic growth. That lost ability of central bankers typically takes place when debt levels are high, interest rates can’t be adequately lowered, and the creation of money and credit increases financial asset prices more than it increases actual economic activity. At such times those who are holding the debt (which is someone else’s promise to give them currency) typically want to exchange the currency debt they are holding for other storeholds of wealth. When it is widely perceived that the money and the debt assets that are promises to receive money are not good storeholds of wealth, the long-term debt cycle is at its end, and a restructuring of the monetary system has to occur. In other words the long-term debt cycle runs from 1) low debt and debt burdens (which gives those who control money and credit growth plenty of capacity to create debt and with it to create buying power for borrowers and a high likelihood that the lender who is holding debt assets will get repaid with good real returns) to 2) high debt and debt burdens with little capacity to create buying power for borrowers and a low likelihood that the lender will be repaid with good returns. At the end of the long-term debt cycle there is essentially no more stimulant in the bottle (i.e., no more ability of central bankers to extend the debt cycle) so there needs to be a debt restructuring or debt devaluation to reduce the debt burdens and start this cycle over again.

Does this remind you of anything that is going on right now?

With monetary policy at an effective zero bound (I don’t really care whether the interest rate is 0.25%, 0.75% or -0.5%, it is effectively zero and the negative bound is the ability to store paper currency underneath the mattress), the ability for central banks to stimulate the economy (without causing reams of economic damage with massive inflation) is effectively toast. The large recent failure was to not attempt a better normalization after it was perfectly evident the 2008-2009 economic crisis was passing, coupled with the US government not being fiscally responsible. In Canada, Harper was on the right track (he got the budget balanced and the Bank of Canada was able to escape the economic crisis with far less intervention than the US Federal Reserve), but Trudeau and the Liberals have done an exceedingly fine job of reversing this, and now Canada is basically in the same boat as the USA – central banks are employing quantitative easing as a last resort to stimulate economic activity.

The big difference this time is that when the government also mandates a shutdown of the economy, it doesn’t matter how much stimulus you put out there, the real economy is not going to respond. Why would a restaurant owner at this point in time make any investment at all when you have talks of COVID-19’s “second wave” and this can just start all over again?

The real interesting implications occur after one asks what the new currency will look like when it goes from fiat back to something that the public has confidence in. Will that be gold, or bitcoin (or some other crypto)? My big problem with bitcoin, and most cryptocurrencies in terms of them providing a “hard asset” is the dominance of the hash – most of the power in the network has been increasingly centralized to miner pools and it is getting to the point where the possibility and allure of collusion is effectively the equivalent of 51% of people deciding to steal the 49%’s capital.

I would deem it more likely that central banks will try to introduce a parallel currency.

Coronacrash #4 – this time in crude oil

Crude oil is down the biggest percentage I have seen in my investing history – West Texas Intermediate (WTI) currently down 20% (from a close at US$41 to US$33 presently). Brent is about US$37. There is no way to describe this other than a crash.

Canadian oil has been trading at a heavy differential, with Western Canadian select closing last Friday at US$28/barrel.

Needless to say, this is going down on Monday, probably to around US$22/barrel if we keep things at a 20% discount to WTI.

There is no Canadian oil company that can survive at this price level. Even though there are some companies where this is under the marginal cost of extraction (e.g. looking at CNQ’s last year, they had a CAD$12.41 marginal cost of extraction for their North American production, not including royalties) you still have costs associated with drilling and financing to pay off, and a US$22/barrel model completely destroys this.

Some obvious implications are that capital spending is going to decrease to the bare minimum, even more so than what has previously been announced. High cost production is going to be shut down, and we will be seeing another wave of insolvencies in the energy sector. Not pretty at all.

In these high-volatility situations, there is always money to be made by correct timing and correct decision-making, and right now the winners are those that don’t have a single barrel of crude oil in their portfolio. There will be spillover, however, plenty of it.

For example, geopolitically, countries that are heavily reliant on crude imports can’t continue to function for very long. Iran, for instance. Rock-bottom crude oil prices will have ripple effects that are not immediately obvious on a first order level of thought.

Down to zero – interest rates

As the whole world at this point knows, the US Federal Reserve reduced short term interest rates to a target rate of 1-1.25%, down 0.5% in response to economic concerns about the Coronavirus.

I’m not sure how changing a very low short term interest rate into something that is even lower will help matters.

The yield curve today looks like this:

1-month: 1.11%
3-month: 0.95%
1-year: 0.73%
5-year: 0.77%
10-year: 1.02%
30-year: 1.64%

Needless to say, these are low. Not European-style negative rate low (Germany’s bonds are trading at a -0.81% for 5-year and -0.63% for 10-year), but things clearly are at the point where if you’ve got reasonable credit, you can borrow money for nearly free.

QE4 is also alive and well, with $400 billion more in purchased securities on the federal reserve’s balance sheet from August 2019, most likely ending up in the stock market.

I’m guessing the Bank of Canada will probably announce a rate cut tomorrow to follow lock-step with the USA. The only question is whether they’ll drop a quarter point or a half point.

The analogy has been used many times before that lowering rates from current levels is like giving the metaphorical drug junkie another hit of heroin to keep high just a little bit longer – I can’t imagine on anybody’s financial spreadsheets how the incremental reduction in a 0.5% rate decrease from 1.5% to 1.0% will alter a capital investment decision, say to spend $10 billion dollars on a pipeline over the next 3 years, when there are so many other dominant variables that will take priority.

I also project there will continue to be a massive amount of government spending and deficits that will be incurred – when the cost to borrow is effectively free, why not?

This would explain why Gold is going crazy, but in theory, any assets that have the capacity to generate (inflation-adjusted) cash should also do relatively well.

Macroeconomics – one reason perhaps why the S&P 500 has been rising

Take a look at the S&P 500 over the past two months:

It is not entirely coincidental this aligns fairly well with the monetary loosening of the next phase of quantitative easing by the US Federal Reserve, which started in September:

Most of this excess capital tends to find its way pumping demand into the asset market. Right now, that demand gets centered around the large capitalization, large liquidity companies, but eventually that demand flows to parts of the economy that still offer morsels of yield.