Category: Economics

Sometimes when you step back, get away from the computer for a couple days, and then step forward again, you take a different perspective on things. Such as what to sort through first in an inbox that has 60 unread emails.

I have typically experienced that a hands-off approach works better than a hands-on approach to portfolio – every time you touch your portfolio, you have to be making a correct decision compared to the person on the other end of the trade.

This time when I returned, I noticed that practically all resource and commodity-based equities, in addition to the broad indexes were up. My portfolio received a minor increase, so it is always emotionally difficult to look at everything else go up, but I am buffering that against the fact that I have a risk-adverse portfolio with a significant amount of cash.

The two obvious factors that went on this week was:

1. US Congressional Elections – Republicans take the House, Democrats keep the Senate. My projection here is that the state of the fiscal situation in the US government will not change to a significant degree – there will be massive fiscal deficits for years to come. It will be unlikely that this new congress will be able to restore some sort of fiscal balance. In fact, the decision might be whether to bail out certain states or not, which have accrued liabilities that is far beyond their ability to pay. What is interesting is that the market predicted this result in advance, but there was no significant market reaction.

2. Federal Reserve engaging in potential quantitative easing – they announced a number less than what the market was expecting, but announced it nonetheless.

The big macro issue is that in order to stimulate exports, countries are reducing the value of their currency by pumping more of it into the economy, which you see in the form of government deficits. Since every country that has an export base is doing the same thing, you do not see much of a shift in relative valuation, but you do see a shift in valuations with hard assets, such as commodities and to a lesser degree, equity and debt. This creates a rather volatile situation in the marketplace.

I don’t know how this will resolve itself – my instinct has always been to purchase commodity-linked equities, but it feels like a crowded trade. Cash feels like it is depreciating by the day. Fixed income has valuation and risk/reward issues, especially if/when long term rates increase. Shorting long-term bonds is something to be considered, but doesn’t alleviate the problem of what to do with cash. Income-related securities have also been bidded to the roof, and barring any price corrections between now and year end, one of my 2011 predictions will be that income-related securities will underperform.

The least of what seems to be all ugly options is cash, specifically Canadian currency cash. There are a few reasons for this:

a. You can get a 2% yield on it (retail) or slightly less in institutional amounts (1-year treasuries are about 1.2% right now in Canada).
b. The Bank of Canada is not engaging in quantitative easing. In fact, by smartly increasing short term rates to 1%, they have probably done the whole country a favour.
c. Being a Canadian resident, I am intimately familiar with the country and the Bank of Canada, although I should point out there are three provinces that I have yet to visit.
d. Cash is very liquid and can be deployed at a button click’s notice into something better that appears on the radar.

Ultimately, investing in what you know will be in demand, at a good price is the generic fallback, macroeconomics be damned. But the macro situation is becoming something an investor has to pay very close attention to even with their microeconomic investments. A couple weeks ago I mentioned that some of my research lead me to place orders in two (US-denominated) securities. One of them went above my order price and has not gone back down. The other has been hovering in a range, and I have established a 6% position in.

Besides for this, I continue to watch, although I know my US cash holdings feel vulnerable to depreciation of purchasing power.

The Government of Canada released their annual report for the 2009-2010 fiscal year (April 2009 to March 2010). The headline number is the $55.6 billion deficit.

Although the report is a pleasantly short 30 page read, I will concentrate on the expenditure side of the budget. A lot of people have the impression that federal government spending can be easily slashed. Apportioned by percentage, the $244.8 billion of expenditures look like this:

Looking at the pie chart from largest to smallest percentage expenses, one can easily see how cutting expenditures is not politically feasible. For example, a full quarter of expenses are transfers to persons. These include Old Age Security, EI payments, and child-related transfers – all three would likely have massive backlash if there was a cessation of benefits.

The government in the 1990’s, when faced with a deficit crunch (when a third of the revenues went off as interest payments) decided to cut transfer payments – this goes to the provinces mainly to pay for healthcare. Again, this would be highly unpopular if the government did so.

The discretionary expenses that the government has a chance of implementing are on defence, crown corporations, and “the rest of the government”. This is approximately 29% of the 2009-2010 fiscal expense profile. Even if you were to decrease these expenses, it would make little progress at reducing the entire expense profile, which is ballooning as the population ages.

Every Canadian should be able to understand this document, but sadly, few ever read it.

The US dollar is clearly on a downslope:

With central banks having huge incentives to devalue their currency, it is going to be a classic case of a “race to the bottom”. It is not a surprise to see commodities and gold perform in such an environment.

Canada is in an odd position – with an economy strongly aligned toward commodity prices (energy and mining), it will create strength in the dollar. Exports become less competitive on pricing, which suggests that short term interest rates will not rise because of the cooling effect of a strong currency.

In a more retail oriented environment, this will also mean that imports will be cheaper, and the most Canadian tradition of them all – cross-border shopping – will be cheaper to partake.

Mass devaluation is not quite the same as inflation, but will likely have the same result. The only question is which assets to park your cash into.

The Governor of the Bank of Canada, Mark Carney, made a speech today. Although the media is reporting otherwise, Carney is still keeping his options open:

Since the spring, the Bank has unwound the last of our exceptional liquidity measures, removed the conditional commitment, and raised the overnight rate to 1 per cent. Following these actions, financial conditions in Canada have tightened modestly but remain exceptionally stimulative. This is consistent with achieving the 2 per cent inflation target in an environment of still significant excess supply in Canada and the demand headwinds described earlier. While Canada’s circumstances and the discipline of the inflation target dictate a different policy stance than in the United States, there are limits to this divergence.

At this time of transition in the global recovery, with risks of a renewed U.S. slowdown, with constraints beginning to bind growth in emerging economies, and with domestic considerations that will slow consumption and housing activity in Canada, any further reduction in monetary policy stimulus would need to be carefully considered. The unusual uncertainty surrounding the outlook warrants caution.

Historically low policy rates, even if appropriate to achieve the inflation target, create their own risks. Aside from monetary policy, Canadian authorities will need to remain as vigilant as they have been in the past to the possibility of financial imbalances developing in an environment of still low interest rates and relative price stability.

If you read the context of the rest of the speech, essentially he is saying the economy cannot be solved with monetary policy alone, which is correct.

Also, 3-month banker’s acceptance futures (the proxy for the overnight rate projection) are not moving as a reaction to this speech.