Tariffs v2.0

This will be a short one.

I stand by everything I wrote back on February 2, 2025 on the matter. So far this post is aging well.

BoC will drop rates 25bps on March 12, 2025 (to 2.75%) and April 16, 2025 for a 2.5% policy rate after April’s rate cut. Prime will go to 4.7%.

Pay attention to the yield curve – 5yr GoC is at 2.63% and this is going to open up the spigots for more government spending. Prime example – British Columbia today announced their budget, and the year-to-year projected change in debt is $23 billion, on a $84 billion revenue account (page 11, “total debt”).

With this much government spending they can barely keep the economy afloat – and it is going to be the same for the rest of the country. As we know, government spending is rarely directed towards the most productive recipients and the population is going to continue to wonder why their standard of living will continue to decrease.

Thoughts re: Tariffs, Politics, Economics and the Markets

There are so many moving parts going on that it is very difficult to distill what is going on in a few short soundbites. There are political and economic considerations at play, in addition to geopolitical considerations that go beyond Canada and Mexico.

Strategically, Canada is in poor condition to fight a trade war with the USA, primarily through neglect but also through various acts of commission that have worsened the situation. There are significant political fractures in the traditional (Quebec vs. the rest of the country, and also increasing western alienation from Ottawa) domains but also a newer type of political vector which can be vaguely categorized as strong foreign interests (whether state-owned, or quasi-state owned) that want to steer Canada as a launchpad for their own interests. While this has existed before in the past, in the modern era this influence is much easier to remotely project due to globalization, the acceptance (whether coerced or otherwise) of immigration and the ease of communications via the internet. In the case of China, Canada is the closest analogy to what Cuba/Nicaragua was for the USSR in the 1960s to 1980s, and various interests from India are fighting proxy wars in Canada for leverage in India’s domestic conflicts (few have questioned how the leader of a junior parliamentary coalition partner propping up the current government has well known involvement in India’s affairs to the point where India banned him from visiting) – including the allowance of a plurality of Canada’s inbound immigration from that country. There are other foreign interests too numerous to mention, but needless to say the overriding concern with the current government is maintaining domestic incumbent interests while any concern shown for overall public welfare is usually ancillary to the entrenchment of very well-known entities in Canada.

Reference:
(Scotiabank – Canada trade briefing, January 31, 2025)

Economically, Canada imports and exports nearly a trillion (CAD) a year, split 80/20 with products/services, and about 75% of its export trade flows to the USA. Just less than half of Canada’s imports are from the USA. Canada’s GDP is approximately CAD$3 trillion so the fraction of the economy that depends on trade of some sort is immense. Given that a quarter of Canada’s GDP flows to the USA, while roughly 2% of USA’s GDP flows to/from Canada, there is a huge disparity between the economic dependence of both countries to each other. Putting it lightly, the USA has the ability to inflict 10x as much economic harm to Canada than the other way around.

This disparity in the relationship has historically been reconciled with historical geopolitical cooperation (in particular with the cold war with the USSR) and generally shared values. These factors of historical cooperation have more or less faded, with Canada not being particularly interested in defence policy of any sort (mostly abdicating its own responsibility and letting the USA handle defence), coupled with the Canadian government dabbling with international players that are adverse to US interests. These factors have been an acid that has corroded away links between the two countries and have indirectly facilitated the political ease of making tariff actions.

The reasoning for the tariffs is cited as illegal importation of Fentanyl across the border, while a very real concern, affects the southern US border much more than the northern border. However, this is to facilitate the tariffs themselves as a result of the Canada-US-Mexico free trade agreement ratified in 2020.

The only leverage of any economic consequence Canada has is the production and export of fossil fuels. About 20% of Canadian exports are energy products and the substantial majority of it goes to the USA. The USA has a fossil fuel deficit of about 7 million barrels of oil a day and much of its refining infrastructure is geared toward the processing of heavy oils, which Canada conveniently provides – Venezuela was the alternate provider for this type of crude oil, but geopolitical relations have been (pun intended for those that understand crude oil parlance) sour. As I write this, that oil gets sold to the USA for a significant differential, roughly US$60/barrel while WTI trades at US$73. Given the price inelasticity of crude oil, it is likely that the bulk of the tariff costs will be passed down.

Because Canada did not develop competitive export capacity away from North America, or even domestically (one of the country’s many economic acts of self-sabotage was to kill Energy East) there is a huge economic dependence to exporting oil to the USA. Conversely, if oil exports were to stop to the USA, the USA would find it very difficult to source crude oil on short notice and energy costs would materially rise domestically.

Finally, there is the consideration that Ontario and Quebec’s fossil fuel infrastructure is entirely dependent on imports – either from the Atlantic or via a pipeline which goes through the USA (Enbridge Line 5). As Ontario and Quebec consist large of the “incumbent interests” that I referenced previously, an attempt by Canada to curtail fossil fuel exports would likely result in a retaliation of export controls by the USA, causing massive disruptions in fuel supplies. As much as the Liberals find Alberta to be a political wasteland (and indeed punish Albertans for this reason to curry votes in Ontario, Quebec and the Atlantic provinces), even they realize what a catastrophe would ensue if oil were curtailed to the eastern Canadian refineries.

Politically, both Canada and USA are advantaged by a conflict, but for different reasons.

In Canada, we have a very unpopular Liberal government which would be decimated in the polls if an election were to occur, coupled with two other political parties that would go from having some power in the House of Commons to no power in the event the opposition Conservatives form a majority government. This is the reason an election will be postponed until the last nanosecond legally possible unless if polling circumstances change. A trade war is a great event to occur for a change in polling circumstances. “Never let a crisis go to waste” is the cliche, and as we have seen in the past, governments have taken conflict and used well-tuned persuasion techniques to stir up public emotions to great advantage – it was not very long ago when a federal election was called in September 2021 and the wedge issue was essentially the politicization of Covid-19, vaccinations, travel restrictions and the like. In both Canada and in British Columbia (October 2020 snap election) it worked.

Justin Trudeau gets rightfully pilloried for many reasons, but one thing that he excels at is acting and this is a ready-made moment for him to come out as some sort of hero of Canada for daring to fight Donald Trump, garnering public sympathy and with it a shot at revitalizing his party’s polling numbers as Mark Carney steps into the Prime Minister’s position. There is pretty much no political option for them at this point other than to engage in a purposefully escalatory and inflammatory strategy and the intention is to make Canadians suffer badly, citing it is something that the Americans did rather than a result of Canada shooting itself in the feet multiple times. They will make the argument that Canadians have no choice but to vote Liberal to show their solidarity against Donald Trump. Will this strategy work? They don’t have anything else to try at this moment.

However, the province of Ontario has already jumped the gun and called an election, with its premier declaring himself to be the defender of Canada. As Canada’s largest province by GDP and population, you can be sure the federal Liberals will be watching this election closely, although the provincial competitors to the incumbent governing party are a complete mess at present and not likely to get their act together by the February 27, 2025 election date.

One big problem to impede the settlement of the Canada-USA trade war is the current version of the Liberal Party is ideologically and spiritually in alignment with the Democratic Party – it is no secret at all that Justin Trudeau and the Liberal Party, after the 2020 presidential election, have been incredibly dismissive of Trump and mostly recently have campaigned in support of Kamala Harris and the Democrats (even after the 2024 presidential election, Trudeau lamented how the US public was not progressive enough to elect a female president). This has massively compounded the problem for Canada as one of the motivators for Donald Trump’s actions is to punish his political enemies – the current Government of Canada is considered to be a political enemy of the Trump administration until there is a change in the ruling political party.

On the USA side, we have what can be classified as President Donald Trump attempting to perform in 2024 what he wanted to set out in 2016, but with the benefit of plenty of experience of now knowing what to do to navigate through the “swamp”. Just as the “swamp” attempted to imprison him and his allies, culminating in an assassination attempt, my suspicion is that the President is motivated by getting back against his enemies (specifically the Democratic establishment), but also with a culmination of economic factors that align with US interests, including the on-shoring of industry to the USA and essentially trying to break the economic interests that were favoured by the Democratic establishment.

It is also not mentioned that tariffs themselves are a tax, and the implementation of a 25% tariff on all goods and services will generate a not trivial amount of taxation revenue. There are “multiple birds with one stone” with regards to both the economic and political consequences in the strategy they are pursuing, albeit one with a large amount of risk entailed.

This whole strategy of the Americans works as long as the domestic US economy has an ability to adapt to rising import costs, and that the US Dollar remains the global trade currency – indeed what we are seeing is a US dollar that is stronger than ever despite all of this going on.

One thing to always question is what we do not see going on – in particular, the USA has remained quite silent with Japan despite having a relatively large trade deficit with Japan. It could be because the Japanese LDP government is supportive of Trump (Shinzo Abe and Trump reportedly had a good relationship and there is no reason to believe that the current Prime Minister has a relationship like anything Trudeau has with Trump). Also little mentioned is the additional +10% tariff on Chinese imports – and I suspect one of the geopolitical targets of this whole action is to force China’s hand in some manner – including sending a message in regards to fentanyl.

In terms of the marketplace, whenever there are volatility events like these, correct and well-timed speculation will lead to outsized risk/reward outcomes that typically do not occur during ‘peacetime’ markets. While this tariff move was telegraphed well in advance (and the markets have had time to brace for impact), what I do not think the markets are appreciating is the continuation of these tariffs for longer in addition to the escalation of them – in particular, the Canadian government has too much of a political incentive in sustaining and escalating this conflict. Brace yourself, as Canadian purchasing power is going to get worse and the acceleration of the decline in our collective standard of living will continue for the foreseeable future until the country addresses its strategic weaknesses. What we are seeing happen is simply a symptom of a core problem of lack of investment and productivity and robustness in our domestic economy – all of this over-investment in real estate development does not make for a strong economy without having a sufficient amount of other building blocks in place.

As a reaction to this, the Canadian government will use it as an excuse to spend and “invest” – in their incumbent-friendly stakeholders. There will be some “tariff subsidy bonus cheques” given by the Canadian government to lower income individuals (this will be the substance of the deal the NDP will cut with Mark Carney to survive) and the result will be a significantly increased deficit (well beyond the projected amounts) and the currency will drop further than what we have seen – the currency value is the only escape valve when interest rates are being lowered to the zero bound. The Bank of Canada has already lowered interest rates and removed quantitative tightening, but they are likely to take it one step further and resume QE again once they have finished lowering the policy rate. They will be careful to not fuel inflation by ensuring the deficit spending is kept within the financial system and only fuel asset inflation, not consumer price inflation (the lesson from Covid-19’s CERB, CEBA, etc. was learned here).

This is a very fluid situation and I feel like the tip of the iceberg has been written in this essay and there will inevitably be changes to this outlook going forward. I’m remaining liquid, nimble and patiently observing where most of the panic breaks – there could be opportunities resembling a milder version of what happened in March 2020 coming up. Unfortunately, just as the March 2020 decision to shut down the entire economy showed, as a whole society, we will become poorer.

What a difference interest rates make

The market has long since baked in the upcoming drop in interest rates.

As a result, anything “yield-y” have been bidded up substantially.

I note the REIT sector, which at one point earlier this year was mostly negative year-to-date is now, with a couple exceptions, up solidly.

We have the go-private transaction (99% sure to succeed) for Melcor (TSX: MRD) repurchasing the minority interest in its REIT (TSX: MR.UN) – the fact that MR suspended dividends some time ago should have given a clue as to its financial condition, but apparently they have some assets on the balance sheet that’s worth paying a healthy 60% premium to market for.

The larger REITs, e.g. REI.un, AP.un, CAR.un, etc. are all up roughly 25% over the past three months.

This is purely due to the quantitative effects of interest rates dropping. I will question the economic fundamentals of such price moves.

We also look at other (restaurant royalty) income trusts, including KEG.un, AW.un, BPF.un, etc., and they are all up. I will also question the economic fundamentals of such price moves. Do lower interest rates cause more people to go to restaurants?

While high prices are great if you are already holding and intend on selling, returns on investment drop with higher prices.

It’s getting pretty tough out there. As cash yields less and less, investors will be compelled to march up the risk spectrum to make the same returns that investors are fighting for.

The good news, however, is that having a slate that is cleaner than it has been since 2008 gives some mental clarity. I am not going to force cash to work for the purposes of increasing yield. It does hurt in some manner, knowing that every day cash erodes in purchasing power.

Despite government-published CPI statistics showing that inflation has moderated, anybody with a functioning eyeball will know that cost escalation is still significant and ongoing, especially with goods and services that people actually require. Costco is an excellent barometer for this.

The deflation you see are for goods that nobody needs. Take a look at Craigslist ads for furniture and you can explore a market that is besieged by deflation. Do you want somebody’s discarded Roomba? That can be had for $50 or $60.

There is also another metric to determine how much purchasing power has declined and that is to measure the portfolio value not in dollars but rather ounces of gold – gold as measured in Canadian currency is up almost 25% year to date, which is more than my own year-to-date performance this year. Just in case if I wanted to pull off a “Scrooge McDuck” and cash everything into one ounce gold coins and go swimming in the vault, I’d have less today than I would have last year!

Interesting times always lie ahead. The environment today is a lot more difficult than it was in 2020-2022.

The slate is being cleaned

Slate Office REIT (TSX: SOT.un) today announced an update on its “portfolio realignment plan”, also known as “We’re trying to dump this stuff as fast as we can but can’t find anybody willing to pay a price that will pay down the mortgages” plan:

Slate Office REIT (TSX: SOT.UN) (the “REIT”), an owner and operator of high-quality workplace real estate, announced today that it continues to make progress on its previously announced portfolio realignment plan, and in connection with the foregoing, continues to engage with its senior lenders to determine a mutually acceptable path forward in respect of its obligations to such senior lenders, including in respect of its revolving credit facility. The REIT also announced today that, notwithstanding those ongoing discussions, its senior lenders have provided notices of default, which currently restrict the REIT from making further payments of accrued interest in respect of its outstanding debentures (collectively, the “Debentures”), for so long as such defaults have not been cured or waived. The REIT has determined that based on the information currently available to it, there can be no assurance if or when a cure or waiver in respect of such defaults will be achieved, and as such, the REIT does not expect to make the cash interest payments due on June 30, 2024 in respect of its 7.50% convertible unsecured subordinated debentures and 5.50% convertible unsecured subordinated debentures, nor does it expect to make the cash interest payment due on August 31, 2024 in respect of its outstanding 9% convertible unsecured subordinated debentures. Pursuant to the trust indentures governing such Debentures, failure to pay interest on the Debentures for 15 days following such interest being due will give rise to an Event of Default under the terms of the Debentures.

Needless to say, it isn’t looking good for them. This could be inferred from previous public filings, in addition to them having to beg to shareholders to go above their prescribed asset to debt ratio.

My attempts at being a corporate raider (November 2022) was incredibly brief before I came to the conclusion that there’s no way to win.

My question is not necessarily for Slate (we will see how George Armoyan can try to salvage this situation) but rather whether there will be any ripple effects in the office REIT sector if Slate does decide to go into CCAA. In the sector include AP.un, D.un, SOT.un, TNT.un, and diversified REITs which contain significant office components including BPY/BPO (preferred shares), HR.un, AX.un, and to a lesser extent MRC/MRT.un.

A little bit of QT – and general economic thoughts

The whole financial sector of the country knows that the Bank of Canada dropped interest rates by a quarter point a few days ago (from 5.00 to 4.75%). Those holding floating rate debt will see a little bit of alleviation of expenses, and those holding CASH.TO and the like are seeing their risk-free rate drop – nudging the capital further right along the risk spectrum.

However, the overall picture of the inverted yield curve has not changed –

It is still deeply inverted, with a 125bps spread between short and long term yields.

The transmission rate of dropping interest rates (or raising them) and the impact on the real economy is a very slow process – the literature cites around 12-18 months before the full impact of rate hikes and drops come into play. Entities look at their cost of capital and decide to invest or not in projects (e.g. residential strata condominiums or chemical factories) that have a five year development cycles and when the decision is made, the economic impact occurs well into the future. It is not like you can order one of these on Amazon and get it shipped in a day!

You can infer this by looking at employment statistics. Why is construction labour down about 34,700 jobs year-to-year? Major capital projects are running off the ledger (e.g. TMX is finished, Coastal Gaslink is nearly done, etc.) and the decisions to do residential construction occurring in cities were made in 2021 when rates were at rock-bottom and these projects are just completing now. The only sort of capital projects are are hitting the “buy” button are government works – except these are all running into massive cost overruns (e.g. using some BC examples, the Site C dam, the Metro Vancouver sewer plant, any hospital project, the Broadway Skytrain project, etc, etc.). Only government projects are allowed to have any amount of money thrown at them for completion – and this of course attracts contractors like a moth next to the flame. When your competition is able to spend infinite amounts of money, what makes you as a private developer, able to compete for those services? No chance at all – hence cost inflation. With your cost of capital is still relatively high, there’s no avenue for profit.

Finally, I will observe that the progression of quantitative tightening, albeit very slow, is still progressing – the following chart is the “Members of Payments Canada” line item on the liabilities ledger of the Bank of Canada:

The last slab of QT took the “Members of Payments Canada” line item (which is a measure of reserves the financial institutions have with the Bank of Canada) below $100 billion for the first time since the Covid-19 pandemic. As the current $248 billion stack of government bonds, mortgage bonds and provincial bonds get bled off of the Bank of Canada balance sheet, there will be a corresponding drop in bank reserves held at the Bank of Canada. This is not a fast process – $15 billion is scheduled to mature in the remainder of 2024, while $32 billion is slated for maturity in all of 2025. While QT is still ongoing, it is at a glacial pace – hence, “a little bit of QT”.

My reading of the tea leaves makes me suspect that the Canadian currency is going to get pushed down further in relation to the US dollar. Canadian exporters should benefit from the upcoming shift. I also do not view this as beneficial for the domestic economy. There is not a lot of safety out there and cash continues to earn a very good risk-free rate while patiently waiting for the capital values of various entities out there to implode in some sort of panic (the last one being 4 years ago with Covid, although I am not anticipating anything with that magnitude happening again in my lifetime).

The only question that remains is whether we will see a bounceback in inflation. Given the million+ increase in demand for housing in urban areas without a corresponding increase in supply, I do suspect that the most heavily weighted component of the CPI will continue to exhibit an increase. A lower Canadian dollar will also result in costlier imports. Finally, labour inputs are also increasing – wage growth provisions in contracts are rising and here in BC, minimum wage is now $17.40/hour – and correspondingly, your “extra value meal” at a fast food joint is now at least $10, and that’s with a coupon! The wage-cost spiral is a very difficult one to break without a deep recession.

It is difficult to passively wait, but I don’t see the risk/reward for moving up the risk spectrum that good right now. Even the oil and gas sector in Canada with current commodity prices are trading at valuations that are “blah” rather than being a great value.

Any sectors out there getting your attention?