Monetary Policy Around The World

Monetary Policy Around The World 

Today, I'm going to briefly comment on a few monetary policies that I find interesting for various reasons. Either they've done something different or there's some abnormal idea that comes from their situation.

Including: Brazil 1, Canada 6, Japan 2, Poland 4, Switzerland 3, & The United States 5.

And some global commentary & energy comments.

***SARCASM WARNING!!!***

Brazil

Brazil is a *fun* one... they went way overboard with their hiking (in my opinion) and took real interest rates to nearly 10%... yes... that's 10%... REAL. That said, the leverage in their economy is fairly low vs many more developed markets. Still you saw the ripples globally when international companies like Nutrien essentially said it makes no sense to invest in retail in Brazil because the immense cost of working capital destroyed their margins.

But look, with Brazil's history of inflation, I can understand why they panicked with such extreme hikes. I don't think it was necessary or helpful to the people of Brazil. It has probably been a factor in the sustained strength of the Brazilian currency.

Now however, inflation has rebounded on a year over year basis back above their target, with the last half year would be well below.... Despite this rebound in headlines, they're easing. They've now cut their interest rate by 100 bps in the last 2 meetings (50 each). It's still insanely high at 12.75% vs 4.6% headline inflation. (Heading towards 5 on base effects) Headline will probably be in the 2s or 3s in a few months. I think rates need to fall by at least +600 bps to be reasonable and they'll probably fall by +800. The high cost of capital is a hindrance to local businesses and favors large international players with cheaper money who can undercut locals due to better financing terms.

It's a weird mix of early panic unlike much of the world... and now, even thought inflation is higher than Canada for example, they're more aggressively easing why we all freak out about similar misses to targets. (Literally about to see 5 vs 2-4 target vs Canada at 4 vs 1-3 target)

Japan

Ah yes Japan... the answer to the question of, "Whose data should we ignore to keep pretending that the old thinking makes sense?"

Japan didn't raise rates at all in the face of inflation... so by everything I've ever heard, people should be borrowing money at real negative rates to spend... inflation should be accelerating and sticky etc.

Well, it's fallen from 4.5% to 3.2%... despite the currency taking a monumental beatdown. I could make the argument that if the rest of the world hadn't jacked up rates (potentially needlessly) and Japan's currency hadn't been slaughtered, their inflation would probably be even lower... by that line of thought, rate hikes may not actually bring down inflation. All the inflation comes from foreign rate hikes hitting the currency. So if they didn't need rate hikes to tame inflation... what if others didn't... and didn't hike. Then you'd have this bizarre 'impossible' scenario where inflation falls everywhere without anyone hiking. To the "that's impossible, it's not how inflation works" argument that some are certainly thinking... check out what happened after the second world war... exactly that.

Sure it's still above target and higher than in many years. As I mentioned, that's probably partially on the currency. Another element that's almost comical is that Japan is actually stimulating their economy!!!

A point I made long ago is that if cost of living goes up more than incomes... the increase in cost of living isn't sustainable. Higher prices would revert. Japan on the other hand... it TRYING to make their inflation sticky. So they're trying to have their stimulus offset the unaffordability of increased prices... to try to make their inflation stickier. Still, inflation is cooling. The multi-month trend is something like 2.4% annualized... despite the murder of the YEN, lack of hikes and the stimulus. More than 2/3 of their inflation is food (which has global prices and has recently been slowing). Tokyo Core CPI has declined to 2.8% YoY... Not "Solved"... but enough to confuse A LOT of people.

On the subject of sustainability, that's why I was adamant that a lot of the inflation we were seeing would abate (be transitory). The causes were one off factors almost across the board. The stimulus, the supply chain, the prices going from desperate seller to incentivizing supply. the rate of change on none of those was sustainable... not at 0% interest rates or 15% interest rates. Stop paying people to not provide supply, fix supply chains, let incentive prices bring on supply, let the tech companies layoff labor to rebalance with the other sectors and the inflation virtually stops. If something isn't sustainable... it won't sustain. Some countries panicked... and raised the cost of production (making some of the inflation stickier than it needed to be... others didn't)

But here's the distinction that western economists cling to... unemployment. It MUST be that Japan has enough slack in the labor force that wages aren't a problem for cost push inflation and rising prices. Yes, it must be because... Their... ummm... 2.7% unemployment rate provides ample slack.

But let's just go on believing that you NEED to raise rates to bring down inflation. You NEED less people employed to stop it too.

Switzerland

Switzerland, the debt capital of the world apparently, didn't 'need' raise rates much. They only took interest rates to 1.75% and inflation is back down to 1.7% from a near 3.5% peak. Ok...

In a bizarre fact for the "well people would just borrow to keep spending theory" Swiss inflation peaked while interest rates were still negative.

It's almost like low interest rates prevent inflation. (Obviously that's not correct and there are numerous other factors... but if you look at supply and demand from the bottom up, there's something to this.)

It wouldn't surprise me if they're back to 0 rates and fighting deflation again in a few years. It also seems difficult to get there.

In an inexplicable turn of events to the "interest rate differentials drive currencies" crowd, despite this lagging on rates vs the rest of the world, the Swiss Franc has been too strong if anything... yeah, I don't know. I guess maybe, just maybe, you don't need to murder your own economy to save your currency.

Poland 

Poland made headlines a few weeks ago by making a later than expected rate cut despite headline inflation being a whopping 10% YoY!!!

That seems insane until you realize that over the last 4 months their combined inflation rate was -0.2% (-0.6% annualized). 

The currency did take a hit on the surprise scale of the cut. That's gotta be expected as markets react to news. What I'm curious about is if it means persistent bleeding or if that was a one-off readjusting to policy. I think many places think they're locked into bleeding out their economy because if they don't inflation will persist via the currency. That's... in my mind the only rational reason some places can even consider more hikes at this point. If a early actor... (Poland) can disprove that it would be good to know globally.

Hence, I'm instantly rooting for Poland.

This was particularly interesting due to the high headline number and the fact that interest rates remain well below it. My belief is that the rolling off of high comps will make headline inflation fall despite the easing. What I don't know is if it will fall to 0, negative, 2, 4... whatever. It is very likely that it'll look much more reasonable... and it may be fun to poke fun at traditional thinking about what central banks need to do in order to tame inflation as inflation falls along side rate cuts after real rates were never even positive to boot.

United States

The US's mix of high debt and high duration mortgages makes them positioned differently from the rest of the world. Higher rates are passing money from the have nots to the haves. Interest on government debt is helping stimulate the economy to counteract some of the higher rates. Mortgages aren't resetting at higher rates so new slowing is only on incremental mortgages.

I do think that they're still feeling negative effects of higher rates. The term risk is heavier on the banking sector, and the banking sector is the transmission mechanism for money through the real economy. They're also not immune to changes in global demand.

Inflation measures are so obviously lagged that it's a bit of a joke to look at headline numbers. It missed the entire down cycle in rents/OER while still catching up to the last up cycle. The largest component in CPI is only now essentially caught up. Where it does next, I don't know but the momentum has cooled well beyond what is currently measured in CPI. It may still be moving higher as a category but much slower because changes in the situation aren't amplified by broken supply chains and stimulus.

One thing that has seen only minor discussion in passing is the MASSIVE surge in capex in the United states. Capex is short term inflationary, long term deflationary... It takes a lot of money, spending and labor to build something, then less labor to add supply which pushed XYZ prices down as the cost of the plant is paid off. So as that capex becomes opex, it's another headwind to inflation.

I think inflation is heading lower to the mid 2s probably. I think that would and should be enough to stop hiking. We'll probably have to watch from there. I think there's strong underlying demand but with the pressure on the banks from the bond market, prices are now effectively so high for anything that needs to be financed that demand is being deferred.

I think stability on the rate front and time would allow mortgage spreads to come down making even these rates less cumbersome. 

Canada

Most of my other pieces reflect on the BoC so I'll try to be brief.

All our problems are self induced stupidity. 

Trying to satisfy a 1.2M population growth with 250k housing units because we keep attacking our housing development & affordability with rate hikes is beyond insane. That's WHY our rent inflation has started exceeding the US.

The top 2 causes for inflation are what we do to fight inflation, so we're hoping to break other things to more than offset the damage we're doing with our actions. It flies in the face of logic and bottom up economics.

Why? Because people seem to think it's the only thing we can do... I'd think "if you're in a hole, the first thing to do is stop digging" but what do I know.

We should have stopped hiking 8 months ago... we'd have more housing supply & less rent inflation... less mortgage interest cost inflation. If we had food that was in line with global averages at the same time (instead of our Canadian supply management + carbon tax special) that would be another 0.5% off inflation taking us to a very reasonable roughly 2.7%. (4.0 - some food, MIC & rent). I'm sure some would argue that those are causing price reductions elsewhere... I mean that's not what's happening in the rest of the world... but hey if it fits conventional economic theory... let's go with that.

You know, if your goal is to reduce sales volume by killing demand... that also requires sellers to get higher prices to operate... But that's another can of worms.

But... because we've committed to absurdity as a policy... it looks like we're going to hike at least one more time. More developed projects shelved to help rent inflation.👍

Globally

Reshoring was an interesting story coming out of COVID. I think some of the deflation we're seeing out of China comes from the slower growth and overcapacity from supply chains shifting elsewhere. I don't know where China goes from here but remaining overbuilt with a declining population has me questioning what their economy can do. Even a highly managed economy and currency may have trouble with such a large pivot.

I think this is what's causing the big boom in Mexico and US-Mexico trade. With labor tighter in the US "as the narrative goes" Unions are trying to exert their force. Honestly, the ask on this UAW stuff reads "fire us and go to Mexico but I think they may be not quite seeing that as it often seems like professional socialists (unions and further left political parties, have this amazing hole in understandings of economics... or at least pretend to.

Energy Crisis

Some would suggest that an energy crisis will lead to sustained inflation. There could be one which could prolong inflation. I don't believe there has to be one or that it'll inevitably lead to prolonged stagflation. Many places can produce a lot more at $80-90. Canada can add a bunch next year when new pipes come on. People might argue that no one will do crude by rail due to the increased cost. Crude by rail is currently 100kbbl/d down from 400k/d. I'm just going to say that if someone thinks oil will spend any extended time at +120 and Canadian producers won't ship crude by rail because of a $15 discount, I'll take the other side of that bet. Similarly, I know people argue that demand is inelastic but on the margin that's nonsense. Oh, I didn't even get to Brazil or Africa when talking about supply growth potential. Price and time solve this, at some prices there are unsolvable deficits. At other prices there are unsolvable gluts. Meanwhile, recently we've seen Crack Spreads normalize for gasoline... Finally. So yeah, if someone decides to really break S/D there could be an issue. Absent something extreme, we don't need much more energy contribution to inflation before a lot more production can start progressing.

Was I Wrong?

Was I Wrong about inflation being transitory? Yes & No. I mean we've seen in both places that jacked up rates like crazy & places that didn't, inflation come down quickly without too much stickiness. It's also lasted much longer at above target levels than I was thinking. Even now, we've fallen lower and further than the 70s (what some of the sticky crowd feared). I think we could have handled so many things better. If you recall I was critical years ago that they kept blasting QE wayyyy too long. I was also bullish on inflation back when we were handing out cheques & commodity prices were too low. So I guess I'll admit to not predicting the second wave (the war) but even with that or absent that, I think we'd have been even more transitory than the mostly transitory that we got. I also missed the impact of broken supply chains and the second wave of COVID in China.

I was early also in suggesting that rate hikes wouldn't help (which will always be debatable either way). Slowing supply doesn't fix a supply shortfall. Not in Lumber, Steel, Energy, Housing, you name it.

That said, one thing I absolutely got wrong is that rates got here. I still think there's no reason for them to be this high and that they aren't particularly helpful on the inflation front. I thought we may get to 2.5 or 3 percent but am shocked at where we got and still not definitively stopped.

END

How naïve I used to be... thinking that investing was all about buying a good company at a good price. In truth, a good company at a good price can be a terrible company at a terrible price when the people in control of the decisions above triple interest rates to force a needless recession. So much is so arbitrary, so often.

I leave you with a question. Is economics a science, a pseudoscience, or a giant appeal to authority?

Disclaimer: This is not investment advice

Canadian Market Outlook

Canadian Stocks

Maybe you've heard... Canada isn't in a great place. Interest rates have started biting the Canadian economy & without a change in course, that will get worse by the month as mortgages reset for the next 2-3 years. Further still, the Bank of Canada is still deciding if they want to make it worse or not.

Productivity is bad & inflation has been staying higher than wanted. We should probably be in a pretty bad recession already... which should in turn cause worse damage and rate cuts, further damaging the currency... causing more stagflation etc etc etc....

But we're not... and honestly the same reason we're not is why we might not. Population growth.

People want to blame population growth for stress on the housing market and rental affordability. The reality is they're bailing out a financially sinking (because of increased rates) property owner. The fact is... and many people need to hear this... despite the averages "Top 10% salary can't afford the average house!!! (*with no trade up equity and average heavily weighted by most expensive markets... but let's avoid talking about that*)" and what you hear about Canada, Toronto and Vancouver. You can still buy a brand new 3 bedroom, 2.5 bathroom house for 450k (USD$330k) near Calgary, Edmonton, Regina, Saskatoon, Atlantic Canada etc. That's because despite the "immigration making housing unaffordable," when builders can build, prices follow the cost of production. As a reminder, this is EVEN AFTER a decade where "low interest rates made housing unaffordable." In my opinion, at 2.5% interest, $1800/month as a mortgage payment on such a home is affordable. Immigration is obviously not the problem... but it does amplify what the actual problem is. The actual problem being the time, cost and difficulty of building. Also, it's crazy how many people will complain about affordability but when given 5 affordable options, look down on those locations in some form. The averages are warped by people's perceptions about frankly what's not Ontario & B.C. Another issue the MASSIVE take governments reap from inflated land transfer taxes and other such costs. The problem is almost entirely artificial and self induced. Population growth is bailing out our economy from home made stupidity. It's 'easy' to point the finger but it's not the problem. Same with "low interest rates."

Recession or Not

I don't know if we enter a recession. GDP growth has sucked for 6 months & could easily slip negative. On the other hand with adding 25k jobs per month (probably hurting productivity) we've already added 0.5% to our unemployment rate. By year end, that could easily be 1% off the lows without a recession. If we had 0 job growth, unemployment would rise 0.2% per month which would be a similar pace to the GFC. If you believed that inflation was caused by tightness in the labor market... this sounds deflationary... even adding 25k jobs per month sounds deflationary. Also, if we're going to look at wage growth with immense fear "omg still 5.2%" well, I believe we are about to witness some favorable base effects in that regard. 

In the last 8 months January to August, wages went from 33.01 to 33.47. In the last few months of last year, wages went from 31.67 to that 33.01 in January. That's a 1.34 increase that gets lapped vs a 0.46 increase over the majority of this year.

In any case, recessions are transitory. Plus, most of the time by the time everyone agrees it has arrived, the market is looking past it.

We're already in a non-recession... recession.

Believe it or not, I started this not really wanting to discuss macro factors. I wanted to talk about some stocks. I did however want to make an important point. That is, in the discussion about Recession... economic collapse... bubble bursting etc. It's important to realize that the pain & stress is already being felt. We are adding growth potential... companies are adding long term value... the economy is stagnating for now but adding potential. We're not growing but in suffering this (higher rates and higher unemployment) without collapse... we gain the potential value of; 

What if yields normalize at inflation +50bps... 

What if more people find jobs... eventually 

That could mean higher growth, higher cashflows, higher valuations.

I don't like the near term Canadian economy... and think there are real risks there but also think... to use a horrible cliché... what doesn't kill us, makes us stronger... now the key of course is... not dying. (Or suffering permanent damage). I think we need to look South... and West... if the Fed can be done and investment in Oil can bail out our currency we could be surprisingly ok. If the Fed presses onward and our currency gets caught between a rock and a hard place it could push a bad situation towards a very bad situation.

Banks

Ok so... housing bubble... inverted yield curve... possible recession... economic stress etc... who in their right mind would go out and want to buy bank stocks? That's a valid question that many are probably asking. I don't have a good answer... or I should say wouldn't have a good answer if we were talking small 1/10000 banks at full price with marginal equity cushions.

In Canada we have maybe 10 worth a look... 6 that every Canadian has hear of... all heavily regulated and capitalized like a GSIB ( Global Systemically Important Bank) most of these have been adding to their PCL (Provisions for Credit Losses) aka reduced earnings and is at a P/B multiple comparable to COVID or mid GFC. So yes... we may see the implosion of the Canadian economy through gross incompetence... but a normalization of bank performance over the next 5 years could generate something like a 25% IRR... from owning the big banks. That would mainly require enough population growth to avoid a Recession. 

The Canadian banks have been around for many years:

Bank of Montreal 206 

Bank of Nova Scotia 191 

Royal Bank of Canada 159

Toronto Dominion 68 [merger of Bank of Toronto (would be 168) and The Dominion Bank (would be 154)]

Canadian Imperial Bank of Commerce 62 [merger of Canadian Bank of Commerce 156 & Imperial bank of Canada 150]

National Bank of Canada 164 (or 43)

Not to mention Laurentian Bank which has achieved much less in their 177 year history. 

The point being that these banks survived the great depression and the GFC along with 20% interest rates and many difficult environments. That's not to say that they're invulnerable... but they are pretty resilient.

Canada doesn't have the same MBS problem that the US had in 2008. We also regularly have 1/5th to 1/10th the mortgage delinquency rate of the US. Further, a large percentage of mortgages are insured or have a large equity cushions. Then remember we've already seen some decline in construction as prices don't satisfy return thresholds for new supply. 

What I think happens is somewhere in the middle. A few years of reduced earnings before gradual improvement. I don't think dividend cuts are likely so when I run through some possibilities it's an area that looks interesting from a DCA, collecting a few shares perspective. Particularly because my portfolio is light on the yield. I don't like buying things exclusively for their yield but I think that in a few years those dividends will return to growth in that environment I think there's relevant capital appreciation potential.

Oil

There's a lot to like about Canadian oil. (...but)

Maybe OPEC extends cuts or is near their production limits... maybe the Permian has peaked... maybe the Canadian dollar falls apart. I honestly have no idea... but with a bunch of these companies continuously saying they can make money at $45 oil... I continuously wonder why they aren't putting even more capital to work at $70+

In Q2 we had 10.4B of capex... that was the third most of any quarter since the big oil collapse of Nealy a decade ago. Plus, now their balance sheets are much stronger. Capex is still at roughly half of last cycle. Frankly as a Canadian & someone with significant investments in Alberta, I hope the capital keeps going in. The alternative is basically worse on all fronts.

The problem from a stock perspective is that the volatility of earnings and the depletion type of business isn't necessarily a good long term idea. Now they can grow assets and long term value quickly but that won't always be the case. Investments currently pay back quicker and leave income streams beyond that so it makes sense to invest... and leave the company with more residual value when it no longer makes sense to. This won't remain the case forever because it's a cyclical industry. That's why for energy companies I think one metric that you can't lose sight of is book value. If an oil company trades at 2x book (it's more so asset value than book but...) it might be possible to put a fresh $1B to work and have it be worth $2B. Eventually someone will do that. Whether that's capex from an existing company or a pool of investors putting their dividends to work or a management team with their buyout proceeds... it doesn't matter someone will eventually do it and make a ton of money. Doing it sooner will allow you/your company to make more of the excess profits... doing it later is more likely to miss some excess profits...that's the only difference. Maybe the company can quadruple it's long term value first... maybe more or less is lost to taxes, maybe it takes 1 year, maybe 10... maybe price goes high enough to reduce demand... maybe price is flat... I have no idea but eventually the investment gets made... and at a company level it makes much more sense to do it early.

The stocks are probably a decent hedge for more pain in Canada but too much pain here or globally can backfire in many ways. I like the sector and think there's a lot of profit left to be had in Canadian Oil. I don't think it's as cheap as some nor am I a believer in sustained $100+ oil. But I think the sector is well positioned especially for as long as Saudi wants to give up market share.

Rails

One area of interest for "permanent capital" in Canada might be an investment in one (or both) of our two railroads. Ideally an entry point with a mid teens multiple starts getting quite interesting from a long term perspective. Both rails have been around nearly 100 years and stand a shot of being around for another hundred.

Grocery Stores

Grocery stores are another Canadian oligopoly that's been moreso in the news recently. On one hand I believe they're very stable business and probably have some upside with population and GDP growth longer term. That said, I've continued to be skeptical that the recent pace of growth is realistic. These are very low margin business. That means they do and must pass on price increases quickly. So any nominal price increase that's not their fault results in earnings growth. The hilarious irony of our current government blaming grocery stores for higher food prices is that their very carbon tax has pushed the cost of food higher... and... higher nominal prices mean more profit (although a similar minimal margin). Then the government threatens 'take prices down' (they can't) "or we tax them more." Which could arguably push prices even higher. Before I turn this into a political commentary I'll move on.

The good news is that 'whatever' the factors that pushed food prices this high, globally, food inflation is fading HARD... at least... good news for us, perhaps less for food stores. Supply has responded to higher prices. Part of this feeds in to why I suggest inflation is likely less of a concern than some suggest. Food inflation at 7.8% YoY is roughly 1.2 of the 3.3% add in 0.8 from mortgage interest cost... both of which should quickly roll off should more than offset some rebound in some other components. In fact most other components that went up as quickly as food eventually saw negative YoY numbers. Then figure that if inflation was deemed to be under control, and rates were reduced, that +0.8 could flip to negative too... then new development makes sense and rents don't need to increase anymore... more inflation gone.

Reflexivity. If we believe inflation is gone it will be (with some time). If we keep creating our own inflation it'll stick around. (Higher rates = inflation + need for higher prices = inflation= taxes = higher prices = inflation= rate hikes = inflation.

I got slightly off topic in my attempt to say that food price inflation disappearing will likely mean slower growth for supermarkets. But with reasonable valuations I think the outlook is fine.

Utilities

The utilities and pipelines are another interesting sector. They have been double hot by the rise in interest rates. The highly levered utilities now face a wall of more expensive capital upon maturity. They also face the fact that with higher rates and the availability of yield on GICs, there's less value/demand for high dividend stocks. This is a similar challenge for real estate. Both may now be in a position to reset with a new baseline of assumptions which they can perform against... in other words, if rates peaked and decline, you get the revaluation higher & improved cashflow fundamentals from lower refinancing cost. I think we're somewhere in the repricing. I don't think all of them have fully priced in higher rates persisting but I think most are in the process of slowly assuming that maybe rates will remain a bit higher for a bit longer. I don't think they should fully price in higher rates (that view comes from my personal opinion on rates). The more that they do price in, the more asymmetric the investment. The companies are mostly fine but the appeal of the price of years ago wasn't what investors hoped. There will probably be a stretch of less growth while debt is managed. It's a place where there's probably some time but may be worth picking up some long term holdings over a few years.

REITs

Real estate is in a weird spot. From a price to book/NAV perspective, it's extremely cheap. (There's a rather significant discrepancy between public and private prices.) From a 'I can get a 6% GIC' perspective... less so. 

The two things that matter most are interest rates and NOIs. If rents/incomes keep rising then existing debts can incrementally be retired and long term values can be fine. If occupancy or rent falls then we have a more complicated situation... especially if funding becomes more expensive.

We haven't seen yields like this out of REITs in many years. It is possible that they stay here... or are cut. It's complicated and can't be answered with blanket statements. I suspect with catch up rents and incremental deleveraging, the new set of expectations is probably pretty low. The discount to NAV simply means they are much cheaper then their private/I traded alternatives. They may or may not be extremely cheap... it depends where interest rates settle.

Miners

At the risk of repeating myself, mining is a difficult business. While not apparent in the same way as for REITs and Utilities, miners are similarly worth less in this kind of environment. Inflation = cost inflation too. And interest rates make the capital more expensive.

On the other hand, and this is something I've been mentioning for a while but goes directly against traditional economic thinking... in commodity -like capital heavy industries, capital is your most. It's not a great moat and it will be overcome eventually but it is some moat. This is because you need (Risk free rate +) for the investment to be worth it. The more capital costs, the bigger that number needs to be. Higher rates need higher prices to get the same returns... and higher rates mean even higher still prices are needed to justify taking the same risk.

I want to be clear, I'm not saying higher rates are purely Inflationary... they remove capital availability too (that's deflationary) what they do is make people poorer and life less affordable.

Gold, I don't have a strong view 

Silver is roughly fair value

Copper, I'm bullish on demand longer term but think price is higher now than bulls give it credit for & has two way risk short term. My history has taught me that you really only need to buy these when the metal has been flushed.

Lithium there's very little on the TSX but I'll say. Lithium price was ridiculously too high, it's now decently high. It's demand longer term is pretty obvious but I'm less sure how much that translates into price from here. Most companies can make their projects work with prices at half of current levels, so the odds are pretty good that eventually prices fall by more than 50%. Maybe the stocks make 1000% first, that I don't know.

Exporters

One area that I think has more potential is export companies. In the Oil segment, I mentioned in passing that maybe the CAD falls apart. A weakening currency would be a tailwind to companies that cost in CAD and sell in USD. It's funny actually, the other day, prior to a discussion that got to this point, I saw someone tweet a weird boast. They said they converted a bunch of CAD to USD at 0.65 back in the day but that's good because now they have USD investments that give them USD cashflow. I immediately thought... ok... why not just own Canadian businesses that sell into the US (oil qualifies) if you want protection against a falling CAD. It's hard to find many pure-plays of this as most have diversified operations as well as sales. Still, at present it's a more interesting area because A: you don't have to deal with struggling Canadian clients... B: if the currency sucks more, you're hedged as margins should improve.

That said, I don't know if I've ever gotten a currency related trade right... there's always more to it or expectations than what I imagine and I have no idea how to measure prices or what the market is saying. There's economic strength, rates, trade, inflation and so on already built in and evolving, most of the time I just figure, currencies go up, currencies go down... I'll never know why. Even still, there are times when I appreciate a more global sales exposure & other times when being regional is nice.

'Cheap'

On a price to earning basis... as well as a price to book basis in many places... the Canadian market looks cheap. Or at least, cheap relative to recently or relative to the U.S. That is however, not the be all end all of security analysis (despite what some may say). It's the market's message that current earnings or asset values are in danger. Maybe that's transitory earnings capabilities, margin normalization, pending recession-related losses, maybe end of cycle pricing...etc

This pessimism may or may not be misplaced. I would suggest that, commodity companies and tech stocks shouldn't trade at similar multiples. Asset heavy businesses have growth constraints that other companies don't. Being that capital and balance sheet capacity is often the limiting factor, the risk for such business is often tied closely to marginal changes in the economy. I mention this because Canada has a lot of asset/balance sheet heavy businesses. First and perhaps most relevantly when looking at Canadian stocks... the banks... then oil etc.

I think that a lot of Canada is set to perform well at some point but I think things need to point in the right direction first... or at least stop pointing in the wrong direction. This can be especially annoying because some things are moving in the right direction but sentiment is not and has capped them. There's a lot of torque in the Canadian market's earnings. With bad things happening they can easily fall a lot more that the US and that what central banks keep trying to cause. If we could get past that to an actually good economy like the late 90s or mid 00s the entire picture can flip. What is now '20% discount to book because of losses coming' can become '2x a 40% higher book' the difference there may be 2 or 3 x in earnings multiples (more in some cases) but 300% in stock price. We could be at the start of a decade of outperformance or the start of a multi year brutal underperformance. I think the current expectations are skewed to the pessimist side, but I also think at these rates, our economy is in an awful position in the short term.

Bonds

Bonds are tricky too.

I think short rates need to move lower... but I don't know if they will. (Yes you heard that right)

I don't think the long end needs to go lower... but I can't bet on the front end going lower without thinking the same event would push the long end lower.

I also don't know when or how much because the whole thing isn't a bet of what should happen or what makes sense, it's a bet on the choices of parties that seem completely illogical. 

I don't believe low rates are bad. I think there's a massive "back in my day rates were" bla bla bla ... "those were the good ol' days of 11% unemployment and 10% interest rates when we nuked our own economy because of an exogenous oil shock," out there by people in positions of authority. When you get into logic of how rates actually helped anything be better back then, the arguments fall apart... they turn into "well if nobody could afford it and everyone was struggling then things would be better for everyone." The honesty of the matter is most people should just say "I want to make 5% on my money for taking no risk; because I have money."

The problem is, with today's taxes, costs, demographics etc I don't think the country functions at +3.5% interest rates. I think it leads to very bad things, economically, socially, politically etc. I also think that things are comparatively fine at 2% interest. We could have great growth and prosperity without problematic inflation.

Any prediction needs to be a mix of will and should... so if I were going to make one it would be something like: YoY is probably almost 4 before October data... so they may panic and do one more hikes before realizing in ~March that inflation is falling very quickly and by ~April that they're way too restrictive. Then they start cuts around then... probably (as I mentioned above), once they start cutting there's probably a long way to go. Probably +250bps of cuts over many quarters because they'll stay concerned about a rebound. However, this basically assumes they act like headline chasing trained monkeys. If thought goes in to other data, they could easily move the timeline up 3 months... I mean if they really were concerned with data they could move the timeline up 8 months... but evidence suggests that's unlikely.

Wrap Up

When I talk to people, many seem to think we are in a lose lose situation. For lower rates, they believe we need a recession. A recession has historically meant catastrophe earnings felines/losses by sensitive companies. In other words it is believed that companies need to do poorly in order for the pain & unsustainably higher rates to end. I don't know if that's accurate. It does seem to be what the market is looking at in a few places. I think Canada is buffered by the ability to export to the US... and simultaneously at added risk because of Currency on imports. Buffered by population growth and at risk because that masks the true pain some are experiencing. This might mean no recession or a very mild one... or cause the BoC to go massively overboard and do severe damage. I do think that there is a tremendous amount of pent up demand in some of our more rate vulnerable areas. The incremental relief at some point could do wonders.

Everything is to a large degree... interest rates. So far that has been a running shock. In some ways the economy handled it well, in others we've handled them terribly. Led by our debt and mortgage resets I think that rates are already too high for much of the country. I've given up on believing that what should happen will or that there's consideration of factors beyond headline inflation. There was plenty to suggest that we should have stopped before 4%... it seemed insane to resume after the pause at 4.5... they did. So yes, I think we've gone far further than necessary. If food reverted to global averages and we excluded Mortgage Interest Costs we'd have BELOW target inflation... I digress. Other parts of the country/economy are completely survivable and doing fine. The yield curve also matters, what discount rate is used? 5% or 3.5%. The higher a number you can make work, the better the odds of success. 

That said, if you're asking my opinion of what eventually happens. 

Let's look at it this way. The people who currently own the 10 year bond at 3.65% probably think that short end rates are going lower (if not they'd roll short treasuries). When that happens they believe that long rates will go lower and long bonds will become more valuable. In other words, they expect long rates to drop and short rates to drop to an even lower level than that lower long end level. So a 3.65 10 year is probably a suggestion that the short end may go to 1-1.5% and the long end would be 2-2.75% or something. This is basically what bulls of the 10 year are thinking. If that happens, real estate and other supply can react, affordability can improve and the economy can function properly. The one thing preventing us from getting there is patience (inflation). I say patience because, there are no signs of a wage price spiral, the economy is incredibly clearly not overheating... so what we need is time for the volatile/incentive prices to roll off and stability to return to the supply side. You know, it's ironic that central banks claim they want to achieve price stability yet their actions are essentially trying to crash some prices thereby creating volatility.

We're clearly not overheating... we may be stagflating but I think at some unknow point the Bank of Canada will regain sense and stop intentionally hurting the economy. On a lag from that point there are a lot of companies out there that to varying degrees are pricing in the pessimism that I spoke about. I don't know exactly when the point of peak pessimism will be but keep trying to look beyond that at the 'next cycle' and think we're starting to see some interesting longer term prices.

Canada may not be in a great place right now... but you really can't find many people that think it's doing too well... and it shows.

A Few Points About Local Inflation

 

Inflation Update

On so many levels I hate that I still have to write about this. Yet, I do feel like there's more to be said... And a number of repeated points that some perhaps haven't adequately considered.

The inflation target in Canada is a range of between 1% and 3%. People call it 2% and I won't fight much with that definition as it is the center of the range.

If I said to you that we've had an unexpected bounce back in inflation, you might look at me like I lost it... after all inflation looks like this:

Canada CPI YoY

But I believe we have.

The leading inflationary force in Canada is (drumroll please) Mortgage Interest Cost... That's right, cost of living is being most increased by the brilliant measures we use to stop the cost of living from increasing. This measure has increased so much (more than 26.4% YoY) that it now accounts for 0.7% YoY (according to statcan, my estimate was slightly lower) according to the CPI. Or more than 15% of all 'inflation'. (To the Americans laughing at our stupidity, may I refer you to OER) Luckily we seem to have started to recognize this as a society. Six months ago my frustration with the situation had me feeling like I was living in a different universe.

Yes that means interest rate hikes is the most significant inflationary force in the country by a wide margin.

Producer prices aren't part of the CPI or what's considered inflation by many but it is an interesting signpost. If producer prices are going up they're going to need to increase prices to stay in business. They were going up a lot... Last year. Since then however, PPI inflation got transitory in a big way. Prices are down over many timeframes. This doesn't immediately translate into CPI falling but it at least means that businesses don't have to keep raising prices and can flatten/reduce them. Margins can neither be too high nor too low indefinitely.

You decide for yourself, this is PPI, now +1.4% YoY

I'd call that transitory.

Wages 

Wages which aren't measured in CPI, have been more rounded. They actually ticked lower in march and not simply in YoY terms. 33.12 in March (5.3%) vs 33.16 in February (5.4%). This didn't keep up with CPI last year so in some ways it's not surprising that it remained above trend. Despite this, this measure of wages is hot. Wages would need to remain flat until the fall for it to normalize.

Base Effects

Now we're approaching a strong period of inflation from last year meaning a time when base effects should be a significant help.

Last year May, June, July had, 0.6%, 1.4%, & 0.7% inflation respectively. Which means if each month comes in slightly hot this year (0.3) inflation would fall by 1.8%. at 0.2 average it would fall by 2.1%. Both of those scenarios would put it back in the target range. That's without accounting for adjustments related to Mortgage Interest Cost or Core vs Non Core inflation. We could realistically have inflation (ex-MIC) below 2% this summer without a recession.

However, if we put in another quarter like last of 1.4% inflation it's more complicated. Although the number would be 3% including a significant amount from MIC, I'd still be disappointed vs expectations from 3 months ago. We'd lap the biggest reason for optimism and as far as I'm concerned then be looking at more of a risk of inflation stickiness. 

I just keep looking at inflation post May or June. After May's results, the leading measure of inflation will most likely still be Mortgage Interest Cost. Flat from here would be ~25% YoY or still ~0.6%. Yes, it's technically part of 'core'. Bank of Canada stated they expect CPI to be ~3.3% in the summer... So roughly 1/6 of which is MIC... Or roughly 2.5% inflation with rates firmly in restrictive territory. That's not 'so bad'. Is it high? Technically slightly yes. Is it sticky? Maybe. Is it a recession? No.

The problem is, that's all I've got... I was very much saying and thinking that inflation would be highly transitory. My belief was that would be largely the case whether we raised rates at 2.5% or 4.5%. The shock was going to roll off. The supply chains were going to improve. Those elements were completely predictable and the disinflation was probable. When we hit June data, if we're not THERE... The incremental small step lower will be difficult. July onwards the base effects reverse and you could see a step up in inflation.

There's enough noise in the data lag and enough slightly pent up inflation and deflation beyond that point that I honestly don't have any idea which way it goes. I don't know if it matters, but if we're going to make it matter, I don't know the solution.

I think the debate will become, "How restrictive do we need to be around 2.5-3.5% inflation?" 3.5% probably means higher for longer but what would 2.5-2.75% mean. It's within 'the range' and rates would be fairly restrictive (positive real rates). That could go either way. Lowering to 4% or even 3.5% would still be technically restrictive but might spur some acceleration which might reverse the intent. On the other hand there's the risk of sustained higher rates doing further unnecessary damage to growth.

If there's an answer, I think it will come with wages. if wages are flat or falling over the next 3-6 months I believe we'd be much closer to an easing bias. If wage growth is in the 4s it's probably more 'on plan' and if wage growth is still in the 5s there might be more concern.

Annualized Different Periods

If we annualize different stretches and examine inflation over them, I believe it's easier to see my lack of immense enthusiasm.

3 Months: 5.6%

6 Months: 3.2%

9 Months: 2.0%

1 Year:      4.3%

Now I could argue that seasonal adjustments would make the last 3 months 0.3, 0.1, 0.1 instead of 0.5, 0.4, 0.5, but I generally don't love seasonal adjustments so I won't say too much about it aside from, "there might be hope."

Food

To date, Food Inflation has been mocking me...

It may have rolled over but the lag between it and the roll over months ago has been high on my radar given my holdings in the agriculture complex taking hit after hit on pricing while "food inflation" has been a non stop talking point. Crop prices are WELL off last summer's levels yet increases in grocery stores and the CPI measure have continued further pressuring rate hike enthusiasm.

I think this part of inflation should come down but if it tracked in real-ish time, it would have already so I can't say if, when, why it hasn't. I can suggest that the margin reparation/expansion of someone in the supply chain means the situation is getting better below the surface. Things are normalizing even if it can't be seen yet.

Shelter

Shelter is a big topic & a messy one. It accounts for roughly 30% of CPI. I could (and probably will at some point) write an entire post about shelter in Canada. The problem it 

1: It's not really discretionary

2: High rates slow supply (at least funding construction via pre-sales)

3: Care to guess which category the +26% YoY mortgage interest cost is part of? Even ignoring that component by itself, what does that do to rent demand... which is also a big talking point on inflation.

4: 4 new residents per housing start is problematic and demand quantity is independent of interest rates

You can obliterate the economy and destroy a lot of lives before having much impact on this problem. You can also make it worse by attempting to 'fix it' the wrong way. If you raise rates to the point where developers are bankrupt or can't develop new residences you're doing just that.

Non Core

People love to mock the exclusion of food and energy from inflation and say "CPI excluding things you actually buy" or something. I get it. I also very much believe that CPI is a bad and lagging measure. In this case however my feeling is mixed. Yes of course those are big components. However, with all commodities, sometimes prices are high enough to incentivize increased production and sometimes they're not. Food and energy prices weren't high enough to be sustainable a few years ago, now they are and that's trickling through in it's own delayed time to CPI. Gasoline crack spreads are through the roof on temporary factors, do you want central banks breaking the economy because of a strike in France? Imagine how much trouble we'd be in if that were the case.

Economic growth

One last point is that economic growth isn't inflation. Arguably it can be the solution for inflation too. the whole bad news is good news, good news is bad news is a pain. Some things matter, I'd say focus on wages, food & rent. If they moderate good news can be good news again. "Slowing down the economy," sounds gentle and all but may have effective limits given supply is also part of the economy.

Conclusion

The headline number is coming down & will likely continue to come down even if we're not in the clear. Food can come down a lot and energy, after April, may well put in negative numbers. There are some outliers and crazy factors (MIC) but most things are moving in the right direction. We likely remain stuck in the 2.5-3.5% range for at least a number of months despite how quickly we've been falling recently. Most of this decline in inflation likely didn't require rate hikes... look at every component where the solution was eventually a supply response. Despite the record and dangerous rate of increases, the damage to date hasn't been as extreme as it could have been. All of the first increase, the recent decline, and the recent resurgent impulse have been largely driven by cyclical pricing factors in global markets. It's still messy, but there's a good deal of hope.

P.S. Now real rates are above inflation, so anyone who believed that was necessary to take down inflation can also claim victory despite the fact that we moved from 8% to 4% without positive real rates taking down inflation.

P.P.S. Hearing Poloz speak about inflation is orders of magnitude more confidence inspiring about competence of central banks than... Some other former governors. Poloz 'Has a feeling' that rates may go lower next and sooner than some think. Hopefully he's right.