“Where We At?”

A note from Rod:

The title may read a little silly, but it is meaningful to me as the writer. A couple of weeks ago, I was driving our three year old granddaughter home from a sleepover at our house. As I was driving, I was thinking about President-Elect Trump’s victory and based on the current rhetoric, “What does it really mean to Canada’s economy or the investment markets in general?” This is when a little squeaky voice came from the back-seat of the car and suddenly blurted out “Where we at Papa”? How ironic! My three year old granddaughter’s words resonated with my thoughts about the Trump victory, economic policies, our currency and of great interest to us (pardon the pun), interest rates. It isn’t a naturally brilliant title but it makes for an important question as we approach a new investing year.

‘Where are we’ in the markets and what should we expect going forward? Since Trump’s election, it has been a very busy time for investment markets and traders within those markets. Trading involves switching credit risk, taking profits and accepting losses, and reinvesting those proceeds into other areas of the market. In the past couple of weeks, we have witnessed the Dow Jones Industrial Index approach 20,000 and the S&P TSX Composite Index approach 15,500. Our “big-picture view” remains the same and very simple; we expect inflation to grow on both sides of the border, albeit at different speeds.

While the daily market update focuses on the stock market, we believe the more important gauge of potential economic volatility are in current and future interest rates. Our article from May 2014 posted on our website www.viewstone.ca identified the challenges of a low interest rate or no-interest rate environment. At some point, we articulated, interest rates would stop going down and would begin to ‘creep’ back upwards. Our thinking at the time (and still today) is that the transition from falling interest rates to rising interest rates would catch Canadian investors and debtors off guard. We readily admit that our timing was very off, as we were calling the current interest rate environment two years ago. Our thinking may be coming to fruition; in the past two weeks, major banks in Canada have raised mortgage rates in a meaningful way.

Real interest rates, as measured by the Government of Canada bond curve from 2 year to 30 year maturities are just a way to gain insight into the how the market views rates of inflation and the direction of future interest rates. ‘Real’ rates are different from federally administered interest rates that control the overnight funding costs for banks, otherwise known as the “Bank-Rate”. Since the US Election, US bond yields as measured by the 10-Year and the 30-year Treasury Bond have risen sharply, as have the yield on the Government of Canada 10-Year Bond and 30-Year Bond. (see Table 1).

Table 1 Nov 8 – 2016 Dec 20-2016 Change
US 10-Year Treasury Bond 1.82% 2.54% 39.5%
US 30-Year Treasury Bond 2.58% 3.12% 20.9%
10-Year Gov’t of Canada Bond 1.71% 2.32% 35.6%
30-Year Gov’t of Canada Bond 1.81% 2.40% 32.6%

This has had an effect on top-rated lenders (banks) who have raised mortgage rates by 35 – 50 bps virtually overnight.

Prior to the election, a 5-year fixed rate mortgage could be obtained at 2.29% and now could be obtained at 2.86%. (www.mortgageintelligence.com). This represents a 26.6% increase in costs. Consider that a mortgage can represent a 25-year investment (the amortization period) and therefore the cost of servicing that mortgage has risen by 26.6% and could realistically stay higher for the entire 25-year term. In real terms, this means that a $400,000 mortgage paid monthly would result in a 6.50% increase in monthly costs from $1750 to $1864. Over the term of a 25-year mortgage, a rise of just over 50 basis points, increases the cost of a mortgage of just over $34 000 from $125,091 to $159,309.

table2Simply stated, the most significant reaction to the Trump election has been the 40+ basis point surge in 10-Year US Treasury yields. The upward movement in yield reflects a combination of high real rates on the expectation of more stable growth, and a higher inflation premium. Inflation remains modest but it has been grinding higher. In Canada, headline CPI (Consumer Price Index) has climbed from effectively nothing a year ago to a two-year high of 1.60% largely because energy prices have turned higher. Core inflation has been hovering at 2% or higher for more than a year now.

If anything, we believe that pressure on core inflation will continue to mount under a Trump administration. Any steps towards protectionism could lift import prices. The US exports high value goods and services (engineering, technology, pharmaceutical) and imports low value goods (clothing & consumer goods). Tougher immigration enforcement could tighten an already tight job market south of the border. There are plenty of signs that the sub 5% jobless rate is finally beginning to have an upward impact on wages.

table3For example, just prior to the election, the policies of the Obama administration were expected to raise wages over the three remaining months of his presidency.

This uptick in inflation expectations raises a sticky   question on policymakers in the US. Monetary policy (determining interest rates) is the purview of central bankers.   Fiscal policy (government spending) is the purview of elected officials. Janet Yellen is asking the question “Is this really the appropriate time to be embarking on a big fiscal push?” In recent testimony by Janet Yellen she stated;

  • Fiscal policy is most effective when there is lots of spare capacity (unemployment)
  • Policymakers should take into account that we are near full employment already (in the US)
  • There are longer-term fiscal challenges – the deficit is already above $500 billion, and demographic pressures alone will make the deficit rise
  • There is not a lot of financial ability by Government if the economy was hit with another shock (crisis)
  • The market is already anticipating the inflationary impact of an expansionary fiscal policy. Said another way, the market has risen with the expectation of higher government spending.

There are rarely any free lunches. We believe that there is a major inflation threat from increasing fiscal spending. OPEC may finally be getting serious about lifting oil prices. On November 30th, OPEC decided to lower oil production and this was followed by both Russia and Kazakhstan lowering their production. This could lead to higher oil prices and increases in the price of gas at the pump. So with potentially higher oil prices, and increased government spending to boost growth, this leads to potentially higher inflation, a stronger US dollar and definitely higher long-term interest rates.

Rod Stein

My friend Doug Porter, Chief Economist, at BMO Capital Market in the BMO Economics Weekly Chart Deck, dated November 19th, 2016 said:

“Speaking of inflation, there are few sectors showing as much pricing power these days as Canadian home sellers. October’s home sales data revealed another eye-popping rise in the MLS Home Price Index of 14.6% year over year. While this measure is heavily tilted to the large cities, and thus driven by extreme gains in Toronto and Vancouver, it also takes quality changes into account; and, therefore, is one of the truer underlying metrics of home price pressure. The policy response to this extreme strength has been a tad bewildering, to be frank.

Since the tightening steps taken first by B.C. and then by Ottawa, it appears that the tide is rushing out again. This runs the gamut of; a) a central bank that has effectively washed its hands of the powerful price gains; to b) a Federal Finance Minister who seemingly encouraged more foreign buying last week – “We are absolutely open to foreigners investing in Canada in all areas and real estate is no different… if any of you are interested in buying second homes in Canada there’s lots of beautiful spaces to do that. We’d be happy to welcome you.” To c) an Ontario Finance Minister offering a modest subsidy to first-time home buyers, thus potentially further fuelling an already piping hot market.

Putting the latter into context; Ontario will double the credit for land transfer taxes for first-time buyers by $2000 to $4000. Over the past year alone, the average home price for all of Ontario has jumped by more than $88,000. In other words, home prices are rising by $2000 every 8-9 days, so the new subsidy will be gobbled up by underlying home price inflation in little more than a week. BMO wouldn’t want to call this type of measure futile, but it seems to be roughly the equivalent of trying to stop a charging elephant with a pop gun.”

A note from John:

For the past 9 years, a typical December has been spent reviewing underlying investments, speaking with investment and fund managers, and reading a vast array of economic and market projections. The goal of this has been to help us to construct an investment thesis for the coming year, and expanding on this thesis, to construct model portfolios for various investor profiles. It is from these model portfolios that we assess all accounts in our 1st quarter review with clients, and to determine what shifts in an account or portfolio should be recommended to reflect our thesis.

December 2016 has been fundamentally different. In light of the upcoming inauguration of President-Elect Trump on January 20th 2017, it has been a difficult process.   We continue to read vast amounts of articles and commentaries, but it is like a grade-12 reading of ‘Waiting for Godot”, we keep expecting information from President-Elect that never comes. President-Elect Trump has stated that he wants to keep people guessing and his economic agenda and areas of interest for his first year in office are still very much unknown. With a US stock market at all-time highs, and the reality that the US has been the strongest equity market since the financial crisis, we are waiting to get more information that should come from Trump’s inaugural address. Just like in times of market crisis, often the best action is inaction, until more information is known. Making decisions on information that is knowable before it is known is like writing a math exam before taking the course.

This deferral is of greater importance to an investor looking for more growth or who has higher risk tolerance.

We believe waiting for the inaugural address and the information we expect to receive from it, will help us in formulating better recommendations for portfolio strategy and investment allocation. In the meantime, we will continue to assess investments on their merits under different scenarios preparing for action after the US inauguration. We look forward to speaking with you and all of our clients in the new year.

We wish you and your families a wonderful New Year!