Canada's Banks

Some Hedge Funds are shorting Canadian banks.  Their main argument is that the Canadian real-estate market is pooched, and many consumers are facing massive defaults due to excessive personal debt.  There is no doubt there are some risky loans on the bank’s books, but the hedge funds are fear mongering.  We feel the risk to our banks are minimal. 

First off, it will take a 1930 style depression or a world war for this to occur.  If this happens, it would make little difference where your money is parked.  Everything, except actual cash, will experience a substantial price drop.  It should be pointed out our banks only lowered their dividends, as opposed to cutting them all together, during the Great Depression and both World Wars. 

Secondly, Canadian banks are amongst the most financially sound in the world today. Sure, some more than others, but overall our banks are very safe.  Banks must maintain a capital ratio of 8 or higher.  BNS is just over 11 as most other banks are as well.  TD is at 12.  These numbers are amongst the highest in the world. 

Last, but not least, the Canadian banks have been transferring high risk loans and mortgages, plus a few high-quality loans, to their mutual funds.  By doing so, they are reallocating the risk from their balance sheet to the unitholders of the mutual funds.   The banks in turn take a fee every year to manage these types of loans in their funds. During the 2007-09 meltdown, Canada’s loan losses ended up being just over 1% of assets. Not a big deal. Banks do not want to foreclose so in many cases the loans are re-negotiated.

While the Hedge Funds did not say how many shares they shorted, the banks are showing significant short sales according to the most recent IIROC Consolidated Short Positions Report.   Hedge funds begin shorting prior to making their predictions public.  The public hears this and sell their holdings, forcing the price down.  Guess who buys back their shorts at a profit?  While illegal, it is a common practice and very hard to prove market manipulation in the courts.  

We expect all Canadian banks to raise their dividends at least once over the next 12 months. We will not be selling our holdings and recommend purchasing more in any sell-off.

It is official, the latest Federal Budget shows Ottawa will continue to hurt the energy sector.  There was not one item that will benefit Alberta or Saskatchewan.  Take this as a sure sign that if the Liberals get re-elected in October, they will attempt to shrink the energy sector even more. This destroys any hope of a West to East pipeline under the Liberals.  Rather than helping his own country, he has made it so demand for Saudi Arabia’s oil, and other nations with questionable human rights records, from the East Coast will continue.

Shrinking the West’s energy sector does the same to Ontario’s economy.  This is because the province provides most of the steel needed by the energy sector.  We would not hold any shares in any Ontario business that provides the steel and other needed materials for the energy sector for as long as Trudeau is in power.

One budget item that might help the economy is that first time home buyers may borrow up to $35,000 from their RRSP’s. This could possibly slow the housing correction in many cities. The one flaw in this of this policy is how many young people have saved $35,000 in an RRSP, especially if they have student loans, car loans, and other debt? Plus, the money must be paid back. If not, Revenue Canada will consider the $35,000 as income from the year the money was withdrawn.  The person will have to pay back the taxes owed, plus interest.  Revenue Canada can also add in a penalty at its own discretion.  

This is just an example of one of Trudeaus promises he made in the Budget. Most of the goodies in this terrible budget are spread out over five years.  In other words, most will be cancelled after the election. It is a political move, but in realty has no value.  Not surprising, this gimmick starts in September - just in time for photo-ops for the election.

The Liberals continue to tell us how great the Canadian economy is doing. Conveniently, they omit that is on the back of record household debt.   The truth is the economy is slowing as Canadians have started to feel the pinch. Normally every smart government (and individuals) uses this good time to pay down debt and build up a cash reserve.  Not this bunch. The Liberals intend to add to a mountain of debt, which means in the coming recession (beginning in the fourth quarter) taxes will have to go up even more.  Plus, it appears they want to push the value of the Loonie down.  A sinking currency causes citizen to lose purchasing power and always results in rising unemployment.  At all times every government must try to push their currency up.  This is the road to prosperity.

Then there is the destructive carbon tax which is going to shrink the disposable income of every Canadian.  Only the government will benefit, and they be increasing this revenue every year until 2024.  Add to that, CPP premiums will be increasing every year until 2026.  It is estimated that a Canadian with an income of $55,000 in 2026 they will pay an extra $500 a year in premiums. At least if one lives long enough, they will get some of this money back. 

The coming recession is going to be 100% Ottawa induced.  There is obviously no one in the Liberal party that has a clue of basic economics.  But, what do you expect when both the Prime Minister and the Finance Minister have been handed their wealth?  Trudeau has never had to meet a payroll.  His trust is from his Grandfather building a chain of gas stations in Quebec.  He is a Golden Spoon benefactor.

The good news is that once the fools in Ottawa clue in to what the real economy is like, they will have to rush and save the energy sector.  Ottawa will become desperate for all that tax revenue oil and gas generate across Canada.  They will have to stop the rising unemployment.  Rough times in Canada are coming.  Build up a cash reserves and fast.

The action of a stock market reflects the way investors see the future of a country.  Since Trudeau came to power the TSX has been flat and foreign investment has fallen significantly. The hardest hit sector has been the energy.  As soon as Trudeau announced the  Carbon Tax, investment in new pipelines and oil fields collapsed.  Very significant companies have also moved their money elsewhere since then.  Roughly 50% of small energy companies have disappeared since Trudeau came to power.  Energy is one of the biggest tax generators for all levels of governments. Ironically, it was not until it looked like Trudeau was going to be given the boot that the TSX and foreign investment started to rise again. 

Since the Liberals were in power the average Joe investor has seen little gains investing in mutual funds and ETF’s because the markets have been flat. Add to that few mutual funds out perform the stock market to begin with. Plus, they are designed to transfer one’s money via fees to management over time.  When you add in roughly the 2% annual management fee, investors are down around 8% if they have held for the past five years.   It will take an 8.7% gain just to break even.  Sadly, Guaranteed Investment Certificates easily beat most mutual funds over that period. Considering most mutual funds are owned by the banks and insurance companies, it is better to invest in the companies that own the funds.  They offer higher yields and have a better history of capital gains.

Interest rates have been at record lows for the past decade.  After paying taxes the average return on GIC’s has been slightly over 1%.  This means it will take 72 years to double one’s money if you re-invest the interest earned.  Not to mention inflation would eat most of those returns, which means even though your capital remains intact, it has lost purchasing power.

Many have also gambled their retirement on real estate.  Most who have bought a principle residency in the past 5 years have either lost capital or are barely breaking even once the costs of ownership are included.  Many investors in real-estate are renting out property at rates that are below the monthly carrying costs.  Even if the place is paid off, you could earn a much higher yield elsewhere.  As we are witnessing today, prices are falling and many are finding it is difficult to sell at their desired price, creating even more risk.  Yes, house prices have increased the past decade exponentially, but todays buyers have disappeared, inventory has skyrocketed, and now prices are falling. This will turn out as a disaster for many.

There are too many retired people taking out those terrible Reversed Mortgages to continue the good life. We are 100% against this. Suppose a home is worth $500,000.  You can borrow up to $225,000. minus expenses (lawyers fees to register the deed plus annual fees).  The term can be up to 20 years.  Over those 20 years the lender adds the monthly payments based on the interest rate of the loan to the outstanding debt.  After the 20 years the debt grows to $500,000.  Hopefully the house grew in value over that period. If it didn’t, the borrower ends up with zero equity at the end.  It would be cheaper to sell the home and invest $250k in a GIC.  Today they would receive around $12,000 a year in additional income without risk. The remaining funds can be used to downsize ones home. 

No matter what age you are, we recommend you start to readjust your spending to take in account an increase in taxes via the Carbon Tax. Ottawa is determined to destroy the Canadian economy by this tax.  If re-elected in the fall they will become very successful at it and all Canadians will have less money to spend.. 

There is an old saying: “The more the world changes the more it stays the same.”  Since the end of WWII the world has had the greatest improvement in mankind.  Better knowledge gives us new ideas everyday that makes our life easier.  Yet we must never forget history.  Since the Dirty Thirties there has not been a serious economic pullback anywhere.  When there has been it was political like in Zimbabwe and Venezuela. 

During the 19^th century and lasting up to the 1930’s deflation caused economic corrections to occur.  In those days it was hard to borrow money.  There were no credit cards, Payday loans, no lines-of-credit, no hedge funds, and too many small banks.  The small banks were always vulnerable to one bankruptcy and it would go broke.  As a result, money in the financial system was able to dry up quickly.

Today, access to debt has never been easier. It has allowed levels to reach heights never experienced before.  It is not just consumers, but every government (the worst is Japan with 240% of GDP) and, to some extent businesses, especially in China.  Many companies today are cash rich, have manageable debt, and continue to increase their dividends.

Up until this last decade, the average consumer interest rates bounced between four and six percent, with credit card and Payday Loans hitting upwards of 29%.  Only fools borrow at this rate.  Before when interest rates went below 4% it was a signal of an economic slowdown coming.  Rates that climbed above six percent warned of inflation becoming the enemy.  For this decade, low interest rates have only encouraged people to borrow too much at the expense of savings. 

One outcome of low interest rates is that prices of homes bear no relationship to household income.  The rule of thumb with a 20% down payment is to never borrow more than 3-times household income.  Today it is normal to see many people paying 5-times or greater.  In places like Sydney, Hong Kong, and Vancouver prices are over 8-times. This will be a trip to the poorhouse for many.  Like the last financial meltdown, the issuing of bonds backed by poor mortgage portfolios has returned, and while the current numbers are not bad, the trend is for a repeat of 2007-2009.

Wages are improving, albeit at a snail’s pace.  However, governments, including many throughout Canada, are dipping into our pockets for all those wage gains, plus some. The result is that wages are shrinking. Of course, there is no sign of governments wanting to use the extra tax revenue for paying down debt, instead they prefer to spend it wastefully. Plus, the continue to borrow more.  This means further tax increases are coming to meet the growing interest charges.  At some unknown point consumer spending will stop and deflation will take over. Signs of this are already appearing in housing markets across the globe.

The financial system cannot sustain this level of debt.  Where is Washington going to get $15.4t to pay off the Treasury Bills outstanding, plus interest?

When it will implode is anyone’s guess.  It could be as early as tomorrow or five years from now.  It will be like all past corrections we failed to learn from, quick and vicious.  History always wipes out the excesses.  Tomorrow will be no different.  

We follow numerous indexes to help us make our investment decisions.  The CRB Index is our favourite.  It is a futures price index based on commodities.  It indicates demand for the necessities of the global economy and has been showing little change for months. This tells us that demand for goods are flat.  Only one chart really concerns us, the Baltic Dry Index, which measures shipping activity across the oceans.  Over the past 12 months this index is down 62%, with 52% of the decline taking place since January 2019.  This means Trump’s destructive tariffs are working and world trade is slowing down rapidly.  This will show up in global GDP figures in the next year.

The 2007-2009 meltdown had a lucky result because interest rates could be lowered a significant amount.  The next one will be much worse as the debt is substantially higher and there is very little room for monetary stimulus.  This is a big election year. There is no leadership anywhere in the world.   Let’s hope we can get some smart people to make the hard decisions that are needed.  Sadly, there is not one on the horizon.

We cannot stress enough get rid of all debt.  Hold only ‘blue chip’ shares and insured money market investments.

Four of our recommendations increased their dividends since the last blog. 

2019

We will begin to see the first signs of an economic slowdown in North America in late 2019.  The main cause will be real estate, politics, and excessive personal debt.  Other notable reasons for a slowing economy is a lack of world leadership, the attack on world trade by the United States, and surpluses in just about everything we grow and produce.  Plus, Ottawa and B.C. continue to tell the world to not invest in Canada.  Business people are listening and directing their investment dollars elsewhere, mostly to the U.S.

National home prices are falling only slightly now, but we expect sizeable drops in the new year as house sales will confirm they are falling off a cliff. No matter how one twists the numbers, house prices share no relationship to family income.  History says house prices must fall or wage gains must soar.  Since after-tax wage gains do not equal inflation, coupled with numerous tax increases coming to Canada in 2019, Canadian house prices must fall.  The same can be said for most major cities across the globe. 

The TSX is trading at the same level as it was in June 2014.  This is four and a half years of no growth. Investors either broke even or lost about 6% due to commission.  Fortunately, if you followed our portfolio you have had one of the best rates of return in all of Canada.  Almost every company has raised the dividend at least once a year.  In the 195th issue we predicted that “for the rest of this decade dividend income will be the main source of earnings from investments.”  On August 1st, 2016 the portfolio dividend yield was 7.5% while the GIC rate of return was .75 of 1%.  The yield had grown to 10.4% in 2018 based on the recommended purchase price.  It should be higher again in 2019.    The TSX is not going to experience new highs until Trudeau stops scaring away foreign direct investment. 

Other warnings are that copper prices are down 8.5% from a year ago.   This is the most important industrial metal and is a leading indicator. Its price decline is warning that construction and manufacturing spending is falling. The Baltic Dry Index, which measures the cost of shipping, is down 15.1%.  Is this a sign of shrinking world trade?  Figures show that car sales are falling.  Platinum warned of this as the price of it is now down 12.3% from a year ago.  The CRB Index is off slightly which shows people are still carrying on their day-to-day spending.

The sell-off in the stock markets in December was due to two things; no leadership anywhere in the world and, more importantly, stock markets were seriously overvalued.  Markets over the long term are based solely on corporate earnings.  The Dow Jones a year ago was trading 28.45 times earnings.  This was double the 99-year average and indicated that investors expected corporate profits to double every 2.5 years, which is literally impossible.  Today, the stock market is trading in this millennium’s average price earnings ratio of 18, but still high compared to its historical average of 14.6 times.  At 19.6 times, the S&P 500 Index is also trading in expensive territory based on their 119-year average.

The North American economy is currently running well enough to justify rate hikes.  This should mean interest rates will go up in the U.S. and Canada at least twice in 2019. Not even a slowing consumer will stop the coming increases.  The stock markets are probably at or near the bottom. But there will not be a big rebound due to the dysfunction of Washington and Trudeau.  It is time for investors to buy the blue-chip shares that offer a good yield and chances for increases in the years ahead.  Our selection in the Sacola Financial Newsletter have yields of between 6 and 8% at current prices.  They remain a buy.