During what is considered the greatest economic depression throughout modern history, interest rates during the Thirties fell to around 2.5%. By the time interest rates finally bottomed, the Dow Jones Industrials lost 89.9% of its value between August 29^th, 1929 and mid May 1932.  The global economy did not recover until after World War II and it was not until 1954 that the Dow Jones made a new high.

Today, the unemployment rate in the U.S. is 5.1% (supposedly), only once the Labour Participation Rate is factored in.  Ours is slightly higher but many jobs go unfilled as there are not enough people willing to work at minimum wages.  Interest rates across the West, except in Australia and New Zealand, are stuck around 0%.

Two weeks ago U.S. 3 month Treasuries were trading at negative .04 of 1%.  This means every buyer was paying the U.S. government to hold their savings.  For 6 months the yield was .01 of 1%, or a yearly return of 1 cent per $100 invested, before taxes.  Over the last 4 months, the 10 year Treasuries has gone from 2.5% down to 1.92%.

Savers are slowly being destroyed.  Without these investors there cannot be any long term recovery.  Around the world not one politician or economist understands this basic economic fact.

When interest rates begin to rise it will take at least 2 years for them to hit a fair rate of return (around 4%).   Today, we are at least 3 years away from getting there since income earned is paid at the end of the term.

The real danger today is the world is heading into a period of deflation.  Prices for everything are set to fall or have already dropped.  As we have reported in the Sacola Financial Newsletter, we believe house prices throughout North America, Europe, Australia and Hong Kong are today at their peak.  Starting next year we will experience falling house prices that could easily last a decade.

Adding to the woes will be government and personal debt at record highs.  This debt is hurting the economy.  The pain will get worse once interest rates rise.  Today, it has not been noticeable but from here on out, governments will be forced to cut back  on spending from falling tax revenue for the next few years, at least.  With no inflation and prices falling, all debt becomes 100% destructive because it overshadows the assessment that they represent.

The only recommendation is to pay off all debts as fast as possible.  Stock markets today are discounting the economic slowdown, so they will do little for the next couple of years.   Dividends will remain the main source of returns for most investors.

From today on zero interest rates are slowly destroying the world economy because  every saver is becoming poorer.  We will not repeat the Dirty 30s but we will have a long slowdown.  It will be 100% induced by politicians as they are clueless on economics.  The longer interest rates stay around zero the worse it will be and the longer it will last. 

The Road to Nowhere

To the surprise of everyone, but us, China’s economic data has not been accurate.  We have repeatedly stated never believe in Chinese figures.  Generally, there are three sets of financial books; one for the government, one for Wall Street, and the real books are for management.

The boom in commodities was in large part due to China importing large quantities to stockpile for future use and to build infrastructure and cities.  Some of the cities built over the past 15 years remain pretty much empty today ( https://www.youtube.com/watch?v=0uxv5_GoY80 ).  Similar to Japan during the 1990’s, they built roads that led nowhere.  During July, the so called experts were telling us the Chinese economy was on the way up because they were big buyers of copper and oil.  The truth is China is taking advantage of low prices and is buying to stockpile.

Contributing to their exceptional growth over the past decade was the West going on a debt fueled spending spree.  Thanks to record high debt levels among the rich nations, the demand for Chinese goods will not exceed the levels of the past for years.  That does not mean the Chinese economy is toast though.  It will still bounce along because there are over a billion people that must be fed, clothed and sheltered. We often forget that the average Chinese income is roughly $5,500 (2013), and hardly an amount to put the world economy into overdrive.  

One of the biggest reasons why all stock markets are going nowhere is due to zero interest rates.  Rather than providing stimulus, they are slowly destroying the world economy by shrinking savings. After taxes and inflation the risk-free rate earns a negative rate of return on the cash (purchasing power is falling).  This is now affecting real estate because people must wait longer to save for a down payment.  This is why today all real estate prices in almost every corner of the globe has peaked or are falling. 

Two Indexes that are telling us the global economy is slowing are the Baltic Dry Index and the CRB Index (commodities).  The Baltic Dry Index measures the price of shipping dry goods index.  While the index is up 15% this year, it still remains down 44.7% from 2 years ago.  The 15% increase this year is more of a sign the world economy is bouncing along.  It signals that we are in a slow down, but nothing serious.

The other metric we use is the CRB Index.  Only three times, since being created in 1976, has the CRB index gone under 185.   Last month marks the fourth.  The index peaked on July 2^nd, 2008 at 473.52.  The number to watch, which initially was hit on Oct. 25, 2001 is 181.94, the all-time low.  Two consecutive days under this number will mean the world economy is contracting and the risk of recession increases dramatically.  It is also telling us that deflation is gaining strength.

With the index bouncing around the 190 area today it is telling us stock markets will be flat to slightly down.  However, based on today’s earnings and dividend yields, stock markets are trading at their long term norms. 

Our recommendation is be careful in investing and avoid taking on debt.  Invest in companies that have a strong dividend record.  Watch the Baltic Dry Index  and the CRB index to see how the stock markets will be acting. Cash is becoming the best asset to hold.

Over the next 2 weeks there will be plenty of speculation the Federal Reserve will be raising interest rates.  The truth is anything under a 2 percentage point increase is irrelevant.  It will do nothing but add to their debt burden by making it a little more expensive to carry debt.  Interest earned on deposits will only make a tiny improvement because financial institutions have a nasty habit of slowly moving up the rates, and usually at half the speed of debt charges rises.

There is no set rule what a fair interest rate is, however we believe 4% is a fair yield.  This would still make loans affordable at around 6% and allows risk-free investors are properly rewarded.  The truth is that if a person cannot afford to borrow at 6% then one should not borrow.  This is just basic finance.

The Bank of Canada cut interest another 0.25% on July 15th.  While the cut will help those with an oversized mortgage on an undersized condo, it is another slap in the face for those relying on their savings for income. Falling rates have created a flood of equity in the real-estate market that has made homeowners feel wealthy.  “The wealth can be tapped by taking a loan against the equity”, so the story goes amongst the housing bulls. Taking the equity out of the house via a loan eliminates the equity on the spot because the cash is as good as spent since it is matched with a liability. Therefore, in order for the equity to create the true benefits of wealth in the economy, the asset must be sold or the borrowed funds must generate a return greater than the rate of interest being charged.  I can guarantee that very few people do this.  Today’s real-estate market has become nothing but a Ponzi scheme which, to quote Warren Buffett, “only when the tide goes out do you discover who is swimming naked.”

Toronto has a reported condo rental vacancy rate of 1.2%.  This number does not include any vacant unit owned by investors which there is plenty of because investors are finding they cannot rent their unit to cover the mortgage payments, let alone the ever growing strata fees.  A new condo tower in Yorkville (Toronto) is supposedly sold out to investors but most of them sit empty today because people cannot afford what the investors are asking.

A third of Canada’s population will be retired within the next 20 years.  This is the demographic that has all the wealth.  However, todays’ retirees are being forced to dip into their savings at a faster clip due to falling interest rates.  Many are retiring with mortgage and credit card debt, and taking out those terrible Reverse Home Mortgages.  They are also the biggest users of Pay-Day loans.  Not surprising, seniors are the biggest sector declaring bankruptcy.  Assuming savings amongst this demographic average $100,000, the current risk-free rate will earn them roughly $70 per month instead of the historical norm of $400.  Multiply this sum by 10m Canadians and the benefits of higher interest rates will be exponential.  Or, we can continue to hold the hands of those who were romanced into the largest mortgages in history and push forward an inevitable housing correction.

People like to point out that the cost of a mortgage has declined allowing for the homeowner to pay the principal faster.  This would be correct in a fairy-tale economy but the average size of the mortgage has grown with house prices leaving the average mortgage term of 25 years unchanged.  At the end of the day, the average price of a house is based on the amount of principal and interest combined a borrower can finance.  When interest rates decline the consumer borrows more principal pushing up home prices in the process.

Both home ownership rates and consumer debt are at an all-time high.  Eventually, demand will deteriorate and force prices down with it.  Of course when the economy improves and rates start to move up many homeowners will find they cannot afford the higher interest charges.  The higher the interest rates go, the greater the collapse in house prices that will occur.  Either way, house prices are going to take a beating.  Our leaders can accept the fact and begin to reward the saver and cause short-term pain in the housing market, or continue on today’s path and strangle those with the savings that are needed for a healthy economy.

Given we are now into election time and not one politician has the guts to be a proponent of higher interest rates, Canada is at least 2 years away before the economy can begin a sustained recovery.  However, we can see the actual recovery being delayed until 2020 due to the huge outstanding debt.  Returning interest rates to historical norms would force a much needed housing correction but generate a flood of cash into the economy at the same time.  Would a risk-free rate of 4% which will generate higher passive income not benefit the economy more than accommodating a $500,000 mortgage on an overvalued home?  Time will provide ample evidence that it would.

Houses price today bare little relationship to family income.  The rule of thumb is to never pay more than 3 times family income.  Today, due to zero interest rates, 4 times might be acceptable if the buyer has no other debt and some assets.  In places like Toronto and Vancouver it is normal for people to pay a minimum 6 times income.  This means once interest rates move higher many will lose their homes as they will not be able to afford the increase debt charges.  Canadians are already stretched financially with $1.65 in debt for each dollar of income.  This means no extra funds to spend, as any interest rate increase will consume additional disposable income.

One cost of owning a house is going to increase substantially in the years ahead will be electricity.  Both Alberta and Ontario will be raising power rates for years to come. With rising energy prices the trend will be for smaller homes, meaning there is a potential for today’s large homes will become hard to unload in the years ahead.  Unless the government allows a large number of immigrants into Canada there will be surpluses of homes for decades to come.

Similar to the U.S., Europe and all other Catholic countries, Canada has a birth rate under 2.1 per woman which creates a shrinking population without immigration.   Canada’s fertility rate is 1.7.  Even India, with improved education, has seen their fertility rate fall from 5 thirty years ago down to 2.4 today.  The trend throughout most of Africa is also down due to better education.  Only in the Middle East countries, parts of Africa and Bangladesh have high rates. 

Today, zero interest rates are a boom for purchasers of homes.  However, if the rates stay low much longer it will become a negative for housing.  Specifically, it will cause the number of eligible buyers to dry up.  How can anyone save enough money to put a down payment on a house when interest earned is less than 1%?  If a family is lucky enough to have high paying jobs that allow for savings of $1,000 a month, which very few do, it will take roughly 8 years to save for a down payment of $100,000.  In other words, house price must fall to meet the savings of tomorrow’s buyers.

If you are one of the many Boomers who are relying on the equity in their home for retirement, now is the time that you should consider selling.  All indicators point to this summer being the peak of our housing bubble.  For investors, if we are correct about the future, real estate will be a terrible investment.  Real-estate investing today is an extremely high risk venture.

If one wants to buy a fixed income investment, then make sure to stick to a term of one year. If one wishes to purchase longer, do not exceed a term more than two years.  Most bond yields currently result in losses after taxes and inflation.  This loss will be exacerbated once the price of fixed income assets decline in value with a rise in interest rates. 

Let us explain.  Assume, back in the good old days you purchased the average 5-year bond trading at par ($1000) that paid you 7%.  That’s a decent return so you go and brag to your annoying neighbor Joe.  Filled with envy, he too decides he wants to invest in some.  The next day you wake up and there is a little bit of turmoil in the Middle East and the bond market reacted by pushing up interest rates premarket.  Joe can still get your bond, but cheaper and it now pays 8% (see chart).  He happily buys some. 

You hear his gate slam and you know he is on his way over to rub it in your face that he received a 15% higher rate of interest than you.  Just when you were wishing he would keep his mouth shut, he is quick to add that he was able to buy it at $875 which means he will receive an additional 15% on his dollar when the bond matures.  He raises his hand for a high-five and you bitterly participate.

As he turns away to walk home, you’re not only kicking yourself for bragging to  Joe the day before, but you’re hoping that you do not need a few quick bucks soon because if you do you will be forced to sell your bond at a 12.5% capital loss.  Even if you’re not forced to sell, you will still be slapped with opportunity cost and the fact that Joe has smug rights on you. 

As Joe found out, there is too much risk in buying longer-term fixed income securities when interest rates have bottomed.  In ordinary times it is difficult to accurately predict when interest rates are in a trough, but today it is a no brainer because they are at historical lows and cannot fall much further.  Furthermore, it is hard enough to guess what is going to happen next year, let alone 10 years from now.  

The Bank of Canada has made it clear it wants a lower dollar.  They continue to voice concerns about “the damage a strong dollar will do to the Canadian economy”, and believe Canada needs a weak currency to promote growth. Yet, a falling currency is the worst thing that can happen for the simple reason that it lowers ones purchasing power by pushing up the cost of imports. This makes its citizens poorer on the global stage.  A rising currency allows us to purchase more.    

The Bank of Canada’s interest rate policy is encouraging rising unemployment and a weakening economy. Interest rates have allowed for the average Canadian household to acquire debt to the tune of 165% of their income.  The Bank is determined to make every saver poorer in order to keep the borrower afloat.  Our interest rates are still sliding with no bottom insight.  Nobody in government or in the Bank of Canada understands that if consumers have little money they will not spend, let alone save.  Without savings, there is no investment and a weak economy.  Keeping borrowers happy with low interest rates solves absolutely nothing.

Canada’s strongest economy occurred between 2002 and 2007.  During this period we had near zero unemployment, low inflation, and the saver was rewarded with interest rates bouncing around 5%.  The Canadian dollar was the hottest currency in the world at the time.  On March 13, 2002 the Canadian dollar was worth $0.626US and then climbed by 75%, to an all-time high of $1.10US.  The Toronto stock exchange over the same period rose 34.4%.  Clearly, a strong Loonie had a positive effect on the economy.

There are plenty of examples throughout history that a currency can attract investment and contributes to prosperity.  Between 1970 and 1990 the Swiss Franc, the Dutch Guilder, the German Mark and the Japanese Yen all increased in value by over 300% against the U.S. and Canadian dollars.  During this period, all four experienced booming economies.  During the nineties the most successful economies were the U.S. and Australia.  Guess what?  Their currencies soared.

Today, the strongest economies are the U.S., New Zealand, and Switzerland.  All three have strengthening currencies.  Why can the Bank of Canada not see what has taken place and understand that a rising currency results in prosperity.

In the summer of 2007, Canada’s GDP was growing 2% annually and interest rates were 4.5%.  Today, Canada’s GDP is growing at 2.6%, yet 10 year T-bills are 2.04%.  The situation is the same in the US where in 2007 the 10 year T-bill yields 4.22% and GDP was 2.4%.  Today, that yield is 2.4%, GDP is 3% and savings accounts earn 0.09%.  North America is going backwards.

Today’s policies are punishing savers and probably forcing many people to work beyond retirement age.  The majority of savings are in bank accounts earning anywhere from .1 to 1.2%, before taxes. Doubling interest rates would increase passive income, attract investment throughout the economy and create a much needed higher currency.  The end result will be a wealthier Canadian.