• David Cockfield

Oh Canada!


While in past issues of The Artisan we have focused more on the problems facing the world generated by the Great Deleveraging, this edition will deal in more detail with specific issues facing Canada. However, it is important to first provide a brief review of recent events outside of Canada.

In Europe the lack of a central authority to control the banking system became painfully apparent with the banking crisis in Cyprus. While Cyprus constitutes less than 1% of the EU economy, a plan to tax bank deposits sent tremors through the whole of Europe. In Italy a recent vote to elect a new government has created a political impasse, with anti-austerity candidates receiving strong support and the austerity program begun by the previous government now in doubt.

In the U.S., there has been better progress as some spending cuts and tax increases have been achieved. Continued Federal Reserve stimulation efforts have allowed employment and housing numbers to continue impIn Canada the appreciation that we are in a once-in-a-lifetime economic restructuring similar to the Great Depression is slowly taking hold. It is not yet accepted that, like the Great Depression, this restructuring will likely last for another three to five years. The Federal Government, recognizing that much of the Western world has had real estate markets drop sharply, has tightened mortgage qualification requirements. The purchase of new housing remains the most significant source of new debt. Given that Canada remains one of the few areas in the Western World where real estate values have not fallen, some caution is warranted. An upward move in mortgage rates to the typical levels of 6% experienced in the 1990’s would be a major burden on today’s young new home buyers. If one wants to imagine a truly frightening situation, think of the 15% plus mortgage rates of the early 1980’s. It should be remembered that the very low interest rates now in place are government policy generated and rather artificial. At some point in the future these rates will move higher. So far real estate values have been stable and prospects are for values to drift sideways or slightly decline. Therefore, Canada should avoid the very negative economic impact of a real estate price collapse as experienced by the U.S.

As a resource producing nation, Canada has always been vulnerable to international commodities market fluctuations. With the growth of international markets and particularly the rise of China, the positives have outweighed the negatives over time and as a result Canada has survived the soft wood, lead, zinc and aluminum price declines. Recently, however, the energy sector, a long term provider of growth, has run into problems. First it was natural gas with new shale gas production drawing down prices, and then demand from the U.S. Now oil is experiencing price and demand pressures. The U.S. for the first time in decades has experienced rising oil production both from shale oil and the Bakken oil discoveries in North Dakota. To add to Canada’s problems is a major new pipeline - the Keystone Project - designed to carry Canadian oil sands production to the U.S. Gulf market, has been delayed by environmental concerns and even if approved soon it will not be operational for several more years. The price for heavy Alberta crude is $25 to $30 less than the basic benchmark for the North American crude oil prices. While various pipeline proposals are being made to gain access to eastern Canadian markets and ultimately the Atlantic coast (and also the Pacific Coast) the timeline is still one of years. Shipping oil by railcar is expanding rapidly and should provide some relief, but cannot replace the volumes needed to return Alberta oil prices to past profitable levels. This situation has already caused, and will continue to cause, a slow-down in the development of Canadian oil resources. This in turn will mean slower growth for Canada as a whole, as the energy sector has been an engine of growth for Canada for decades. In the longer term low energy prices in North America, plus the ability to export to the developing world, will be an economic plus for Canada and the U.S. In the short term however Canada will suffer.

The recent Federal Budget offered a strong contrast with what is happening south of the border. While some tax advantages for small business were eliminated, no significant tax increases were proposed, and expenditures are under control. The Federal deficit should be eliminated by 2016. In contrast the U.S. has only taken some small steps to increase taxes and cut expenditures. Unfortunately the psychology of what is happening in the U.S. has had and will have an impact on Canada. Further political bloodletting is likely to come in the U.S.

While Canada, despite its problems with energy prices, seems an island of relative calm in the deleveraging western world, our equity markets have significantly under-performed those south of the border. Why has this happened? The first reason, that is obvious, is the makeup of the TSX, which has significant commodity content. With commodity companies facing profit growth headwinds, stock prices have languished with the TSX, as at the end of March 2013, with negative return for the last two years. However earnings plus dividend payouts have risen in that period, but investors, perceiving greater future risk, are demanding lower price earnings multiples as compensation. The out-performance of U.S. equity markets has also attracted the capital gain seekers in the Canadian investment community. Canadian buying of U.S. investments means selling Canadian investments thus putting pressure on Canadian equity prices. The other question that should be asked is, why are U.S. equity markets, particularly recently, out-performing and breaking historical highs and also out-performing virtually all equity markets in the world? The answer can be found in the U.S. Federal Reserve stimulation program. The Federal Reserve, by pumping liquidity into the banking system, is creating a situation where some of that liquidity will spill over into equity markets. So despite major unresolved fiscal and monetary problems, plus a dysfunctional political situation, U.S. equity markets continue to forge ahead. Needless to say the risks of a market correction in the U.S. are high and rising.

Our investment strategy remains the same. Recognizing that while some progress is being made in the western world’s deleveraging process, progress is minimal and significant risks, particularly in Europe, remain. The corporate sector in North America remains in excellent financial health and should be the focus of investment. Equity markets will remain volatile and capital gains elusive. Cash flow from predictable sources, both dividends and interest, should be emphasized as well as preservation of capital. The market environment we are experiencing is unlikely to change any time soon. It is not an environment that that will reward foolish risk taking. Against this backdrop, we continue to see opportunities in select areas of the real estate, credit and equity markets.


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