Canada`s Fiscal Policy Shift

Guest post by Norman Mogil

After nearly a decade of fiscal policy taking a back seat to monetary policy, the newly elected Liberal Government moved public spending into the driver`s seat with its first budget since the election last October. Canada will now use fiscal deficits to re-invigorate its limping economy. It has launched a policy of fiscal stimulus, lead by large infrastructure investment for at least the next five years. While the political analysts argue as to which election promises were kept and which were broken, the principle issue in the budget concerns the role of deficits in generating economic well-being.

Deficit financing has been used in Canada several times over the past four decades, as successive governments contended with economic downturns (Chart 1). Recovery from the severe recession of 1980-82 and again in  1991-93, Canada ran very large deficits - in excess of 4% of GDP. From 1997 to 2008 government finances returned to the black, only to be hit hard with the 2008 global crisis, necessitating a return to deficits in the order of 3% of GDP . That deficit position was ultimately eliminated by 2014-15.

Once again, Canada faces a very difficult economic environment and now turns to deficit financing to clear a path towards higher economic growth.

When the election was called in the summer of 2015, the Liberal Party advocated deficit spending and proposed a deficit of C$10 billion in the first year. By the time the budget was delivered on March 22, 2016, the forecasted deficit was increased to C$29 billion and the Government planned to run up a total C$100 billion in deficits over the next five years. What  happened in the interim between the election call and the budget delivery?

According to Finance Canada documents, surveys of private sector economists taken in June 2014, indicated a relatively robust growth path. ( Chart 2). However, the collapse in the commodity markets changed everything . Forecasts were significantly lowered for nominal growth GDP, by as much as 7% for 2017. The original deficit projections could no longer be justified.

The principal culprit was the severe drop in investment plans in the energy sector and its knock-on effects for the rest of the economy. Industrial sectors, outside of the energy-producing provinces, were suffering a decline in nominal incomes. Overall, capital investment in Canada has been on a decline for several years, and the collapse of commodity prices has only served to accentuate that decline. No longer can we count on the commodity sector to sustain economic growth.

Canadian governments at all levels have made considerable strides in reducing debt ratios over the past 25 years. Chart 3 traces the debt-to-GDP ratio for all governments over that period. The ratio has declined from nearly 90% in the mid -1990s to under 50% today. As the deficit ratio fell, the  bond rating agencies raised Canada's ratings  and today the country enjoys one of the highest ratings in the G-7 countries. Within the Federal sphere, the debt-to- GDP ratio has fallen from nearly 70% in the 1990s to just over 30% today. The 2016 budget projections expect that ratio to continue over the planning time horizon.

Starting in 2016-17, the deficit will be financed by a record issuance of C$133 billion of which C$92 billion is rolling over old debt from the previous borrowings and the balance represents the deficit to be financed this coming fiscal year. Interestingly,   Finance Canada recommends issuing bonds in the two-, three-, and five-year borrowing periods, rather than locking  into low rates for 10 - and 30-year bonds. One could argue that, given that much of the deficit arises from infrastructure investment, they should be financing with long term rates which are at historic lows. However, if the goal is to return to a balanced budget at the end of five years, then using short-term rates seems appropriate. This was the strategy of the Harper government as it sought to return to a balanced budget by 2015. Either way, today's borrowing costs affords an opportunity to expand the budget without measurably adding to the burden of interest costs.

Turning to Table 1, the outstanding Federal debt will be increased by C$113  billion over the period. Nonetheless, the debt as a percent of GDP remains static at approximately 30% throughout the period. And, more importantly, interest costs as a percent of total revenues marginally increase from 8.8% in 2016-17 to 10.3% in 2021. Both measures suggest that the Federal debt position is sustainable and does not impinge on the expansion of programs designed to stimulate the economy.

 In the past, Canada has relied on foreign capital inflows to help finance it public sector deficits. Given the Federal Government's sound bond rating and also that Canada's offers competitive interest rates - certainly higher than those in Europe or Japan - there is every reason to expect that the international investing community will look favourably upon future bond issuances.

The budget has prompted many forecasters to reassess their earlier growth projections.TD Canada and BAML both bumped up their forecasts for 2016 and 2017 on the strength of the proposed budget.  It is no secret that the Bank of Canada has had its hand stayed, awaiting Federal budget .This level of deficit spending will be welcomed by the Bank as a tool to augment its accommodating monetary policy. The central bank  estimates growth of 1.4 percent in 2016 and 2.4 percent in 2017, in the absence of fiscal stimulus. At least, the Bank now finds it has a partner in promoting economic growth.

A final word. With the EU countries under austerity regimes and the US operating with a relatively non-expansionary Federal budget, Canada now embarks upon a program of deficit financing to counter its problems of slow growth. It will be of interest to many other nations to see if this strategy is what is needed to pull out of the current weak economic environment.


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Canada`s Changing Financial Landscape, Part 3: Lifecos and Real Estate

Guest post by Norman Mogil

Lifecos

Although innocent bystanders in the 2008 financial crisis, the life insurance companies were most impacted by the knock-on effects of the fall in equity prices, declines in long-term interest rates, poor credit quality of debt and a general decline in economic activity.

As Table 1 demonstrates, the industry remains permanently ( i.e. long lastingly) impaired. Share prices of the major lifecos are, largely, below pre-2008 levels and/or have not participated in the upswing of equity prices enjoyed by other financial institutions. Major lifecos, such as Manulife and Sunlife, remain well below levels of a decade ago. More importantly,  prior to the 2008 crisis, the industry commanded price-to-book values  of 2.5 times, only to see that metric drop down to 1.5 times today. The industry continues to face a challenge of repairing  balance sheets and of tailoring their products to reflect the changes in today`s economic environment.

Above all else, the lifecos have suffered at the hands of today's low-interest rate world. They are in a constant struggle to match  the return on assets to the requirements of future liabilities. Re-investing fixed income assets at successively lower rates, in effect, increases the risk of long-term liabilities. In particular, the liabilities most at risk are annuities and guaranteed income products. Low rates also affect reserves and capital margins, necessitating capital infusions to meet industry regulations.

Although the bulk of the industry`s assets are in fixed income, the industry was compelled to seek greater returns from equities and other asset classes-- the familiar "stretch for yield". Many of these other assets groups failed to provide the needed additional returns to offset the declining returns from bonds. For example, Manulife assumed a higher risk profile from the purchase of equities, specifically in the oil and gas sector; the slump in energy prices has hurt profitability. Any mismatch between assets and liabilities leads to profit volatility, a state of affairs that continues to exist.

Persistent low-interest rates are changing the product mix that lifecos offers, for example:

• certain long-term guarantee products will likely disappear ( e.g. permanent life insurance);
• some risks will be shared with customers; and,
• premiums will rise, at the risk of losing potential customers.

One bright spot is that the aging population allows the industry to expand its
wealth management business. The industry is increasing its ``investment  type``
products, such as mutual funds, universal life policies and managed accounts. The growth of this segment is reflecting the maturity of the baby boomers and their needs for retirement income. Finally, given that the domestic market is quite mature, if not saturated, the majors are looking at markets internationally, especially in Asia.


The Canadian Housing Market

If you live in Toronto or Vancouver, you cannot help but be confronted constantly by conversations about the hot housing market. Continuing a trend started more than a decade ago, home prices in these two cities registered double-digit increases in 2015. The accompanying Table 2  shows that Vancouver's home prices increased by over 20% and Toronto's by more than 10% in the past year; whereas, the rest of the country exhibited  quite modest increases. The reasons behind this two-city housing market were examined previously. (http://soberlook.com/2015/08/housing-in-canada-tale-of-two-markets_2.html)

There has been no end of warnings by domestic and international organizations that the Canadian housing market is primed for a major fall, a correction that many consider long overdue. The Canadian Mortgage and Housing Corporation ( a crown corporation) cites the " problematic overvaluation conditions in local markets". The OECD claims that the Canadian market is anywhere from 30-50% overvalued. It is not our intention to get into this debate directly. Rather, we want to point out a number of mitigating conditions that will operate to cushion, if not actually prevent, any  major decline in house prices.

From the borrowers' perspective, one of the most often cited metrics is that which measures the level of household debt  to household incomes. There is no magic ratio that will automatically trigger a significant market decline. No one can answer the question: how high is too high? What is more relevant is the nature of  the household sector's balance sheet.

Table 3 sets out some basic parameters by which to judge the vulnerability of the housing market from the perspective of household wealth. In the past 12 months, households' net worth to disposable income has increased by more than 2%. At the same time, debt-to-assets remain constant at a very low level of 17%. And, most importantly, owner's equity in their homes remains constant at 73%, indicating that homeowners have amassed a considerable amount of equity. Hence, there is an adequate buffer within the household sector, providing stability in the housing market.

From the mortgage lender's perspective, over the past 5 years, the Federal government has tightened up lending practices by:

• reducing  amortization periods from 40 years to 25 years;
• reducing  the loan-to-value( LTV) lending percentage from 95% to 80%;
• reducing the cap on gross debt services levels, and
• upping  the insurance premiums on mortgages with less than 10% down payment.

The commercial banks dominate the mortgage market, capturing over 80% of all mortgages issued. These lenders' have been relatively conservative in their management of their mortgage portfolio. On average, the major banks have issued mortgages with an LTV between 65-70%, and , in addition,  50-60% of all mortgages are insured (Chart 1). For the industry as a whole, 3% of its total loan portfolio is in uninsured real estate in Alberta. In sum, there is  a considerable buffer created by the banks and the insurers in the event of a sharp decline in housing prices. Both borrowers and lenders are reasonably able to maintain stability in the Canadian market.

Summing Up

The Canadian financial institutions have weathered the storm of the 2008 crisis, yet many challenges lie ahead. Investment dealers are struggling with changes due to technological innovation, government regulations, and a seriously weakened natural resource sector. The commercial banks are challenged by persistently low interest rates and the current weakness in the energy sector and its spillover into the national economy. The lifecos are looking at new strategies to ease the task of matching assets and long-term liabilities in an effort to stabilize profits.









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China's Wealth Management Products, a Q&A

We've had a number of questions regarding the growth and the risks surrounding China's Wealth Management Products (WMPs). Here is an overview in a Q&A format.

Q: What are the reasons for the continuing demand and proliferation of WMPs in China?

1. China's bank deposit rates have been extremely low over the past decade and until recently have been artificially capped by the nation's central bank, the PBoC. The reason for these low rates is Beijing's effort to make sure that the banking system has access to cheap financing in order to stimulate credit growth.

Source: Tradingeconomics, PBoC

These days, awash with deposits, many banks pay even less than the latest rate set by the PBoC. Here is one example showing why China's depositors have been desperate for yield.

Source: Bank of China (one of the 5 biggest state-owned commercial banks in China)

2. Another reason for the explosion in WMPs in China is the rapid growth in money supply, with limited options to deploy all the new cash. The chart below shows China's  broad money supply (M2), now 15 times the size it was at the end of 1999. That's a great deal of liquidity sloshing around.

3. More money poured into WMOs last year after the massive "correction" in China's stock market, as investors looked for other sources of yield.

Q. What rates do banks offer to their WMP customers?
A. In 2015 the typical WMP product yield ranged between 4.5% and 5%.

Q. What is the typical WMP term?
A. According to HSBC, "more than 90% of China’s fixed duration WMPs are shorter than a year".

Source: HSBC

Q. How do WMPs generate returns?
A. These days most are invested in corporate bonds although some also invest in private loans. The most popular type of bond in WMPs' asset portfolios is a AA corporate (domestic agency ratings of course) with a 4-5 year maturity.

Q. What is the yield on such bonds currently and is it sufficient to pay the WMP rates?
A. Here is the RMB AA corporate yield curve. With a little help from leverage (usually via the repo market) and/or a big duration mismatch, WMPs generate the necessary yield.

Source: HSBC

Q. Has the WMP growth impacted corporate bond yields in China?
A. Yes. Since early 2014, China's corporate bond yields have been steadily declining. A great deal of this is the result of China's WMP demand.

Source: S&P

Q. Who manages WMPs?
A. While banks actively market these products, these days the management is outsourced to brokers (and other non-bank entities) with asset management/trading desks. Banks used to manage WMPs but due to regulatory and resource constraints have shifted the process to third parties.

Q. What sort of arrangements do banks have with WMP managers?
A. WMP managers operate like hedge funds, retaining 20-30% of the upside above the "guaranteed" contractual return of 4.5% - 5% (this is on top of the management fees).

Q. What type of risks are inherent in this market?
A. Given the hedge-fund style upside, this can be an extremely profitable business, encouraging higher leverage as rates decline. Since this activity is concentrated outside of the banking system, it is not yet regulated, resulting in rapid growth in China's "shadow banking". In fact this is one of the key reasons the PBoC has been so reluctant to lower the target interest rate, focusing on the reserve ratio (RRR) instead. Lower rates will encourage further "reach for yield" and increase leverage in the system.

An even greater systemic risk in the WMP market is the asset-liability mismatch - one of the key problems that precipitated the financial crisis in the United States (funding illiquid mortgage bonds with asset-backed commercial paper or repo). The chart below shows the amount of WMP placed vs. what is actually reported at year-end by banks. Many WMPs are timed to mature before the bank reporting date ("window dressing"). Most WMPs of course mature several times a year and the industry relies on the WMP customers to roll (on a net basis) their maturing WMPs. Moreover the market's tremendous growth has banks and managers believing that rolling would not be an issue. If some investors pull their money out, there will always be plenty of new ones wanting to come in. Sounds familiar?

Source: HSBC

Q. Why isn't Beijing addressing this rising systemic risk?
A. The PBoC has to tread carefully in order to avoid disrupting its growing domestic bond markets. The situation is quite fragile and any hint of a serious regulation could send the corporate and other bond markets tumbling (starting a deleveraging cycle). As the regulators try to figure out how to contain these risks (including endless discussions with the major banks), the WMP market continues to grow.



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Canada's Changing Financial Landscape: Part 2, Banking

Guest post by Norman Mogil

Canadians generally take pride  that their banks have been able to weather the 2008 storm well and continue to exhibit solid performance . Recent financial results point to growing profits, increases in dividends and improvements in reserve requirements. Yet, the industry is aware of serious challenges from the collapse of oil prices as well as the challenges that all banks worldwide face from a low or negative interest rate environment. In this blog we will look at what will influence the performance of the Canadian banks in the near term.

For the benefit of our American readers, we should point out there are significant differences  between the Canadian and US banking systems. The industry in Canada is dominated by six large banks ( Big Six) which are national in scope, each having as many as one thousand branches throughout the country and each providing a full range of commercial and personal banking services ( much like the money centre banks in the US) . There are  dozens of much smaller banks that operate only regionally or in specific market segments In the US, even after a consolidation ,post-2008, there are about 7000  commercial banks and savings institutions , the majority of which operate independently only in local communities and have no national presence.

Canadian banks feature a high percentage of assets in personal loans, especially mortgages; whereas, the US banks sell their loans through the securitization market. The Canadian banks carry very little risk of loss since higher loan-to-value mortgages must carry mortgage insurance.

Finally, the Canadian financial regulatory environment has remained basically untouched even after the 2008 crisis; the US industry underwent dramatic changes that are still being  implemented to this day. With a more stable regulatory environment, the Canadian industry is able to operate with little disruption, compared to what we see happening in the US and in the European market⁽¹⁾. 

Lets turn our attention to challenges facing the Canadian industry. To begin, we note the structure of  banks assets and revenues. Chart 1 sets out the asset classes and their relative importance.

Personal lending occupies more than half of all bank assets; personal accounts make up 16% and mortgages for an additional 36%. Business loans make up 31% of all assets. These proportions have remained relatively static over the years.

Regarding revenues, Table 1 reveals that the prime source of revenue ( 47%) is net interest income (NII), the basis of all banking operations. Ever since the banks purchased securities dealers in the 1990s, the industry has grown to rely increasing on capital market returns which ,on average, account for about 21% of all revenues. Finally, the Canadian banks have  steadily increased the importance of fee-based income which now generates about 1/3 of its total revenues. The question we need to explore are :  what  factors will impact bank revenues and, hence , profits going forward?

There are four developments that need to be watched carefully as the industry copes with a changing environment.

1) Asset growth slowing. Domestic personal lending, especially mortgages has slowed . The banks are concerned with their exposure to that segment of their portfolio in view of weak economic growth and, especially, the impact of a hard-hit energy sector. Caution has taken hold.

2) Exposure to the energy sector. Canada's depressed energy sector is now hitting the banking community. The banks have steadily increased  provisions for loan losses with each  new quarterly reporting. However many analysts are arguing that these provisions are insufficient. The banks are conducting various stress tests to counter these arguments. Only six months ago, the price of oil was around $60 bbl and now trades at $30-35 bbl; the full impact of this dramatic decline has not yet been felt by lenders. The longer oil prices remain at this level, the more we can anticipate corporate and  personal loan losses will climb .Time is not on the side of the banks in this regard.

Industry analysts have been trying to get a handle on just what is the exposure  of the Big Six  to the oil patch. Exposure takes two forms: 1) direct outstanding loans and 2) untapped credit lines. In the accompanying Chart 2, according to  Bloomberg.com, the total outstanding exposure is C$107 billion, not the C$ 50 billion highlighted by the banks in their recent quarterly reports. The difference lies principally in how much of untapped credit lines exist and other commitments the banks have undertaken to support clients. To be fair, these commitments in total will overstate the banks' actual risks, since not all lenders will draw down  all these lines, even in times of  greater difficulties; nevertheless, as the energy  sector continues to operate in this tough environment , the banks' exposure needs to  be watched closely.

Source: @business

3) Narrowing  of net interest margins (NII). The biggest single determinant of bank profits is the shape of the yield curve. Particularly ominous for the banks is the spread between short- and long-term rates, between the 2 and 10 year rates. Banks do well by borrowing short and lending long; the  steeper the  yield curve, the greater the opportunity for profits. However, as Table 2 clearly points out, the trend has been moving in the opposite direction. This spread has narrowed considerably, from 100bps in 2014 to just 54bps in 2016. In an era of super low interest rates, this narrowing of the spread is putting tremendous pressure on the banks to generate profit growth quarter after quarter. Worse yet, the decline in long term rates herald a weakening economy and deflationary developments, further pressuring profitability. The spectre of negative interests, as is the case in Europe and Japan, is also of great concern to the Canadian banking community.

4) Capital market volatility.   Capital market revenues have to be earned afresh each day. That is, the revenues are a combination of trading profits, underwriting and advisory services, and as such exhibit a lot of volatility. As such, these revenues cannot be relied upon as a consistent and recurring source of income in comparison to mortgages or business loans. Moreover, as we explained in Part 1 of this series, this segment of the industry is undergoing major structural adjustments and profitability is becoming  illusive. (http://soberlook.com/2016/02/canadas-changing-financial-landscape.html ).

5) Housing market .Canada's housing market poses an additional challenge to improving NII. There are many different opinions as to when and to what degree a slowdown in housing prices will take place. It is clear, however, that mortgage originations are not going to continue at the recent rapid rates of growth. The banks have signaled that are  they concerned  regarding the connection between household debt and home prices.  Given that mortgages represent about half of all loans outstanding, this possible slowdown combined with a flattening yield curve will impinge on NII.

We will look at this housing and mortgage topic in Part 3 of this series.

⁽¹⁾ See the CIBC  Bank Primer - 2015

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The Fed could be back in play in 2016

One or more rate hikes by the Federal Reserve in 2016 remains a real possibility. Why would the Fed consider such a policy action given the recent collapse in inflation expectations?

Over the past couple of months many analysts and the futures markets have assigned a rather high probability to the so-called "one and done" - no change in policy in 2016. Indeed, here is what we've heard recently from St. Louis Fed President James Bullard:

Reuters: - The Federal Reserve must act to stop inflation expectations from getting too low, St. Louis Fed President James Bullard said on Wednesday, reiterating his concerns about continuing to raise interest rates.

The U.S. central bank cannot let low inflation expectations "get out of hand," he told a dinner of bond traders here, adding he "can't stomach" currently low readings. "It's just that they've fallen so far that it's got to be a concern."

Source: @auaurelija

However a number of researches have suggested that with a relatively stable core inflation in the United States, oil prices would need to collapse to levels that are neither consistent with today's forward curve nor sustainable. Therefore, these studies argue, the current market-based inflation expectations are simply irrational.

1. Here is the latest analysis from Goldman Sachs.

Source: Goldman Sachs

2. Also, a study from the St. Louis Fed shows a similar result.

Source: St. Louis Fed

Moreover, US inflation measures are starting to stir - especially in the services sector. This is something the FOMC is not going to ignore. Below we have some of the recent reports.

1. The core PCE inflation, the Fed's primary inflation measure, exceeded consensus on Friday.

2. US CPI measures, both the headline and the core, also came in above expectations.

Source: Investing.com

3. As an example of where some of this inflation is coming from, shown below is the medical care CPI. It has been subdued last year but is now is waking up again.

Source: St. Louis Fed

Additionally, the cost of shelter in the US is now rising at over 3% per year, with the rate continuing to increase. Sadly, this is materially higher than the national wage growth rate, putting pressure on Americans with low-paying jobs.

Source: St. Louis Fed

4. We also see the so-called "sticky" CPI (the less volatile components of the CPI) reaching 2.5% - the highest since 2009.

Source: St. Louis Fed

Some analysts (RBS for example) have been suggesting that deflation is about to sweep the global economy, pulling in the US along the way. For now however there is simply no evidence of deflationary pressures in the world's largest economy.

Other indicators released last week could add to the ammunition of the more hawkish FOMC members.

1. US consumer spending was stronger than expected last month. Alas, some of this increase was driven by higher spending on healthcare, but it's an important data point nevertheless.

Source: St. Louis Fed

2. While this next item is more symbolic in nature, it's an important milestone nevertheless. US house prices (at least according to the government's index) are finally above the pre-recession peak.

Source: St. Louis Fed

The futures markets are starting to react to all these reports, with the Fed Funds futures falling on Friday (lower futures prices imply higher rates).

Source: barchart

In the coming months the Fed will be closely watching two key economic measures as the Committee contemplates further rate hikes.

1. Any indications of acceleration in wage growth will get the Fed going again. The high-frequency Gallup jobs indicator suggests that US labor markets remain stable, but material improvements in wage growth have been elusive.

Source: Gallup

2. The recent market turmoil has ignited concerns about tight credit conditions. The Fed's surveys suggest stricter underwriting standards in business lending while other indicators point to weakness in credit availability for middle-market and smaller businesses. And of course credit spreads have risen sharply, especially for the more leveraged firms. However the overall corporate loan growth remains close to 11% per year - for now.

Source: St. Louis Fed

Some suggest that raising rates in the current environment is nothing short of insanity. Given the monetary easing by the ECB, the BOJ, etc. (as rates move deeper into negative territory) or the dovish stance by the BOC, the BOE, and others, the US dollar is bound to resume its rally, causing further damage to the US economy. In fact the latest PMI measures, (from Markit as well as ISM) suggest that the US economic activity has already slowed sharply in the first quarter. Nevertheless, given the Fed's focus on some of the indicators discussed above, rate hikes in 2016 are now back on the table.

Source: Markit

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Canada`s Changing Financial Landscape, Part 1: the Securities Industry

Guest post by Norman Mogil

The worldwide collapse in commodity prices is now working its way through the financial markets in Canada.  Canada is just now experiencing  fundamental changes in the financial community, the sector  better known as F.I.RE  ( Finance, Insurance and Real Estate ) . This sector accounts for approximately 20% of national income and employs more than one million workers, providing a  broad spectrum of  services to all parts of the economy. One subsector, in particular, the investment or securities industry has been hardest hit of late.. This blog examines the adjustments in the securities industry; future blogs will look at the banks, life insurance and real estate markets.

To appreciate just how much the F.I.R.E. industry has suffered , we turn to the TSX and its major components as listed in Table 1.  In the period 2007 to 2014, the Canadian stock market as a whole fell by 4%. However, the  financial sector as a whole  performed relatively well increasing by some 21%, largely on the back of the commercial banks, supported by good loan  growth and capital market activities.  However, within the investment community, independent investment houses have taken quite a beating. The two publicly traded companies, GMP and Canaccord, have seen their corporate value been  truly been decimated ( a price drop of  80%) . Finally, the lifecos have yet to recover from the 2008 crisis and continue to see their stocks trade well below pre-crisis levels ( as much as 60% lower).

These  trials and tribulations  continued over the past 12 months as all segments of the FIRE industry have seen values drop further.  Along with the decline of the TSX60 , the finance sector is off a further 19% , partly in concert with  the decline  in world stock markets, but more reflective in the fall in oil and other commodity prices. Even the much vaulted Canadian banks are feeling the impact of losses in the energy sector. REITs which have been a haven for investors are now in decline( off by 18%). And, of course, the investment dealers continue  their slide as they suffer under the weight of several factors unique to the industry. We now turn our attention to those issues.

       Investment Industry Under Pressure

The securities industry, and in particular, the independent dealers are crucial to a well-functioning capital market. The big six banks have swallowed up major investment dealers in the 1990s; they use these  investment firms to continue to fund large publicly traded companies . Independents, on the other hand, supply funds to  small and medium size industries, especially in the  resource and tech sectors. Often these companies are deemed  too risky to qualify  for  conventional bank lending . Thus, they have filled an important gap in the capital markets and their  current weakened position will have an adverse impact on  the effectiveness of the Canada's  capital markets to promote economic growth.

These are not happy days for the investment dealers. Revenues are weak, costs are escalating and the nature of their business is undergoing structural changes.
The number of firms have declined as part of a wider consolidation as profitability is squeezed throughout the industry. Chart 1 illustrates the change in revenue sources between 2007 and 2015.

With the exception of fixed income trading, all categories of revenues have declined, especially equity trading commissions and investment banking fees - two stalwarts of  the past. Table 2 summarizes the main financial operating results of the past 12 months. The two notable impacts have been  the reduction in revenues and the rise in the  cost of operations. Overall, profitability is dismal compared to prior years--- 4.6% rate of return in an industry accustomed to rates of 20% or more. As a result, shareholders' equity has taken a beating, forcing weak companies out of business and others to shore  up capital to meet regulatory requirements. What is behind this poor performance?

A series of  radical changes  has hit the industry simultaneously :

•  the collapse of the commodity markets. Many of the independent firms specialize in financing  medium size resource/extraction enterprises; the collapse resulted in very few investment banking opportunities, shrinking that  revenue segment of the industry significantly,

• technological driven price wars. There has been a relentless move towards lower commission prices and electronic trading, contributing to the fall off in revenues.

• compliance and regulatory changes.   Ian Russell  the President of the Investment Industry Association of Canada (IIAC), estimates these costs have risen by 7% in 2015, on top of a 6% rise in 2014. He believes " the relentless rise in operating costs will squeeze profitably" in 2016.

 The industry features many small independent, boutique -size firms that no longer can compete for capital; the bulk of the firms are capitalized at $10 million or less, precluding them from participating in larger financing deals. Russell expects a further consolidation as firms either merge and/or shut down.

The IIAC recently conducted a survey of its members on the outlook for the industry.
The majority of members remain pessimistic , citing the following:

• Rising costs owing to higher compliance  and new technology requirements; both add to staff and to total operating costs;

• Weak economic conditions as Canada adjusts to the new realty in commodity prices and the slowdown in world trade;

• Consolidation and restructuring. Over the past 4 years, 25% of the industry has left the business through mergers and amalgamations , closing operations entirely or transferring business out to competitors.

It is no wonder that the majority of the industry leaders expect further contraction in the coming years as part of shake out in the industry . It may turn out, in the longer run, that the Canadian capital market will benefit from this re-structuring and may be stronger as a result. However, at present,  the principal concern is that this consolidation will negatively affect the  viability of the industry to participate in the financing of future economic growth.




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The case for “global quantitative tightening”

Guest post by Marcello Minenna

In January 2016, global foreign reserves (FX) continued their decline after an absolute peak in June 2014, declining significantly in distressed emerging countries and some notable oil-producing economies (see Figure 1).

Figure 1.

China and Saudi Arabia, the leading owners of foreign reserves outside the OECD circle, both experienced an outflow greater than 5% of their outstanding reserves in less than 6 months (see Figure 2). A common factor explains these drawdowns: both the countries are struggling to defend their currency peg to the Dollar. The pressures on the exchange rates can be traced back to three intertwined drivers: the (still to come) interest rate hike cycle in the US, the low oil price and the China slow growth. While the “US rate hike tantrum” can be considered as a symmetrical shock for all the worlds currency different from the Dollar, the other factors have hit the distressed countries in differentiated ways.

From the Chinese side, the worsening growth’s prospects and strong capital outflows are forcing the People bank of China (PBOC) to employ its FX reserves with the aim to manage a controlled, but unavoidable, devaluation. Meanwhile, the persistent slump oil price (that depends a lot from China’s slowdown) have decimated the revenues of the Saudis. Since these money flows count for over 80% of the State budget, the government is now tapping the debt market at the astronomical pace of 16% of GDP at year to compensate for the loss. This dramatic reversal in the health of public finances obviously put pressure on the fixed peg with the dollar.

Figure 2.

Indeed, as it emerges from the comparative analysis of Figures 1,2, both the declines for China and Saudi Arabia took off and reinforced during the prolonged crash of the oil price. The same phenomenon can be appreciated on a global scale (Figure 3): world FX reserves peaked and declined in sync with the oil price. Net of “value effects” that depend from the changing composition of the reserves, falling oil revenues and GDP slowdown in major exporting countries remain significant explaining factors.

Figure 3.

A central bank’s monetary policy stance is often captured better by changes in their overall balance sheet that comprehend both FX reserve movements than other conventional monetary policy actions, e.g. reserve rates cuts or repo operations.  Broad-based indicators such as monthly variation in central bank total assets are more informative of the aggregate global value of central bank liquidity.

Figure 4 illustrates the historical movements of central bank assets in the past 6 six years: Fed QE 2 and 3 are clearly identified by the navy bars, and Shinzo Abe’s QQE (Qualitative and Quantitative Easing) is captured by the red bars. The first expansion in ECB balance sheet of 2011-2012 (light blue bars) is attributable to the two big LTROs, and the subsequent contraction is due to LTROs repayment by European banks. In 2015 the Draghi QE (the Public Sector Purchase Programme or PSPP) has taken off and has pushed the ECB net liquidity flows in positive territory. It’s interesting also to notice the expansionary pulses of the Swiss National Bank (SNB) monetary policy, aimed at maintaining the peg of the Swiss Franc with the Euro in 2012-2014. The last frantic efforts ended suddenly in January 2015, when the ballooning the of SNB balance sheet and the accelerating expansion of the monetary base forced the SNB to readjust the CHF /EUR exchange rate.

Figure 4.

Declining FX reserves caused concern in global markets following the decision of the PBOC to abandon the Renminbi fixed exchange rate with the Dollar. Struggling against mounting pressures on the Renminbi / Dollar exchange rate, the People Bank of China flooded the market with US Treasuries, causing a spike in yields and turmoil in global equities. Since selling foreign assets acts as a counterbalance to Quantitative Easing, some market participants applied the phrase Global Quantitative Tightening (QT). In other terms, by liquidating US Treasuries and other OECD government and private bonds, the central banks of emerging countries resupply the market of securities, balancing the purchase made by their OECD counterparts. This QT action by emerging and oil-exporting countries would therefore drain liquidity from the market, neutralizing expansionary policies of Eurozone and Japan. In this perspective the $ 130 billion of fresh money injected monthly via asset purchases by the OECD central banks would be offset by their emerging counterparts.

Our indicator of central banks' global liquidity seems to support this reconstruction. In 2015, EM central bank sales of foreign assets reduced central banks’ liquidity flows (Figure 5). The effect began in July and peaked in September during the Renminbi crisis.

Figure 5.

The concept of global QT gained traction in September 2015 as the negative correlation between global equities and foreign reserves increased. The Fed’s decision to maintain interest rates relieved the downward pressures on Renminbi and the interest in QT quickly waned. 

There have been reasoned opinions on the economic theory behind global QT. More than one analyst correctly observed that a USD asset sales by foreign central banks will not drain liquidity and counteract Fed monetary policy because these assets simply change hands and do not disappear. Changing ownership does not preclude reinvestment in the US banking system, which limits the sale’s tightening effect. Moreover, as already pointed out, changes in foreign reserves may not reflect a central bank’s attitude towards monetary policy since they do not account that other conventional monetary policy actions on banks’ reserves or interest rates can dominate changes of foreign reserves.

In the last quarter of 2015, the correlation between global stock indices and central banks net liquidity is again up (see Figure 6).

Figure 6.

Remarkably, temporary positive net flows of central banks liquidity are associated with the markets rebound of October 2015.

We are obviously aware that correlation does not necessarily mean causation. From a broader perspective, it's more than reasonable that the same three cyclical drivers that explain drawdowns in foreign reserves (China’s slowdown, the US rate hike cycle, and collapsing oil prices) are also affecting equity markets.

We should acknowledge these changes in foreign reserves as a reaction by emerging countries central banks to these three primary factors. Nevertheless, their impact on net liquidity, which may mitigate monetary expansion by the ECB and BoJ should be worthy of further investigation.

Further Reading:

Winkler, Robin, “The Great Accumulation” Is Over: FX Reserves Have Peaked, Beware QT”, Deutsche Bank Market Research (September 2015).

Asymmetric Wager Blog, September 11, 2015 Economics: The Myth of "Quantitative Tightening" http://prodiptag.blogspot.in/2015/09/economics-myth-of-quantitative.html

Discussion on FT Alphaville, September 14, 2015 "Debunking quantitative tightening in one paragraph?" http://ftalphaville.ft.com/2015/09/14/2140021/debunking-quantitative-tightening-in-one-paragraph/

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The Golden Age

Guest post by $hane Obata


Some people say that gold is dead. They point to deflationary pressures and a bear market that started back in September of 2011. The bulls have been wrong for years; however, that may be about to change…

At present, there are multiple reasons to consider gold:

• Sentiment is very negative and almost everyone is underweight

• Supply & demand fundamentals are positive

• Chinese demand continues to rise

• Gold is a means to portfolio diversification

• The main risks to prices are overblown

In the next sections, we will examine the bull case for gold and the risks facing it. In conclusion, we will try to answer the following question: Is this the beginning of a new golden age?

Sentiment & Positioning

In the latest Barron’s Big Money Poll, only 3% of respondents thought that gold was the most attractive asset class. Moreover, 71% were bearish on the yellow metal. Volume traded in $GLD (the SPDR Gold Trust ETF) has come down dramatically, which indicates a lack of interest in gold bullion. Volume traded in $GDX (miners) and $GDXJ (junior miners) has been increasing; however, interest in “gold mining stocks” has been falling since mid-2011. This suggests that traders are trying to catch the falling knife, even though investors are not convinced that gold is undervalued.

In terms of positioning, market participants are heavily underweight materials and commodity stocks. Is this a contrarian buying opportunity? It could be. Especially because the current bear market is getting old. The following table shows the 5 most recent bull and bear markets:

Gold prices fell by 44% over the 52 months from September of 2011 to January 7th of 2016. Those numbers match the median length and average cumulative return of the previous 4 bear markets. Gold may continue to fall from here; however, we are probably closer to the end of the bear market than to the beginning…

Supply & Demand

~46% of gold production is FCF negative at current prices. In other words, $1100 is not the equilibrium price. If we stay at these levels then supply will likely decline. Analysts at Credit Suisse ($CS) are projecting a deficit to begin in 2016. They expect that mine supply will fall by 11.5% from 2015 to 2018:

Even at higher prices, gold miners will be unable to replace all of their depleting reserves. Also, it will be very expensive for them to bring new projects online. Lastly, it is important to note that major gold discoveries have become scarce. These trends are negative for supply and positive for prices.

On the demand side, Asia and Europe should continue to support the market. Total bar and coin demand (in tonnes) increased 33% YoY from Q3’14 to Q3’15. Furthermore, consumer demand was up across the board, with exceptionally big numbers in the US. According to the World Gold Council (WGC), “coin sales by the US mint during the quarter were on par with that of Q4 2008.” Another key source of demand is central banks. They have continued to buy as they look to diversify their reserve assets. This speaks to gold’s utility as a portfolio diversifier. Total demand has been falling; however, the quarterly numbers suggest it could be stabilizing. Going forward, consumer demand is likely to offset ETF outflows.

India & China are the main drivers of demand for gold. In 2014, they accounted for ~1710 tonnes of demand. To put that in perspective, 1700 tonnes = 53% of total consumer demand:

Gold is a big part of both India’s and China’s culture. As such, it is likely that demand will remain strong.

 China’s Gold Market

There is an interesting divergence taking place in the physical gold market. China’s demand numbers, as measured by withdrawals from the Shanghai Gold Exchange (SGE) are much higher than those reported by the World Gold Council (WGC). SGE withdrawals exceeded the WGC’s demand estimates by 3,193 tonnes from 2007 to 2014.

The following passage is from Bullion Star’s Koos Jansen helps to explain the discrepancy. “The difference was labeled as net investment (in the CGA Gold Yearbook 2013 at 1,022.44 tonnes), which is calculated by the China Gold Association (CGA) as a residual between what is withdrawn from the SGE vaults and gold sold at retail level (jewelry shops and banks). The WGC doesn’t count net investment on its demand balance, but only measures what is being sold at retail level. Net investment, which roughly equals the difference, can only be caused by direct purchases from individual and institutional customers at the SGE that withdraw their metal.”

In China, gold imports must pass through the SGE before entering the market place. In addition, bullion exports are prohibited. It follows that Imports + Mine Supply + Scrap = Total Supply = SGE Withdrawals. Said another way, SGE withdrawals are equivalent to domestic wholesale demand. The preceding formula is supported by reports from the CGA and the SGE. For example, the SGE reported that 2197 tonnes were withdrawn its vaults in 2013. That is the same number that the CGA reported for total demand in 2013. More evidence comes from the SGE’s chairman, Xu Luode, who said the following in 2014:

The main conclusion is that the SGE’s measure of Chinese gold demand is much higher than the WGC’s. If the SGE’s number are correct then China is absorbing most of the world’s mine supply. Gold withdrawals from the SGE for 2015 amounted to 2596 tonnes, or 91% of world gold production:

Diversification & Protection

Gold has a negative correlation with US stocks during expansions. More importantly, its correlation with both global and US stocks is more negative during contractions:

As a result, gold tends to rise when stocks fall, which is good for portfolio diversification.

Gold is also an FX hedge for foreign investors. In 2015, it performed relatively well in non-dollar currencies such as the Brazilian Real, the Russian Ruble, the Chinese Yuan and the Canadian dollar. This is important because non-US countries are the main consumers of gold.

Loose monetary policy is here to stay. This cycle, every central bank that tried to raise rates has had to reverse course. That is bad for currencies and good for gold, since no one controls its supply.

Gold can also protect us against a rising cost of living because it tends to hold its value over time. If you look at the CPI then inflation seems relatively low. That said, the CPI is a utility index, not a measure of the cost of living. Most people would agree that cost of living is rising. For example, education and medical care costs have been outpacing the CPI for years.

Risks

Gold’s main threats are…

1) A stronger USD

Typically, the US dollar index and gold are negatively correlated. Said differently, when the dollar index does up, gold goes down. Even so, last year, the US dollar (USD) influenced gold prices more than it usually does. In 2015, the correlation between the two was -0.50 in 2015, much higher than -0.36, which is the 30-year average. Going forward, it’s likely that the correlation between gold and the USD will revert back to normal.

An additional concern is rising rates. One may assume that higher interest rates are good for the dollar. Actually, that is not the case. Historically, the dollar has stopped appreciating when the US raised rates. If the USD index has peaked then that would be good for gold prices.

2) Rising rates

Despite the fed’s intentions, the yield curve (2s10s) has flattened to its lowest levels of the expansion. The short end has increased but the long end, which is driven by growth expectations, has not. Basically, the market is not convinced that the era of low rates is over.

Even if rates do increase, gold may perform well. According to Sundial Capital Research, gold actually does quite well in rising rate environments. Gold prices increased by an average of 25.2% in each of the rising rate environments from Dec31’76 to Dec27’13. The median gain was 5.2%, which is much less impressive but still positive. Low rates are probably better for gold than high ones. That said, it may show good returns either way.

3) Leverage

In the US, the paper gold market is much bigger than the physical one is. In other words, many contracts are traded but not much gold changes hands. The level of gold dilution has reached unprecedented levels. In a recent blog post, zerohedge showed that there are 40 million ounces worth of open interest but only 74 thousand ounces of registered gold at the Comex. This works out to a gold cover ratio (open interest/registered gold) of 542! The takeaway point is that the amount of gold that is traded is much greater than the amount that actually exists.

The downside risk is that supply in the futures market overshadows demand in the physical market, thereby weighing on prices. Still, there is an upside risk. If demand for physical gold remains strong and inventories continue to fall then then the Comex may run out of supply. If that happens then gold prices will rise as market participants start to question the divergence between the paper and physical markets.

Conclusion

Gold should be considered as a contra buy…

• It is hated
• Its fundamentals are improving
• Demand from the east is robust
• It is negatively correlated with stocks
• The benefits outweigh the risks

Gold is massively under owned. If sentiment improves then it could easily outperform other asset classes in 2016…




$hane Obata & Richardson GMP AM

Edited by Matt Garrett.
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