Category: Market Action

PerpetualDiscounts now yield 5.42%, equivalent to 7.05% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 3.90%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 315bp, a slight (and perhaps spurious) narrowing from the 320bp reported March 7.

Today’s gloom comes to us courtesy of Moody’s:

Canada’s mountain of consumer debt is triggering multiple alarms about the threat to the country’s banks.

Moody’s Investors Service joined the Bank for International Settlements and S&P Global Ratings which have all warned in the last month that Canada’s banking system, dominated by five giants, is facing a growing threat of souring consumer loans amid rising interest rates. The country’s ratio of household debt to disposable income reached a record 171 percent in the third quarter of last year.

The proportion of uninsured mortgages has increased to 60 percent from 50 percent five years ago, including home equity lines of credit, amid government efforts to reduce taxpayer exposure, according to the report from Moody’s on Tuesday. Canada Mortgage and Housing Corp., a government agency, insurers the bulk of mortgages in Canada.

Almost half of outstanding mortgages, many of them on fixed-rate terms, will have an interest-rate reset within the year, increasing the strain on households’ debt-servicing capacity, Moody’s said.

This looks like bad news for Aimia:

PC Optimum points will replace Aeroplan miles as the loyalty program of choice at Esso stations across the country effective June 1, as Imperial Oil Ltd. shifts its relationship to Loblaw Companies Ltd.

Aimia Inc.-operated Aeroplan notified members of the change to its 14-year partnership in an email on Tuesday.

It noted that up to 1.5 miles for every dollar spent will continue to be earned when using Aeroplan-affiliated credit cards for purchases at any retailer, including Esso.

Canadian consumer confidence took a hit:

Economic sentiment cooled for a second straight month in February, according to polling by Nanos Research Group for Bloomberg News, with Canadians increasingly concerned about the sustainability of the nation’s expansion.

It’s been a dramatic reversal in consumer confidence. Over the past two months, sentiment has dropped from near record highs to below average levels, reflecting an overall deterioration in economic conditions for households. These include three rate hikes by the Bank of Canada since July, a weakening Canadian dollar, sharp declines in stock prices, renewed worries about the housing market and a slowing economy.
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Highlights of the Consumer Confidence Report

•The decline in February was largely driven by expectations, rather than pocketbook issues
•For example, Canadians are becoming more negative on the economy’s outlook, with pessimists outnumbering optimists. About 22 percent of Canadians see the economy strengthening, versus about 28 percent who see it worsening. That’s the biggest negative month-end gap since last May
•A month ago, optimists outnumbered pessimists 28 percent to 23 percent
•Expectations for real estate prices also showed a small deterioration in February
•Pocketbook issues like job security and personal finances were largely stable or better in February, after posting large declines in January
•Regionally, Alberta and British Columbia recorded sharp declines in sentiment in February, possibly reflecting a pipeline dispute between the two provinces.

Meanwhile, sabre-rattling over trade continues:

The top U.S. trade envoy said on Monday that bilateral deals could replace NAFTA if the pact is not renegotiated soon, ramping up pressure on Canada and Mexico, already smarting from President Donald Trump’s plan to impose steel and aluminum tariffs.

U.S. Trade Representative Robert Lighthizer said political headwinds would increase the longer the negotiations dragged on, warning that time to rework the 1994 trade deal was running “very short.”

“We would prefer a three-way tripartite agreement. If that proves impossible, we are prepared to move on a bilateral basis,” Lighthizer said, reading from a statement in Mexico City at the end of a seventh round of talks.
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The Mexico City round of NAFTA talks was thrown into disarray after Trump announced a plan last week to impose a 25 per cent tariff on steel imports and a 10 per cent tariff on aluminum imports, arguing they were needed to protect U.S. industries and jobs.

Trump tweeted earlier on Monday that “Tariffs on Steel and Aluminum will only come off if new & fair NAFTA agreement is signed.”

Lighthizer said that meant Canada and Mexico would enjoy tariff exemptions once a NAFTA deal was reached, calling the tariffs an “incentive” to conclude the talks.

But there is no unanimity:

U.S. House Speaker Paul Ryan urged the Trump administration not to move forward on the tariffs, citing risks to the economy, after Trump’s threats led to warnings about retaliatory moves from trading partners.

But it’s entirely possible that the whole tariffs kerfuffle is just a negotiating tactic. Hasn’t Trump bragged about the power of bluster when making deals?

U.S. Trade Representative Robert Lighthizer said the Trump administration has offered to exclude Canada and Mexico from tariffs on steel and aluminum as an incentive to reach a deal on a new Nafta before a string of elections make it difficult.

President Donald Trump’s “view was that it makes sense that if we get a successful agreement, to have them be excluded,” Lighthizer told reporters in Mexico City on Monday following the seventh round of talks to renegotiate the North American Free Trade Agreement. “It’s an incentive to get a deal.”

More trade-war chatter:

World Trade Organization Director General Roberto Azevedo expressed concern at U.S. President Donald Trump’s plan for tariffs on steel and aluminum on Friday, an extremely rare intervention into a WTO member’s trade policy.

“The WTO is clearly concerned at the announcement of U.S. plans for tariffs on steel and aluminum. The potential for escalation is real, as we have seen from the initial responses of others,” he said in a brief statement issued by the WTO.

“A trade war is in no one’s interests. The WTO will be watching the situation very closely.”

And Trump’s boasting that he’s got a bigger button than the rest of the world put together:

U.S. President Donald Trump struck a defiant tone on Friday, saying trade wars were good and easy to win, after his plan to put tariffs on imports of steel and aluminum triggered global criticism and a slide in world stock markets.

The European Union raised the possibility of taking countermeasures, France said the duties were unacceptable and China urged Trump to show restraint. Canada, the biggest supplier of steel and aluminum to the United States, said it would retaliate if hit by U.S. tariffs.

Trump said on Thursday that tariffs of 25 per cent on steel imports and 10 per cent on aluminum products were designed to safeguard American jobs in the face of cheaper foreign products and would be formally announced next week.

“When a country (USA) is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win,” Trump tweeted on Friday.

“Example, when we are down $100-billion with a certain country and they get cute, don’t trade anymore-we win big. It’s easy!” he wrote.

Sure. Messrs. Smoot and Hawley won their war back in the thirties.

So, despite more pointed comments about US inflation…:

Speaking of the Fed, it was behind the S&P 500’s travails Tuesday and Wednesday, a 2.4 percent retreat that before last month would’ve qualified as the worst selloff in a year. Stocks slid as Powell, who has vowed continuity with predecessor Janet Yellen’s pace of interest-rate hikes, hinted the central bank may be faster on the draw than anticipated.

“Powell surprised people by being a bit more frank than folks expected,” said Max Gokhman, head of asset allocation for Pacific Life Fund Advisors. “That doesn’t necessarily work as a Fed chair, especially when we’re latching onto every single word that the Fed officials say.”

The new chairman been at the helm for just a month, obviously too little time to say if the markets like him. What is clear is that a combination of rate angst and Trump’s saber rattling has erased half the S&P 500’s 7.7 percent rebound from a Feb. 8 low.

For the week, the S&P 500 ended down 2 percent, almost twice as much as any decline registered in 2017. The Dow Jones Industrial Average fell 3.1 percent, while the Nasdaq 100 index lost 1.22 percent. Small-caps lost 1 percent.

… Canadian bond yields were down today, with the five-year closing at 2.00%.

Of course, poor GDP numbers probably had something to do with that:

Canada’s economy decelerated more than expected in the second half of last year, amid signs indebted households have begun slowing down spending.

The economy grew at an annualized pace of 1.7 percent in the fourth quarter, Statistics Canada reported Friday, versus economist expectations for 2 percent growth. Third-quarter gross domestic product growth was also revised down.

After leading the Group of Seven in growth last year, Friday’s numbers show a Canadian economy that has lost momentum, seemingly hampered by longstanding productivity issues and the growing potential of a hangover from the real estate boom. The U.S. economy recorded growth rates of 3.2 percent in the third quarter and 2.5 percent in the last three months of 2017.
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What may be worse is that fourth-quarter GDP figures were exaggerated by temporary factors in housing. Spending on residential structures surged in the last three months of 2017 to an annualized 13.4 percent, the strongest quarterly increase since 2012. The gain was led by stronger-than-expected new home construction, and as buyers rushed to get ahead of tighter mortgage qualification rules that came into effect Jan. 1.

The increase in residential spending was responsible for 1 percentage point of the 1.7 percent growth rate, Statistics Canada said.

Let’s have a trade war!

Canada is vowing to retaliate if U.S. President Donald Trump makes good on his pledge to impose steep tariffs on steel and aluminum producers — while holding out hope that it could be exempt.

Trump said he intends to slap a 25 percent duty on steel imports and 10 percent on aluminum in order to protect the national industry, though details remain unclear. His words sent U.S.-based producers rallying but could hurt companies that ship steel and aluminum from Canada, including Rio Tinto Group and Stelco Holdings Inc., without an exemption.
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“The President has just initiated an all-out trade war,” said Jean Simard, chief executive officer of the Aluminum Association of Canada. Aside from the direct impact on the countries affected, Europe will need to protect itself from a flood of redirected metal because the U.S. is not an open market anymore, he said.

“We have to keep hoping” for an exemption for Canada, Simard said.

London-based Rio Tinto, which ships more than 1.4 million metric tons of aluminum to the U.S. annually from Canada, said it will continue to lobby Washington for an exemption given the highly integrated Canada-U.S. market for autos and other manufactured goods.

Surprisingly:

President Donald Trump’s closest Republican allies on Capitol Hill are criticizing his plan to impose tariffs on steel and aluminum imports to protect national security, while some Democrats are applauding.

The upside-down reaction comes a day after Trump irked Republicans and pleased many Democrats by backing stricter gun-control measures and suggesting the government could take guns, initially without due process, from some citizens viewed as dangerous.

Enough of this could choke off the recovery and therefore delay the return to interest-rate normalcy:

Investments by foreign companies in Canada slumped last year to the lowest level since 2010, amid mounting concerns about national competitiveness and uncertainty surrounding the renegotiation of the North American Free Trade Agreement.

Foreign direct investment nosedived 26 per cent to $33.8 billion in 2017, Statistics Canada reported, continuing a trend of declining interest by foreign firms. And for the first time since data collection on the topic began in 2007, foreign firms sold more Canadian companies than they bought.

And it may be that we are finally getting our come-uppance for our cheap labour industrial strategy:

Energy companies are chopping their budgets even as global oil prices climb back from a crash, and may lose about C$16 billion ($12.4 billion) of revenue this year because of discounts on Alberta’s heavy crude — a problem blamed on a lack of pipeline space. Foreign direct investment in Canada, meanwhile, has fallen to the lowest since 2010.

Another unknown for investment prospects is how companies are dealing with production constraints. As firms bump up against production capacity at this high point in the economic cycle, you’d expect capital expenditure intentions to be widespread across industries. Yet capex is expected to increase just 0.8 percent even with capacity utilization hitting a 10-year high of 85 percent.

It’s possible companies are increasingly turning to the labor market to address excess demand, which would explain Canada’s string of red-hot jobs reports last year. That preference could further constrain business investment.

PerpetualDiscounts now yield 5.43%, equivalent to 7.06% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little over 3.90%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 315bp, a sharp widening from the 300bp reported February 21.

The federal budget came out today:

One major change is C$7.2 billion ($5.7 billion) less infrastructure spending through 2019, an amount that has been allocated to other departmental spending.
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On a cumulative basis, including risk buffers worth C$3 billion annually, deficits over the six years including 2017-18 are projected to total C$98 billion. That’s little changed from the October forecast.
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The government has implemented a watered-down version of reforms for “tax planning.’’
•On passive investment, the new system only gradually reduces access to the small business tax rate for corporations with significant passive investment.
•Measures will limit tax advantages that larger Canadian- controlled private corporations can obtain by accessing refundable taxes on dividends.
•The two changes combined, including new restrictions on so- called income sprinkling announced last year, will add C$925 million to government coffers annually by 2022.
•The Trudeau government is also promising new rules to prevent banks and other financial institutions “from gaining a tax advantage by creating artificial losses.’’ The move will create C$560 million annually by 2022.
•A tax increase on tobacco is worth C$1.5 billion over six years, and levies on cannabis are expected to generate C$690 million over six years after it is legalized this summer.
•Canada has also taken a C$2.1 billion hit over six years from lost tariffs due to the Trans-Pacific Partnership agreement.

I’m not happy about the continuing deficit. Government finances should be managed to break even on a through-the-cycle basis, which means that right now we should be running a small but increasing surplus.

I’m also not happy about the Inefficent Business Tax Subsidy; although there has been some progress, the legions of well-connected doctors and lawyers retain their special tax bolthole:

The budget unveiled new details on the taxation of passive investment income inside private corporations.

When companies earn between $50,000 and $150,00 in a given year from passive investments, a reduced amount of their active business income will be eligible for the small business tax rate, which will be 9 per cent in 2019. (The upper limit for business income that can be taxed at the small business rate is $500,000.) The reduction will occur on a straight-line basis, with eligible income decreasing by $5 for every $1 of passive income above the $50,000 threshold.

Companies exceeding $150,000 in passive income will no longer be eligible for the small business tax rate. Those with passive income under $50,000 will not be affected, as was mentioned in a revised proposal.

Davies Ward Phillips & Vineberg LLP has published a more detailed commentary.

In order to pay for this well-deserved reward for those old-stock Canadians who, by dint of hard work, integrity, stick-to-it-ivness and the fact that mommy and daddy were doctors and lawyers, have become doctors and lawyers, the practice of tax surcharges that increase the effective marginal tax rate on plebian scum have been retained:

Click for Big

See that? The benefits claw-back represents an increase to the posted effective marginal tax rate of 14% immediately, planned to decline (precipitously!) to 12% in the future. From this one programme alone. Yes, sir, it’s very important to destroy incentive to pick up that extra shift, accept that extra responsibility, move to a new province to get that slightly better job! They can have a little extra welfare money, as long as they don’t get too uppity.

Hard on the heels of my mention of foreigner bashing in BC and the interesting discussion that followed comes a Bloomberg story about Canadian mortgage fraud:

Evidence of mortgage fraud amid surging home prices and household debt has prompted S&P Global Ratings to lower a key risk metric for Canadian banks.

The credit ratings agency dropped its economic risk assessment by one notch due to evidence of residential-mortgage fraud at smaller Canadian banks, which could compound existing risks from the country’s hot housing market, according to a statement Friday. S&P lowered the Canadian banks’ economic risk level to 3 out of 10, with a higher number representing great risk, revising the trend to stable. That puts Canada in line with the U.S., but lower than the U.K. and Australia.

High housing prices and debt loads increase incentives for fraudulent activity such as overstating a borrower’s income to meet qualifying criteria. Additionally, a growing share of mortgages is being originated by brokers who don’t bear the credit risk for the loans like lenders, according to the statement.

That second paragraph is very poorly written (I think the reporters had problems with “higher” and “lower” as it related to the scale used by S&P), but given the rest of the article I conclude it means they have reassessed “economic risk level” so that it is less desirable than it was before.

The S&P statement also referred to a press release from Equifax Canada about a report that I can’t find on their website (I can’t find the press release there, either!):

Equifax Canada (NYSE:EFX) data suggests high-risk and suspected fraudulent mortgage activity is on the rise noting a 52 per cent increase in suspected fraudulent mortgage applications since 2013.

According to data from Equifax’s enterprise fraud management solution, ‘Falsified Account Statements’ and ‘Falsified Documents’ were the most prominent application tags, as reported by investigators. The other was ‘Conflicting Information’. Of those applications flagged, 67 per cent were from Ontario while the next highest was 12 per cent from B.C.
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Little White Lies

With respect to mortgage fraud, the results of the recent Equifax survey showed:
•13 per cent of Canadians indicated they felt it was okay to tell ‘a little white lie’ when applying for a mortgage to get the house they want.
•16 per cent said they believe mortgage fraud is a victimless crime
•8 per cent admitted to misrepresenting the facts on a credit or loan application

The Cost of Buying a Home

When asked about housing prices, the results of the recent Equifax survey showed:
•84 per cent believe that the cost of home ownership is too high for first-home buyers today
•Nearly three-in-ten Canadians cite ‘more demand than supply’ (29 per cent) and ‘foreign buyers’ (27 per cent), as the main factors driving up home prices
•B.C. residents (compared to other provinces) were significantly more likely to cite foreign buyers as the top reason for home prices being driven up (75 per cent versus 42 per cent for all other provinces, respectively

So, we’ll see how it goes when mortgage renewal rates go up to 6%, which they probably will at some point, although not necessarily in my lifetime. I have a great personal interest in this matter, as every now and then a prospective client sneers at the pathetic yield offered by preferred shares and condescendingly informs me that he can get 8%, no problem, from a mortgage investment corporation. I don’t think these guys know about risk … but then, they don’t have to! Every one I’ve ever talked to is smart enough that he’ll get out before problems become apparent to the hoi polloi.

Don’t get me wrong! I’m sure that private mortgages are a decent enough asset class and I’m sure that there are some mortgage grantors who are better at their job than others. It’s just that I don’t think a lot of people enamoured of the sector know the ‘Capital Destruction Partners’ paradigm (where you make great returns for twenty years and get wiped out in the twenty-first); and all the MIC advertising I’ve ever seen plays to that ignorance.

For instance, let’s look at Income Trust One, which touts its 8.32% nine-year historical average return. The fund fact sheet refers to a “Weighted Average LTV” [Loan to Value] of 50.8%, which sounds pretty good, right? So I looked further down and got some more detail:

Click for Big

This puzzled me. How does an LTV of 50.8% square with historical returns of 8.32% (and over 7% in each of the three quarters to the 2017Q3 publication date)? So I sent them an eMail:

I would like some clarification regarding your calculation of Loan to Value as reported on your Fund Fact Sheet as of September 30, 2017.

How do your calculations account for the Security Position of your mortgages?

For instance, if a property is considered to have a value of $800,000 and has a first mortgage outstanding with another firm for $400,000 and you have a second mortgage on the property for $200,000, what do you consider the LTV for your portion of the mortgage to be?

… and they were kind enough to answer …

Thank you for your email. Good question.

The loan to value (LTV) is calculated as the total amount of loan been borrowed (not just our portion) on a property (1st mortgage+ 2nd mortgage+…) / the appraisal value of the property.

Using your example below, the LTV will be (1st mortgage balance $400,000 + 2nd mortgage $200,000)/property appraised value ($800,000): ($400,000+$200,000)/$800,000 = 75%

So that seems reasonable enough and is actually quite heartening … but it’s not the whole story because it does not account for the subordination of the second mortgage; it treats the first and second mortgages equally for LTV calculation purposes and so is obviously not a metric one would wish to use much for risk evaluation purposes.

For instance, in a first-mortgage-only situation, a LTV of 75% means that if the property loses 25% of its value, then the mortgage debt is exactly covered. This is also the case when the $600,000 loan is split as above. So far, so good.

But say the property loses half its value. In this case, the first mortgage is precisely covered and the second mortgage is wiped out. That is the crucial difference. This is the structured finance conundrum that led to a lot of people getting nasty surprises during the Credit Crunch, as discussed long ago in the post Hull & White on AAA Tranches of Subprime.

Now I don’t want anybody to think that I’m picking on Income Trust One – I looked at them only because I saw their ad in the paper on the weekend when I had a little spare time that I created by neglecting my programming duties. It may be the best investment ever. It might not be. To take an informed view, I would have to do some very detailed work on the component mortgages of the Fund – and this level of detail is not available in the fund’s offering memorandum or the audited financial statements. Then I’d need some kind of covariance model and all that other good stuff we learned about during the Credit Crunch. Also, one notices from the 17Q3 Financial Statements (unaudited) that the fund is levered up: unitholders’ equity of $127-million is boosted with a $43-million loan, so that has to be accounted for. I’m not going to do all that work.

And I don’t think any of the guys who have sneered at the paltry expected yields on Canadian Preferred shares have done all that work either.

A recent survey shows Canadians don’t know the difference between their bank and their mommy:

Among the most common types of advice retail bank customers seek are investment-related advice (47 per cent); quick tips to help improve their financial situation (45 per cent); retirement-related advice (42 per cent); advice to help keep track of spending and household budgets (32 per cent); and in-depth financial review (30 per cent).

In addition, almost 30 per cent of customers younger than 40 years old say they are “very interested” in receiving advice from their bank.

There’s a good drone story from the UK:

A man who crashed his car in freezing night-time temperatures was saved from hypothermia when he was found by a police thermal-imaging drone.

He was discovered in a deep ditch, 500ft (160m) away from his car on the A16 near Ludborough, Lincolnshire.
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Sgt [Mike] Templeman said: “We didn’t know if this male had been picked up, [or] if he had carried on walking.

“We did extensive searches in the [police] vehicles, obviously we are very rural and it was very dark so you’re limited in what you can see.”

The OPP has a similar system, but I don’t know how widely deployed it is:

The OPP and Georgian Bay Volunteer Search And Rescue (GBVSAR) have taken over the Wye Marsh in a training session today [November 29, 2017]. Volunteers and officers have set up a command post to search for two “missing” men at the marsh. The scenario details that the men didn’t return to their vehicle early in the morning and the OPP and GBVSAR have been deployed to help look for them.

The OPP are able to bring in a UAS (unmanned aerial system), aka a drone, to help aid in the search. The drone has the ability to go up about 400 ft off the ground and travel up to speeds up 16-20 knots. There’s a thermal imaging camera on board to help the operator on the ground track what they are seeing from the sky. The camera is detailed enough to show the operator when something is an animal or a person in possible need of assistance.

BC has a formal testing programme:

A year into a pilot project to test unmanned aerial vehicles (UAVs) — commonly known as drones — for search and rescue, the province says the jury is still out on the high-tech helpers.

Search teams in Coquitlam and Kamloops got the go ahead from Emergency Management B.C. (EMBC) to test the tools last December [2016].
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But EMBC search and rescue specialist Andrew Morrison said the drones haven’t seen enough air time yet to draw any firm conclusions.

“For example, Coquitlam Search and Rescue had zero deployments. Kamloops Search and Rescue had requested a UAV 18 times and deployed nine times,” he said.