Some Investors are Betting Against Canada. Should We Be Worried?

04/30/2013 by Alex Carrick

Some investors are placing bets against Canada. They’re short selling our currency, avoiding our equities and talking down our economy. Should we be worried?

The Toronto Stock Exchange (TSX) has risen only 50% since February 2009, the low point in the recession for share values, while both Dow Jones Industrials (the DJI) and the S&P 500 have more than doubled.

The value of our “loonie” (i.e., the Canadian dollar, not the bird) has fallen below par with the U.S. greenback. It seems to be finding a new comfort zone around 98 cents U.S.

The naysayers have two primary “beefs”.  

First, in their minds, there’s the possibility the current record-high level of consumer indebtedness, combined with unrealistically strong housing starts over the past decade (200,000 units-plus on too many occasions), may have created a speculative bubble.

If it bursts, our previously teflon-coated Canadian banks may be in for a scorching. They breezed through the recession with nary a scratch, but weaker mortgage lending and an upsurge in properties “under water” would test them to an uncomfortable degree.

When the market value of a home falls below the outstanding principal amount remaining on its mortgage, it is said to be “under water”. That’s when foreclosure becomes an ugly possibility.

The banks have an impressive backstop. The majority of Canadian mortgages are insured with Canada Mortgage and Housing Corporation (CMHC). Home prices would have to fall dramatically (i.e., by at least 20%) to cause much anxiety on Bay Street.

In turn, CMHC has the federal government as its piggybank. Only two nations among the G8 – Germany and Canada – still retain Triple A ratings (or the equivalent) from all three major debt assessment agencies, Moody’s, Standard & Poor’s and Fitch. 

Second, since shortly after the turn of the century, the emerging world has been generating an explosive increase in demand for raw materials that only a few nations can satisfy.

Until recently, Canada’s future seemed assured thanks to the upward aspirations of billions (that’s right, billions, not millions) of the world’s poor striving to improve their lifestyles from barely scraping by to middling-going-on-pleasing prosperity.  

But now some of the major developing nations are showing degrees of hesitancy.  

China’s growth rate slowed to +7.7% (annualized) in the latest quarter from +10.0% and higher a couple of years ago.  India has a persistent problem with inflation, +10.4% in March.

Higher interest rates are the traditional answer to rapid price increases.

Russia and Brazil are the other two BRIC nations and their inflation rates aren’t behaving well either, +7.0% and +6.6% respectively.

Success itself is breeding problems for some of these countries. The cost of labor is shifting dramatically higher in China (population 1.4 billion).

Rich-nation firms can still find cheap labor in Indonesia (235 million), Pakistan (186 million), Bangladesh (165 million), the Philippines (94 million) and Vietnam (90 million).

This is proving to be far from ideal. In resource sector trade, morality has been a longstanding issue. Hence the emphasis on promoting conflict-free diamonds, for example (i.e., diamonds neither extracted nor sold to finance civil wars in Africa.)

Ethical practices – given child labor and minimal wages in some poor countries – are ongoing issues for running shoe and inexpensive-clothing manufacturers.

Such social activism will receive a further boost from the recent tragedy in Bangladesh. A structurally faulty building north of Dhaka collapsed, killing nearly 400 garment-industry workers. Cracks were spotted in the building’s exterior the day before. Workers were told by local managers that if they stayed away, they wouldn’t be paid.    

Loblaws Inc., owner of the popular Joe Fresh line of apparel made at the site, has promised to compensate the families of the victims. A number of high-profile companies are banding together to commit funds to ensure better working conditions.

The ties between the developing world and Canada have grown stronger. But our ability to deliver some products to offshore markets is being compromised. For example, construction of new oil pipeline capacity to the Pacific Coast is facing fierce opposition.

Adrian Dix, leader of the NDP Party in B.C., and favored by pollsters to become the province’s next premier, has just voiced his opposition to Kinder Morgan’s pipeline expansion. Earlier, he expressed disapproval for Enbridge’s Northern Gateway proposal.  

The most extreme advocates in the environmental movement don’t want to see these projects built, period. Aboriginal leaders are striving to maintain traditional ways of life and/or ensure that their bands and members maximize their commercial and job opportunities if the projects do proceed.

Canada’s resource sector isn’t the only one struggling to stay afloat in this storm-tossed boat. Coal miners in the Powder River Basin of Wyoming and Montana – where 40% of total U.S. production occurs – want to tap into the lucrative export markets of China and India.

But they’re embroiled in a mighty battle with urban dwellers on the Pacific Coast who don’t want more export terminals built in their neighborhoods. Four such projects are proposed, with the largest to be located in Bellingham in the northwest corner of Washington State.

An increase in the number of trains rolling through Seattle – with the potential to tie up vehicular traffic and clog the atmosphere with flying coal dust – has elicited the expected negative response from city dwellers. This too quickly dismisses high-paying jobs in construction, at the dockyards and with bulk carriers, plus greater tax revenues to fund local spending programs.   

Returning to the global demand for raw materials, a good gauge for the supply-demand balance can be found in commodity prices. We know that gold and copper have fallen into bear territory, which is a drop of 20% or more. How are other commodity prices faring?

The Bank of Canada publishes indices on an annual, monthly and weekly basis. The results are interesting as well as somewhat surprising.

The BOC’s four major commodity-price sub-indices are for energy, metals and minerals, forestry products and agriculture. There’s also a fish sub-index, but it moves in a relatively narrow band influenced more by seasonality than cycles.   

Each of the sub-indices adopts January 1972 as its starting point and base. In other words, each subsequent month’s price level is expressed relative to that opening period. Another familiar way to say this is through the equation, January 1972 = 100.0.  

The energy price sub-index overwhelms all the others. Comprised of oil, natural gas and coal, it reached as high as 2,789 in June 2008. Metals and mining achieved the second highest peak, but only at a level of 851 in April 2011.

Between June 2008 and February 2009, the energy price sub-index declined by two-thirds (-67.5%). It bounced up again quickly, although not all the way. By January 2010, it was about where it had been in 2005 through 2007, the period immediately before the recession.

Since early 2010, with the exception of a secondary peak in April 2011 (2,027), it has remained fairly stable, between 1,500 and 1,700.

The metals and minerals sub-index – gold, silver, nickel, copper, aluminum, zinc, potash, lead and iron – dropped 38% between May and December of 2008, in the early stages of the recession.

Then it soared 69% to reach a new all-time high in April 2011. Over the past two years, with the world mired in a trading slump, it has gradually eased back by almost 20%.

Gold, silver, copper and iron ore have led the price retreats. Major potash customers withheld purchases last year (i.e., a “buyers’ strike”) to force a price withdrawal. They won the argument and international orders have picked up nicely so far this year.

Forestry product prices – for pulp, lumber and newsprint – reached a first peak (367) way back in August 2004. By May 2009, dragged down by more than three years of declining U.S. new home starts, they had fallen by more than one-third.

In the course of the next 12 months, they rose again (+55%) to a second peak (357) almost as high as the first one.

While they rested for the next two years, that wasn’t the end of their journey. Since early 2012, moving in tandem with stronger U.S. residential construction, the forestry products price index has improved to the point where it has now reached a new all-time high (394).

In the latest Industrial Product Price Index (IPPI) results published by Statistics Canada, year-over-year softwood lumber prices are +20.0%.

Agricultural commodity prices started soaring at the end of 2007 and reached a high (323) in February 2008, before plummeting 41% during the next year and half, to bottom out in September 2009 (191).

It took exactly the same length of time (19 months) for them to return to a level (320) in April 2011 almost matching their previous perch. Over the past two years, they’ve stayed elevated, near their all-time record and 60% above their recession low.

The net effect of all these shifts caused the BOC’s total commodity price index to soar to nearly 900 in June 2008, before dropping by 56% to 392 in February 2009. It recovered to 650 over the next two years and has stayed relatively flat since then.

At its current level, it may be almost 30% below its zenith, but it’s more than double what it was from 2000 through 2003. And remember that the spike in June 2008 was mainly due to oil prices that exceeded $140 U.S. per barrel.

And while that historic peak for oil prices had an emerging nation component, it was mainly due to what is termed a risk factor, turmoil in the Middle East.

In summary, the current doom and gloom about global commodity price levels may be overblown.

So I repeat the question, “How worried should we be about Canada’s economic prospects?”

Maybe a little moisture on the brow wouldn’t be unwarranted. Nor a deepening of the fret lines across the forehead.

But a wringing of our hands would be excessive. A little chamomile tea should still be enough to relieve most of our anxieties.

Energy commodities price index (as calculated by the Bank of Canada)
Energy commodities price index (as calculated by the Bank of Canada)
The energy commodities price index includes oil, natural gas and coal.
Data source: Bank of Canada. Chart: Reed Construction Data - CanaData.
Metals and minerals commodities price index (as calculated by the Bank of Canada)
Metals and minerals commodities price index (as calculated by the Bank of Canada)
The metals and minerals commodities price index includes gold, silver, nickel, copper, aluminum, zinc, potash, lead and iron.
Data source: Bank of Canada. Chart: Reed Construction Data - CanaData.
Forestry commodities price index (as calculated by the Bank of Canada)
Forestry commodities price index (as calculated by the Bank of Canada)
The forestry commodities price index includes pulp, lumber and newsprint.
Data source: Bank of Canada. Chart: Reed Construction Data - CanaData.
Agricultural commodities price index (as calculated by the Bank of Canada)
Agricultural commodities price index (as calculated by the Bank of Canada)
The agricultural commodities price index includes cattle, hogs, wheat, barley, canola, corn and potatoes.
Data source: Bank of Canada. Chart: Reed Construction Data - CanaData.
All commodities price index (as calculated by the Bank of Canada)
Commodity price index (as calculated by the Bank of Canada)
The total commodities price index is comprised of products in energy, metals and minerals, forestry, agriculture and the fisheries.
Data source: Bank of Canada. Chart: Reed Construction Data - CanaData.