The Past is Prologue

William Shakespeare, in his play The Tempest, uses the statement “The Past is Prologue” to suggest that all the events that have happened before have presented us with the opportunity we now face. Simply put, history sets the context for the present. Yet, in this world of instant gratification, few investors anchor their expectations using history as a guide.

What is the fair value of the Canadian dollar? Why would policy makers of an export led economy desire a stronger currency? With private debt to Gross Domestic Product (“GDP”) close to 180%, won’t higher interest rates hurt economic growth? Will policy makers be able to generate a soft landing in the real estate market? Meaning, the real estate bubble will pop without generating a significant decline in housing prices. We are entering a new phase in the commodity super cycle. All of the above questions communicated by many pundits over the past few weeks implicitly assume that the basic laws of economics don’t apply to the Canadian economy. We beg to differ.

Remember last year, the global economy was dealing with the crash of prices in the commodity complex. In Canada, wild fires in Alberta added to the problem by forcing a shut down of oil production. The fires in Fort McMurray were a major international story. Yet today, few anchor their expectations about the future on this fact.

The Canadian dollar has rallied over the past few months. The Bank of Canada is claiming victory from the appreciation of the Canadian dollar, caused by the recent interest rate hike. The Canadian dollar has now reached a point where one of the world’s most efficient railroads, the Canadian National Railway (“CN”), stated in its quarterly report that the strength of the Canadian dollar is now a headwind for economic growth. As the economy enters into a period where data gets normalized, those bullish expectations will subside. Looking at the Citigroup Economic Surprise Index, we can see that investors have extremely bullish expectations about the Canadian economy, while having extremely bearish views about the U.S. economy. Mathematics suggests that those expectations should reverse as we get into the fall.

The Bank of Canada has a single mandate: to target inflation. Data released in July 2017 revealed that inflation was at a 20-month low. Fundamentals suggest that the Canadian economy is lapping very easy comparisons, meaning growth looks better than it actually is in Canada, an additional point that CN makes in its quarterly report. Furthermore, basic economic theory suggests that an appreciating dollar is deflationary. So while all the cheerleaders are happy about the strong Canadian dollar, international investors most likely see Canada in a more objective light. The Canadian economy has had the benefit of two super cycles, one in commodities and other in real estate. To many observers, it looks like the Bank of Canada is targeting the real estate bubble. Popping the real estate bubble will not come without consequences, a decline in real estate prices will have a negative effect on economic growth. Some may suggest that the housing bubble can be popped without a decline in housing prices, however we do not see any evidence to support this. In theory, it could happen, but practically speaking, assuming an economy with private debt to GDP of 180% will not see a significant decline in economic growth in light of a decline in housing prices is a very dangerous position to hold.

The Bank of Canada raised interest rates. Was it justified? Were they targeting the real estate market? Is an appreciating currency good for an export led economy? Why are the rest of the world’s central bankers concerned about being below their inflation targets? The Bank of Canada is sure that the long shadow of the global financial crisis and secular stagnation has been defeated. Retail sales (not including the automotive sector) that were reported in July 2017 were negative. Job growth in Ontario was negative. Yet, the Governor of the Bank of Canada, Stephen Poloz, and his team are claiming victory. The Bank of Canada may just be taking back the two emergency cuts they did when oil crashed. Governor Poloz acted as Governor John Crow did to pop the housing bubble in the early 1990’s. Real estate prices declined by 50% at that time and Canada went into a recession. Instead of acting as cheerleaders, many pundits should be sounding the alarm bells. A major policy mistake is at hand. Canada is no longer competitive in manufacturing on a cost basis with the southern United States and Mexico. Canada has just experienced the benefits of two super cycles, commodity and real estate. A strong Canadian dollar is the last thing the Canadian economy needs at this juncture.

It seems that many in Canada don't think that cycles repeat, fundamentals do matter and policy mistakes can happen. Shakespeare was right, The Past is Prologue, but only for those that take a moment and reflect.

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