"Pile On" Canada?

Location Date: 
May 23, 2013

It would appear that Canada is moving from being on top of the world in terms of economic performance and organization to one full of problems. It is a veritable "pile on" in wrestling terms with think tanks, hedge funds, money managers and investment research houses postulating that Canada is in for a rough ride. Seem a bit unfair? Certainly leading up to the 2008 crisis one could easily argue that Canada was the model country - fiscally conservative in both our individual and government accounts. Unfortunately, the fact set that supported this correct view has changed considerably – and not for the better. What has changed? Three things


(a) Home prices continued to surge and are now a big cause for worry. Many forecasters believe prices are 20% to 30% overvalued. The Bank of Canada has been forced in many respects to import U.S. monetary policy. Low rates post-2008 have provided a lot of the fuel for the rally. Relative to disposable income, house prices in Canada have deviated substantially from the U.S. (see Chart 1 below - click to expand) and other markets globally (see Chart 2 below - click to expand).

Chart 1:
Source BCA 2013


Chart 2:
Source BCA 2013

As a percentage of GDP, residential investment has soared (See Chart 3 below - click to expand).

Chart 3:

Source BCA 2013

These factors have not been lost on the government (like it was in the U.S.!!) who have adopted policies to curtail speculation but clearly we may be at a tipping point. An uptick in rates may be the trigger.

(b) Domestic consumption has likely peaked as well. BCA notes that our savings rate is at multi- decade lows and household debt as a % of GDP continues to climb. Assuming house prices fall by 20%, the hit to consumption is likely to be in the order of 2% of GDP along with residential construction at 2%.1

(c) As noted by many financial forecasters, key Canadian exports such as natural gas and oil have suffered due to falling prices, spreads and bottlenecked infrastructure. Given the abundant energy supplies in the US and the relatively high C$, Canadian exports are not likely to save our Canadian bacon in the short run.

You can add the voices of hedge fund stars on Canada: 

(a) The commodity "super cycle" is over according to Stan Druckenmiller

(b) Steve Eisman, who successfully shorted U.S. real estate, is worried about Canada’s bubbly housing market.

All of this implies that we likely have a made in Canada slow down/recession despite an uptick in U.S. growth. Canadian policy makers - on both the monetary and fiscal fronts have few options to prevent the slowdown, especially if the Feds keep their pledge to balance the budget by 2015.

All of this paints I think a realistic view of the next 18 months or so. In my book, being short the C$, AUD$ and Norwegian Krone makes sense versus the US$. This view is not contrarian as CFTC data shows a growing bet against the C$ too. My view is the long bull run in C$ is over so this is an 18 month trade with a target of 90 cents.

Now enter a hedge fund manager based in San Francisco named Vijai Mohan. While he runs a small fund, he was the CIO of a former Soros protégé so he has credibility. The Globe and Mail featured him in a story on April 27th (Click here to read). In the article, it mentions that he has positioned his hedge fund as combined 95% short the C$ and Canadian banks. The well written article discussed why Vijai has these positions on but the thought process might have been articulated a bit better. I had a chance to speak with Vijai (before his G&M interview through a mutual friend in the VC business) about his Fund. I am always intrigued by 'out of the box' thinking. His thesis really is about a potential emerging markets crisis and connecting the dots (implications) back to Canada. There is a whole lot of EM debt out there denominated in USD. Rising rates and a rising USD will make these bonds tougher to finance and pay off. Undoubtedly, many readers are aware of extraordinarily low yields offered on recent deals from 'frontier' economies like Zambia, Mongolia and Bolivia. He notes, as well, that the terms of trade continue to deteriorate in EM land largely the result of rising wages, that in turn, has led to falling ROE's and corporate profitability. Very importantly, the way he has crafted this trade, he feels he will not be "squeezed out" (or experience a large drawdown), while waiting for the EM crisis. Plus he gets a kind of free put option should Canada suffer a real estate crisis independent of an EM crisis. On his C$ short, I whole heartedly agree. On shorting Canadian banks, I am not so sure. Yes they will experience pain as retail mortgages make up a good portion of their profits. Yes they are expensive – but you never, ever short valuation solely. And yes, maybe they will need to raise equity in the future if regulations change. On whether we get an EM crisis in the next few years, who knows? Canadian investors might be better off buying Bank of America (BAC) common stock in US dollars so that you get a "cheap" bank, a rising U.S. real estate market and a stronger currency.

As for Vijai's Fund, there is a lot more to it than is reported – the performance is solid and the idea generation seems logical and well constructed. We are going to do some more investigating – clearly many readers of the G&M cannot or won't bother with that. I was surprised by the number and type of comments on line – it ranged from misplaced patriotism (eg. "The Globe and Mail will search the world to find someone to rain on Canada's economic parade") to incompetent money management ("The very fact that this guy has all of his customers money on a single bet shows he's incompetent"), to a lack of understanding about the hedge fund industry ("I can say from experience that the very successful hedge funds almost never go on record about their positions"). Many comments were comical and many were just plain stupid. Maybe Vijai is on to something after all??

Jim McGovern