So far this year Bay Street has handed investors a 12% gift. That return on the TSX has been double the amount recorded by Wall Street, where the Dow and the S&P are both ahead about 6%. So far in 2016, after eight months, a balanced and diversified portfolio – despite Brexit, Trump & ISIS – has given investors a return of 5%, and it looks like there are sunny ways ahead (as some tattooed dude once said).
So why are investors in financial assets doing okay while the Canadian economy diddles? After all, the latest GDP numbers suck – a big 1.6% (annualized) contraction in the last quarter, thanks to the incineration of Fort Mac, slumping exports and a slowing fading manufacturing sector?
Oil and commodity values sure helped. Crude has gained more than 65% since the winter, for example. The financials are doing okay, as the latest round of bank earnings showed. Preferred shares continue to pump out a 5%-plus return, while REIT distributions have been manly and bond prices have strengthened. So while Main Street’s been pouring cash (most of it borrowed) into real estate, 1%ers have riding the other bull.
But what about risk?
Hard to imagine there’s more in any asset class than residential real estate. Look at the latest RBC anti-affordability survey – the biggest plop in more than a quarter century just too place. It now requires 126.8% of pre-tax income to carry a detached Van house. That’s pre-tax – not the actual money a family receives from working. And the whole thing is premised on having a whopping 25% down payment. In other words, this is a market where housing fundamentals have detached from the economy. It will not last – the basic definition of risk.
In Toronto, it takes 72.2% of median pre-tax income to carry a detached house, which is pretty close to 100% of take-home cash flow. This is the worst that things have been in 16 years, a fact made all the more poignant when you consider a five-year mortgage is now 2.2% and in 1990 it was 12.1%. As pointed out here often, there’s a perfect correlation between rates and house prices. The rate bottom brings peak house. If that’s not now, it’s close enough to smell.
In 1990 a monthly payment of $3,100 carried a mortgage of $300,000. Today for the same bucks you can carry $750,000. See why houses have more than doubled in value? And why they can decrease in exactly the same fashion?
This is risk. Because rates will rise over time, just as they have declined in the same fashion. Home loans of 12% are unthinkable at the moment, but a doubling of current five-year rates are pretty much a certainty. The US Fed will increase at least once this year, and likely twice (or more) in 2017. And Canada will follow.
In fact the next few years should be great for financial markets and misery for real estate. There are a few compelling reasons for this.
Trump is toast. Clinton, massively imperfect as she may be, will win the US election in November, ushering in a significant equity rally and eight years of left-leaning government with increased budgets and deficits. Markets like Dems. They like spending. And lots of government fiscal stimulus will let the central bank tighten up on monetary stimulus. That’s another way of saying ‘higher rates.’ The Bank of Canada, ultimately, will not resist this trend, and the bond market will quickly roll over.
Speaking of Canada, continued US recovery (it’s real, if tepid, and sustainable) will help edge commodity values higher with increased demand. Oil in the mid-forties should be twenty bucks more expensive in a year or so – enough to help rebound our limpy economy. The Bank of Canada knows this, which is why it will not be cutting its key rate even given the bad numbers out on Wednesday.
Meanwhile global growth, believe it or not, is plodding along at about 2%. Not bad, actually. And around the world, central bankers have been coordinating monetary policy in a way that makes those warning of another 2008 look like the Chicken Littles of our age.
Now, having said all of that, you should know this: there’s only one month of the year since 1928 when stock markets have given a median negative return. And that month starts on Thursday. But now you know what to do.