Extremism

Thinking in extremes gets you into trouble. When markets go down, extremists fear they’ll fall to zero. They sell. When houses go up, extremists think they’ll inflate forever. They buy. History shows both extremes never happen. Yet people are convinced.

When the Fed hints rate hikes might end, extremists think free money is back. The next moves will be down, they cry. Mortgages are going back to 2%. Time to get house-horny. But on Wednesday the world’s biggest central bank will disprove that thinking, too, as its hikes rates for the 10th time.

The odds of this happening (according to the markets) sit at 80%.

  So another quarter point will likely be added, with everyone hanging off each word in the official statement, looking to see if the hawks or the doves are winning. It leads to the larger question of whether ten rate increases is too much for the economy to swallow – along with Trump, a trade war and a mother of a deficit – leading the Fed to call it a day. Some people think a recession will happen by the end of 2019. Others peg an inevitable slowdown for 2020. But that’s a presidential election year, and if he survives that long, will Trump allow the economy to reverse?

Nah, doubt it. And his Big Move will be a sweeping deal with China. Tariffs on Chinese goods are already costing the US economy billions, hurting corporate profits, dropping stocks and jeopardizing jobs among Trump’s army of blue collar devotees. Looks like our gal Meng will be a pawn in this whole thing, her Vancouver arrest being no coincidence. We were played.

Anyway, what’s it mean for us? Will cheap mortgages and bidding wars come back?

The Bank of Canada has pushed rates higher five times, or half as aggressively as the Fed. The next decision day comes in early January (the 9th). The latest jobs report was a blockbuster, showing that despite gloom, debt, winter, Maple Leafs, Comrade Horgan, oil and $6 cauliflower, the economy’s okay. In fact renewed demand for Canadian crude and the surge in WCS prices has people thinking Alberta’s cap on production (which depresses economic activity) won’t last long.

Besides, next month we head into an election year in Canada. The latest polls put Mr. Socks and the Tory leader about equal, since Mad Max has yet to emerge as a spoiler. So you can expect the April, 2019 budget to be all about fiscal stimulus as the Liberals stress economic growth and opportunity for the Millennial hordes – something that’s hard to pull off if we’re into a recession.

It all means rate hikes will be with us for a while yet, but in moderation. One this week for the Fed, maybe two more next year in the US, while Canada sees one increase in the spring and another in the fall. But no cuts. Not until it’s truly warranted. And don’t wish for that.

So a China-US trade deal would be cheered by financial markets since it reduces business costs, eases uncertainty and deflates inflation. Likewise the Fed turning dovish would also bolster investor confidence. And a cornered Trump looking to re-election will be pushing every button possible to Make America Gr…etc. Meanwhile T2 needs to point to a shiny economic future to make up for four years of red ink and shattered 2015 election promises.

Not so bad for investors in financial assets, it would seem. But real estate in 2019 is far less certain. Sales have dropped by a meaningful amount in most markets, but prices have proven sticky. It means if mortgage costs remain stable or rise a little and the stress test stays in place that a heavily indebted nation is unlikely to see housing rekindle. After all, why would it happen? Houses still cost a stupid amount compared to what Americans pay. We are among the only people on earth willing to gamble 10 or 12 times our annual income on a property. And already family debt is greater than the entire economy.

Look at Toronto and Vancouver, of course. Poster burgs for delusional behaviour. As we reported last week, CMHC points out that debt-to-income ratios have crested as never before – 208% in the GTA and 242% in Van.

Most of this debt is related to residential housing. While about 66% of all borrowing in the nation is in the form of mortgages, in Van it tops 80%. The debt-to-income ratio means a big whack of people in the region have snorfled so many loans that their only possible salvation is continued price appreciation. But, instead, the market is unstable and about to get worse. Toronto ain’t much better. CMHC has already told us most people buying $1 million+ listings have debt ratios of 450% or more.

A reasonable conclusion: cheaper house prices are a done deal. The real estate boom is done. Gone. There’s no rate cut coming. But when it does eventually arrive, so will recession. If you truly need real estate and can afford it without gutting your finances, fine. Go ahead.

Finally, stop sending me letters like this. Sheesh. Man up, Jamie.

My fiancé and I are debating purchasing a house in Victoria, BC (pause for eye-roll). I’m 35, he’s 37 and we have roughly 1.5 million between the two of us (cash and balanced diversified investments). I’m employed and make 180K a year. He is a yacht captain and is seeking to start a land-based home business.

We are currently living in my 1 bedroom condo (I owe 274k on the 2.49% fixed mortgage) and desperately need something larger with a yard/land. In past both he and I have done quite well with property investments and we have yet to suffer a realty-sting. We’re keen to fix something up and live in it for 3-5 years minimum (he’s very handy). We don’t like the idea of renting and asking permission to paint, plant gardens, etc…

We are watching house prices drop since October’s rate hike and are questioning whether we should hold off on purchasing until after the Feds raise the rates again next year (or longer)?

Plant a tree

DOUG By Guest Blogger Doug Rowat

There’s an old Chinese proverb (I guess they’re all old) that says “if you plan for one year, plant rice. If you plan for 10 years, plant trees.” Well, after this disastrous year, emerging market investors are probably pretty tempted to plant nothing. In other words, give up on the region entirely.

And how painful has it been for emerging market investors this year? Well, the MSCI Emerging Market Index is down 16% and the CSI 300, the benchmark for China A-share equities, which has taken the brunt of the punishment, is down 21%.

With commodity prices plunging, Donald “the Tariff Man” Trump taunting China continuously, rising US interest rates and a strong US dollar, both of which are negative for emerging market economies because of their significant amounts of dollar-denominated debt, and an overall risk-off market sentiment at the moment, emerging market equities are easy to hate. But extreme bearish sentiment presents opportunities.

The long-term thesis for investing in emerging markets is well-known but worth repeating. Emerging market populations are young, emigrating rapidly to urban areas and voraciously adopting developed-world technology. For instance, about 58% of China’s population has Internet access, up from only 23% 10 years ago, according to CNNIC. And China has already surpassed the US in total retail sales. Think of what China’s retail sales numbers will look like when it reaches the US’s 89% Internet adoption rate in the coming decade.

As China accounts for roughly 30% of the MSCI Emerging Market Index, it’s also worth focusing on this country’s mind-boggling urbanization rate. In the 1970s, the percentage of China’s population living in urban centres hovered at only the mid-teens. Now it sits at 58%. Yet, with more than 40% of China’s population still living in rural areas, the ‘citification’ trend still has plenty of room to run.

And China urbanization has an incredible trajectory, with rates likely to approach developed-world levels within the next 10 years. The below chart compares China’s historical pace of urbanization to Canada and the US’s—in this race, developed countries have the lead, but China is, effectively, Usain Bolt. The economic advantages of more urbanization are significant: more jobs are created, salaries can ramp-up five-fold, and demand for material goods and housing both rise dramatically.

Urban population (% of total)

Source: United Nations Population Report

So, to think emerging markets are simply going to disappear under the weight of their short-term economic problems is naïve and overly pessimistic. When the MSCI launched its first comprehensive emerging markets index back in 1988 only 10 countries were worthy of representation and encompassed only 1% of the world’s market cap. Today this index includes 24 countries and 11% of the world’s market cap. Emerging market investing is here to stay.

But, from a timing perspective, should investors buy now? Well, valuation is a notoriously poor predictor of entry points, particularly for short-term investors, but regardless, I would still argue that current valuations are compelling. For example, the price-to-book (P/B) differential between the MSCI Emerging Market Index and the S&P 500 is as wide as it’s been in 10 years.

MSCI Emerging Market Index P/B discount to S&P500 continues to widen

Source: Bloomberg

And let’s take a closer look at this spread. Naturally, emerging market equities historically trade at a P/B discount to US equities given their higher risk profile. However, the discount widened to more than DOUBLE its 10-year average (white line below) before contracting in recent months. Given the still-considerable spread, I wouldn’t be surprised to see the discount continue to contract. But if your investment horizon is 10 years or more, then whether to invest now or later amounts to splitting hairs. Emerging markets, simply put, are cheap.

MSCI Emerging Market Index P/B minus S&P500 P/B

Source: Bloomberg. White line = 10-year average

Relatively speaking, emerging markets have had a sub-par past 10 years with the MSCI Emerging Market Index returning 8.7% annually (total return) versus the MSCI World Index up 11.1%. However, a 20-year time frame paints a different picture, with the MSCI Emerging Market Index returning 8.9% annually versus the MSCI World Index returning only 5.4%. If you believe in long-term cycles of under- and outperformance, the next decade could belong to emerging markets.

And, if you had to choose an area to invest in for the next 10 years, given its impressive economic and demographic fundamentals, long-term outperformance and inexpensive valuation, you could do worse than to pick emerging markets. As it stands now, emerging market equities are not being fairly represented in MSCI indices based on their corresponding share of world GDP. It could be argued, in other words, that the market is not giving emerging market equities their proper due based on their global economic contribution:

GDP share and market share for EM

Source: MSCI, IMF

Eventually, emerging markets will rally, likely strongly. And if you’ve decided to abandon this area of the market entirely because of a few threatening Trump tweets, you’ll miss out on the recovery. And you’ll have no one but yourself to blame.

You’ll be reminded of another Chinese proverb: “if your face is ugly, don’t blame the mirror.”

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.