Canada is putting all its economic eggs in one basket

Tuesday, May 30th, 2017

Martin Pelletier
The Vancouver Sun

Two of the most common mistakes people make when investing are extrapolating past performance into the future and putting all of their eggs in one basket.

Canadians are no different. In fact, we think they have recently been more prone to making these errors than people in other developed nations. Take a look at our economy for example, which is shaping up to be one driven primarily by real estate and a debt-heavy consumer.

The Canadian housing boom is something to be marvelled at, with our home-price-to-income ratio now 40 per cent above the long-term average and among the highest in the developed world. The real estate and related financial services industries have followed pace and represent nearly a quarter of the total Canadian economy, the highest level since data started being collected in the 1960s. In places like British Columbia, real estate, construction and housing-related finance account for an astounding 40 per cent of GDP according to Todd Hirsch, chief economist at ATB Financial.

Consumers have been quick to ratchet up their debt to match higher housing prices and the banks so far have been willing to comply. Nearly half of all Toronto’s mortgages are now considered high-ratio, meaning loan-to-incomes greater than 45 per cent, while Vancouver and Calgary are not far behind at approximately 40 per cent and 35 per cent, respectively.

In regards to diversification, Canada is as close as you can get to being a one-trick pony with financials, energy and materials representing over 67 per cent of the S&P TSX. Therefore as an investor, one should ask if these sectors can deliver over the next 12 months given the current environment.

In regards to energy, we think the biggest gains are behind us as we adjust to an oil price environment that is range-bound with OPEC defending it at any level below US$45 a barrel and U.S. shale producers providing a ceiling by quickly responding to prices above $55 a barrel. Capital is also leaving the Western Canadian Sedimentary Basin and being redeployed in more attractive operating environments such as the Permian Basin or Marcellus Shale therefore making it a lot more challenging to grow north of the 49th.

In regards to the banks, which account for approximately 23 per cent of the TSX, we don’t worry about a fallout from the ongoing situation with Home Capital Group Inc. and the subprime market which is quite small. However, we do have our concerns about their ability to repeat the earnings growth of the past should the housing market top out or worse, roll over.

For example, we tracked mortgage lending over the past few years and it has kept pace with housing prices. As a result Canadian residential mortgages now represent a significant percentage of total bank assets ranging from 15 per cent to 35 per cent.

Then for fun we plotted the total return of the S&P TSX Equal Weight Diversified Banks Index which comprises Canada’s largest six banks against housing prices and discovered a 0.96 correlation. Simplistically, this means the bank stocks are moving in lockstep with housing.

This makes some sense as the banks make more money as their mortgage book expands with a rallying real estate market and personal loan books grow as consumers borrow more to spend on cars, vacations, renovations etc. as they feel buoyed by their higher paper net worth.

As a result, a flat oil price environment leaves housing and its derivative, the banks, to play an even bigger role in driving the S&P TSX return profile. 

Adding eggs to that crowded basket is not something that we feel particularly excited about.

© 2017 Financial Post

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