Highlights from the Canso Market Observer for April

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Equity markets extended their rally in the first quarter and expectations of interest rate cuts continued despite mixed signals from central bankers. But in their first quarterly newsletter of 2024, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. argues that warning signs are flashing on rates, inflation and the Canadian economy—particularly the inflated residential housing sector.

Click here for the full Market Observer.

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Expecting the unexpected

Resurgent financial markets proved all the doom-and-gloom economic forecasters wrong in 2023, and the party continued into the first quarter of 2024. Enthusiasm for trendy artificial intelligence stocks and buoyant U.S. economic data drove up stock prices, though bonds performed poorly as economies looked strong. The consensus market forecast for central banks lowering rates endured, even if it kept getting “pushed out farther and farther as things looked less and less dire for the economy,” the Canso team wrote in their most recent Market Observer newsletter. “Happy days were here again, and nobody wanted to spoil the fortunes from soaring markets that had been handed to investors by saying anything remotely negative this time around.”

There is a fine line, however, between optimism and wishful thinking, and the Canso team is skeptical that the good times can keep rolling. For one thing, they continue to expect that inflation could stay higher than many market participants think, simply because the huge monetary stimulus of the pandemic era has yet to work itself out of the system. As well, valuations “are currently looking stretched to us,” they wrote. And the fact that there has been “nary a thought of market setbacks and/or a weak economy in the financial media,” the newsletter added, “has got us worried. Mr. Market has a way of doing the unexpected.”

Underlying the prevailing investor optimism is an assumption that “we will eventually get back to the zero interest rate La La Land of ZIRP,” the team wrote. Bond investors seem quite happy to lock in their money for longer terms at lower rates, as the inverted yield curve demonstrates. Perhaps, the newsletter suggested, investors have become so accustomed to that topsy-turvy curve—it’s been inverted for three years now—that few fear it as a prognosticator of recession. A “dream state ‘Soft Landing’” is still the market consensus.

Yet the team highlighted the fact that while bond yields have been volatile, they have been generally trending up since the pandemic, and higher rates will tend to “get translated into the funding of consumer and business debt” over time. That means “there is a very good chance that we will eventually get economic weakness, especially in the residential housing addicted Canadian economy.”

The house that ZIRP built

The Canadian economy is highly exposed to the residential housing market. Housing investment as a share of GDP in Canada has risen to more than double the proportion in the U.S., as Canadians have continued to plow their savings and income into one of the world’s most expensive markets and banks have “massively expanded their mortgage lending,” the newsletter noted. Household real estate assets are close to 300% of Canadian GDP—100 percentage points higher than in the States. Close to 8% of the Canadian workforce is employed in construction, and including ancillary workers raises that percentage to 18%—both far higher than in the U.S., the Canso team observed.

Clearly, if things go wrong for housing—and sales are already approaching historic lows—then a lot will probably go wrong for the economy as a whole. The structure of the Canadian mortgage market intensifies that risk. The Canso team pointed out that mortgage terms are usually five years or less, much shorter than in the U.S., and they typically have prepayment penalties. If current interest rates continue, a homeowner who locked in a low five-year rate in late 2020, for example, would have to refinance at a rate more than three times higher in 2025. “That’s quite a shock,” the newsletter noted. As well, higher rates have pushed homeowners to favour fixed rate over variable rate mortgages, which could lessen the effect of lower Bank of Canada rates as mortgages are renewed.

Of course, rate cuts would cushion the blow generally for Canadian housing. But the team questions whether the Bank of Canada will cut by as much as many seem to anticipate. They pointed out that the central bank recently raised its so-called neutral policy rate by 25 basis points, to 2.25%-3.25% from 2%-3%. The team does not expect any central bank, including Canada’s, to return to zero interest rate policy (ZIRP)—that’s likely “dead and gone,” they wrote. Unless there’s an unforeseen drastic drop in inflation or a recession, they expect the bottom bound of Bank of Canada rates to be 3%. Given that long bond yields continue to be suppressed by investor assumptions about a return to the old normal, “we think that there will be a lot of disappointment when the BoC finally moves.”

Inflation: Not dead yet

The bond market’s prevailing view is that inflation has been whipped back onto a path towards the 2% target set by central banks. Yet as recent inflation reports continue to defy gravity, reality is challenging that belief. As well, Break Even Spreads (the rate differential between inflation-adjusted “real return” bonds and nominal government bonds) have been creeping up, suggesting that investors are increasingly expecting inflation to remain “higher for longer.” To the Canso team, the evolving landscape is “eerily similar” to the mid-1970s, when monetary policymakers lowered rates too soon, “only to see inflation then soar once again.” The Volcker era of aggressive tightening followed, leading to “the severest economic setback and recession since the Great Depression of the 1930s.”

Today, with inflation seemingly entrenched in the 3% to 4% range and still above target, the Canso team suggests that central bankers are well aware of the similarities with the 1970s. The U.S. Federal Reserve faces pressure to lower rates, but chair “Jerome Powell and the Fed Governors know the lesson of that period is that the Fed loosened monetary policy too early, and ended up with inflation that once again took off to even higher levels.” Any investors not taking seriously the Fed’s oft-expressed caution on easing may wish to lower their expectations.

Still flashing yellow

To the Canso team, reality should trump hope for investors. If rates and inflation both remain higher than investors expect, many could be in for a rude awakening. In debt markets, the era of ultra-low rates encouraged exposure to high-risk investments, from bank loans and high yield to derivatives and “opaque Private Credit,” they wrote. In bank loans, for example, “the result has been that issuer quality, covenants, and the security of secured bank loans have been thoroughly debauched.” Recovery rates on bank loans, the newsletter pointed out, have historically been higher than on public marketable bonds; today, they are virtually the same.

In this environment, the Canso team’s portfolios are more conservative than they’ve been in years. Previous financial crises, including the pandemic and the Great Financial Crisis of the 2000s, sparked sharp corrections in economies and markets, and the rebounds were powerful as central banks came to the rescue. That might not play out now. “This time we fear it might be a ‘long and grinding road,’ to paraphrase the Beatles,” the newsletter noted. “That means we’re prepared to weather difficult markets and to then take advantage of value opportunities that present themselves.”

This story was created by Canadian Family Offices’ commercial content division on behalf of Canso Investment Counsel Ltd., which is a member and content provider of this publication.