Tuesday, January 26, 2010

Vancouver the biggest bubble in the world.

A new report on world housing is out....



Toronto housing severely unaffordable.

Montreal housing seriously unaffordable.

This excellent report uses housing prices to median family income as a measure. Now, I acknowledge that this measure does not take into account different tax policies, interest rates, demographics, weather, etc… However, big picture, this is an excellent tool to use.

In fact, Canada has poor tax policies, already rock bottom interest rates, poor demographics, tons of available space (we have one of the lowest population densities in the world), mediocre demographics, and poor weather in the opinion of most people.

If you adjusted these values to reflect these factors, our rating would be even worse. For example, the US has lower tax rates and a mortgage tax deduction, less available space, better demographics and better weather.

The report also has some unconventional thoughts on high-density versus low-density urban planning. This is beyond my area of expertise, so I will not comment, although I do like unconventional thinking, and moving back to the suburbs from the city, their arguments have a sympathetic ear in this blogger.

I take some issue with the report`s argument that the reason that many markets are unaffordable is land use policy (which roughly corresponds to supply). This is definitely a factor. However, the more important factor is that we are currently in a mammoth housing bubble. This bubble was caused by many factors, and land use policy is likely a minor factor in my view. The bubble was caused by a great credit boom that has spanned generations. Housing was (and still is, in Canada) psychologically deemed to be a safe investment that can not lose money. It is perceived to be the best investment class, despite little long term proof of that hypothesis. Over a decade or two, housing can be a good investment, but from today`s nosebleed levels, housing (or any other nosebleed asset class) is doomed to be a poor performer for years, and more likely, for decades.

By taking a snapshot at any given moment, we can make a determination (as this study does quite well) regarding whether housing is affordable or not. However, without the fullness of time or a full market cycle, it is nearly impossible to make reliable conclusions.

I believe that once the housing bubble in Canada deflates, it will bring housing prices back in line with affordability. In fact, periods of overvaluation are usually followed by periods of undervaluation. This same study done in 2000 or 2020 would yield very different results, and if it does, I doubt it will be because land use policies have changed materially.

I had suspected that Australia and Canada had the two biggest housing bubbles left in the so-called developed world. This report backs up this suspicion. Almost all other countries (UK, US, Spain, Ireland) have seen their bubbles deflate or start to deflate.

What do Australia and Canada have in common? Both are commodity countries.

The commodities and risk trade that reflated in 2009 (partly retracing the 2008 losses), has allowed Australia and Canada:

  1. Strong export pricing which has lead to
  2. Strong asset inflows and currency appreciation which has lead to
  3. Low interest rates (as inflation is not an issue in this deflationary environment) which has lead to
  4. “Relatively” mild recessions and relatively low unemployment which has lead to
  5. No bursting of the housing markets (unlike the non-commodity housing bubbles)

I missed the call on Canadian housing in 2009, but I believe that both Australia and Canada will play catch-up in the coming years:


  1. The commodity deflation and recession will restart in 2010 which will lead to lower export pricing and lower exports
  2. Strong asset outflows and currency depreciation which could lead to
  3. Higher long term interest rates as sovereign risk worries kick up (Not 100% sure about this one as the deflationary headwinds are quite strong)
  4. “Relatively” severe recessions and relatively increasing unemployment (due to point 6)
  5. A bursting of the housing markets as unemployment rises and personal savings increase and the same debt retrenchment that has happened in the US shows up in the Great White North.

The fact that Canada had a sharp recession in 2008/9 without its housing bubble and only a partial deflating of commodity prices is very worrisome for the next leg down.

Monday, January 11, 2010

Euroland Crisis

We had a mini-currency crisis in late 2008/early 2009, when many currencies (Canada included) dropped about 20%+.

This currency crisis turned out to be relatively benign in most cases, not all, since it was accompanied by a credit crisis. The deflationary impact of the credit crisis and falling commodity prices meant that this currency crisis was actually welcomed by many countries, as it cushioned some of the impact of deflation. The massive collapse in global trade meant that many countries welcomed the falling currency.

Take Canada: Our loonie dropped to 77 cents, approximately 20 cents down from its summer 2008 levels. The Bank of Canada and many exporters were happy with this currency devaluation since it gave a temporary cost advantage to Canadian exports. In a normal situation, a 25% drop in the loonie in 2 months, may have called for emergency measures, including rate increases and would have caused the inflation rate to increase.
Despite the worries about Greece, the Euro remains quite high at $1.45, off from its $1.60 from 2008 and $1.51 in late 2009.

Why do we care about Europe? Besides being a huge economy that rivals the US, depending how you measure it, it has another impact. The Euro is 57% of the widely followed US Dollar Index (this weighting makes little sense but I digress).

A large drop in the Euro in the summer of 2008 preceded the Crash of 2008 by about a month. The Euro fell and so did commodities (as they are often correlated). At first, misguided bulls claimed that this was good as they wanted $147 oil to come down and lead the way out of the slowdown (what recession?). The Euro was dropping like a rock (from 1.60 to 1.45 from mid July to Labor Day). Pundits at the time claimed that this was because the European economy was slowing and rates were going to fall. Whatever, the reason, the rise in the US dollar was powerful and part of a cycle of a rising US dollar and falling asset prices. There is a ton of US debt out there, and when the US dollar rises, it makes that debt more expensive. Especially in 2010, the US dollar is a funding currency with 0% interest rates.

I believe that the Euro currency never made sense but needed a crisis to show this. The logic of the Euro is the following:

The strong countries (Germany, France) benefit since they no longer have to worry about the so-called PIGS (Portugal, Italy, Greece, Spain) devaluing their currencies against them, which would hurt their huge export driven economies. The PIGS and others benefit since they can easily borrow in a stable currency, the Euro, and hence, at lower interest rates. Win-win.

The problem: To greatly simplify, the PIGS took advantage of the lowest interest rates in their lifetimes to run up debt and in some cases, pile into housing. PIGS have lower standards of living, higher debt loads and higher inflation and yet a one size fits all currency and interest rate structure was the prescription.

The less efficient PIG economies have no way out of the current recessions. They can't cut interest rates (they are already near zero), they can't devalue anymore and most importantly, they can't spend their way out (the EU has strict rules on deficits, and these countries have massive structural deficits and looming funding problems). They have to do the opposite: cut spending and get their house back in order, which is a sure-fire recipe for union troubles, riots and social unrest, not to mention instant dismissal at the polls. The Euro is very unpopular as the cost of living in Euros is expensive in these countries.

The EU is not a country and as such, there is no national identity, no mechanism for bailouts between countries nor are there any transfer payments between countries.

Greece will be the test case, as they need to borrow over 50 billion Euros in 2010 and it is possible that they will not be able to do it via the bond market. If so, they may need to go to the IMF or the EU. If they do, they will likely be forced to impose draconian (by European standards) cuts to social programs. In addition, they will set the precedent for the other weak links. Are hurting taxpayers in Germany going to send money to Greece? In a country like Canada, there is a system for transfer payments between provinces. The EU has no such system. An IMF bailout would be a big black eye for an EU country.

I can't profess to know how this will play out. I do know that even if Greece dodges a bullet right now, there are too many holes in the EU dam that are leaking. Greece may be forced to go for some type of bailout as it would give political cover for the draconian cuts. However, it could start a run on other countries such as Spain (huge housing bubble and unemployment rate) and spill over to non EU countries such as Latvia. The EU could even decide to expel Greece if it deems that it does not have the ability to bail out member countries.

The timing is tricky (doesn't have to happen in 2010) but I don't think the Euro stays at its lofty levels. I believe that the Euro will not go away, but its luster will fade and investors will crave the security of the safe US dollar.

The next part of this bear market will involve currencies and sovereign debt concerns, I believe. And this currency crisis will involve the big guys (Euro and Yen- more on that one another day).

We are at a pivotal point for the US dollar and the Euro. A strong move that started 6 weeks ago, from 1.51 to 1.42 has now consolidated to 1.45. If the US dollar is truly in a bull market, it needs to move higher from here. Thus far, the S&P has shrugged off the higher USD, as it did for about 6 weeks back in 2008 before all hell broke loose.

My target for the Euro is $1.25 this year, but a move to $1 can not be ruled out if a 2008 crash develops this year or if we get some domino action (Greece, followed by someone else and with spillover to the usual suspects of Ukraine, Latvia, Iceland, Ireland, Hungary, etc...).

Disclosure: Position in USD, Euro, CAD