CIO’s Quarterly Commentary – Felix Narhi – Q1 2017 – Part 1

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“The concept of a general equilibrium has no relevance to the real world (in other words, classical economics is an exercise in futility.)” – George Soros

The Loonie – To Hedge or Not to Hedge

We have been fielding more questions about currency and potential hedging strategies recently. We are not currency experts or forecasters, but we are keen observers of the lessons from history, respect long-term cycles and are eager to study how the world really works so we can position ourselves sensibly. When contemplating the recent trajectory of the loonie, we are reminded of George Soros’ theories that financial markets do not tend towards equilibrium as conventional theory would argue. Rather, that markets feed on their own misconceptions about events to drive exaggerated movements, which then feeds further momentum. Soros describes this two-way feedback loop between perception and reality as his theory of reflexivity. He claims that speculative runs on a currency can persist for a long time and relative movements in one currency against another are frequently of a long term, secular nature, often measured over many years, rather than days or weeks. That has certainly been the case for the loonie.

Measured by purchase power parity (PPP), or the central equilibrium value of the Canadian dollar relative to the US dollar, the loonie has remained remarkably stable since 1990. According to estimates by the OECD, the loonie has averaged $1.22 CAD/USD since 1990 with a standard deviation of only $0.02. At the end 2016, the CAD/USD PPP was estimated at $1.243. The actual exchange rate has swung around this central value in wide secular multi-year cycles and habitually overshoots its PPP theoretical “fair value”. In the context of historical cycles, the Canadian dollar is perhaps a little past the middle innings after passing through its PPP “fair value” only a few years ago. Today’s levels are not yet extreme from a historical perspective, but we believe the narrative could become more challenging in the near to mid-term.

Richer Than You Think?

A long running ScotiaBank marketing campaign assures Canadians that: You are richer than you think. But is that true? The largest asset of the typical Canadian family is their principle residence. The good news is that the price of the average Canadian home has doubled since 2005[1]. Rich indeed! Yet, despite this apparent financial windfall, not all is well for many Canadian homeowners. According to a recent survey from Manulife Bank, nearly three-quarters of Canadian homeowners would have difficulty paying their mortgage every month if their payments increased by as little as 10%. Even a modest increase in interest rates or a dip in house prices would cause real hardship for many Canadians.

What are the risks of a housing downturn in Canada? Canadian housing has proven to be cyclical in the past and it would be surprising if that were to cease. But the potential risks vary depending on what point we are at within the Canadian housing cycle. As the old investment adage goes, what the wise do in the beginning, the fool does in the end. It makes sense to be more aggressive early in the cycle, neutral in the middle-innings and increasingly cautious towards the later innings. The fact that so many Canadian homeowners seem to be living paycheque to paycheque with little in the way of a margin of safety despite a multi-year housing tailwind is an ominous sign when the sector cools off. Would consumers pull back their spending if they felt less rich than they thought after home prices eased off for a period? Alternatively, if consumers become more cautious, could Canada’s resource sector come to the economy’s rescue? The once-in-a-generation “commodity super cycle” that fueled high wage job growth and the loonie’s rise over the last cycle ended with a thud during the Great Recession of 2008. Given technological substitution and the discovery of vast new energy reserves recently, it is hard to imagine scenarios for a similar mania again any time soon. Of course, we also need to consider the outlook for the US economy and interest rates. The unconventional approach of President Trump adds additional layers of risk. Given all these issues, are the balance of risks to the Canadian economy or the loonie’s relative value to the upside or downside? Because secular trends tend to go to extremes, in part due to reflexive feedback loops, it is critical to be on the lookout for the inflection points and be ready to reverse one’s position.

Lessons Learned

One of the lessons from the US housing crash was that there is a reflexive connection between credit and collateral, where the act of lending can change the value of the collateral. The marginal buyer, who often needs access to easy credit, tends to set the clearing prices. Troubles in the US housing sector first emerged with lenders to the subprime home buyers which ultimately spread to the rest of the sector. The first signs of history possibly rhyming in Canada began over the last few months with Home Capital Group’s surprising unravelling. Soon thereafter Moody’s cut its credit ratings on Canada’s big six banks due to mounting concerns about potential loan losses driven by a slowing housing market and high levels of household debt. In fairness, Moody’s downgrade of the Canadian banks is relatively benign and is not particularly worrisome in isolation. Nevertheless, the risks have been growing for years. This is obviously not good news for the loonie and does nothing to stop the secular multi-year momentum of the loonie’s current trajectory. But such developments can add fuel to unanticipated second and third order effects – as the US experience has illustrated, investors should be wary of the power of reflexive feedback loops.

Due to leverage, unbalanced financials systems can be like unstable snow packed slopes – which are vulnerable to avalanches. One never knows what catalyst might start a slide, but it is probably safest to steer clear in both cases. Sometimes a seemingly insignificant trigger starts a cascade which brings down the entire unstable snowpack. Once initial “triggers” are activated, it is difficult to stop the downward momentum. We believe the balance of risks to the loonie remain to the downside over the near-term due to relative CAD/US interest rates, stretched housing prices in Vancouver and Toronto, elevated consumer debt levels and potential risks to commodity prices. These could add to the loonie’s downside momentum in its current multi-year journey to potentially more extreme levels (and not too dissimilar from its other journeys in the past).

As my fellow Pender PM, Geoff Castle recently wrote in his April 2017 Commentary “When an industry starts to enter distressed territory, our experience has been it does not pay to be the first to swoop in to pick up “bargains.” ” If the dislocation in Canadian housing and mortgages is even half as severe as we believe it may become, there will be plenty of time to find well covered, attractive distressed credits. Of note, we are not directly exposed to these issues in a meaningful way and all of our Funds have elevated cash/ liquidity levels. We believe this provides some downside protection and enables us to act when opportunities emerge.

While our loonie may be slightly undervalued relative to the greenback on a long term basis, the tendency for actual exchange rates to overshoot their long term fundamentals is just as common in currencies as it is in equities. We are mindful of these tendencies when thinking about hedging currency risk. If the loonie continues to weaken meaningfully from current levels, we will be more mindful of potential hedging strategies, but in our view, the discount from fair value is not yet extreme from a historical context.

Felix Narhi, CFA

June 7, 2017

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[1] Teranet’s House Price Index