I’m still in mourning over Mark Carney, the former Governor of the Bank of Canada, leaving us for the Bank of England.
So I haven’t focused at all on our new Governor of the Bank of Canada – Mr. Stephen S. Poloz. So on Tuesday, March 18th, 2014, I was heading to our office kitchen, for my one cup of Earl Grey tea I allow myself, through our trading and technology office space when Mr. Poloz was on our trading floor big screen television and said three words that made my head spin around.
“Blah, blah, blah, … lower interest rates, blah, blah”!
Nursing my whiplash, I know one thing about ‘Central Bankers’; they would never say these three words in any context without thinking through its communication value.
So I went to the Bank of Canada website to read his speech, “Redefining the Limits to Growth”, he delivered to the Halifax Chamber of Commerce, in obviously Halifax, Nova Scotia.
Let me say, every Canadian investor should read this speech! For a central banker this speech is direct, forthcoming and has huge implications for your investments – not to mention the future for your kids and grandchildren.
Mr. Poloz is giving everybody a very direct assessment of the Canadian economy and its not very good. Down right scary as a matter of fact.
The highlights include:
1) Five years after the financial crisis the world economy is still stuck in a period of slow growth – say 2% annual growth, if we are lucky.
2) For the first time in 50 years, and starting in 2011, the growth rate of the population of working-age Canadians crossed below that of the overall population. As a way of comparison the US still has 0.2% – 0.3% growth in hours worked – a small but still growing population of working-age people.
Why is this important? Mr. Poloz explains in his speech, “Long-term economic growth is driven by two factors: 1) growth in the supply of labour, which is connected to population growth and changes in its composition, or what we call “demographics;” and 2) productivity growth, which is economists’ shorthand for how efficiently we produce goods and services. For illustration, if we had 2 per cent trend growth in the supply of labour and 1 per cent trend growth in productivity, trend growth for the economy would be about 3 per cent.
So the growth rate of the population of working-age Canadians will be negative for the seeable future, say negative 0.1% – 0.2% annually.
Therefore our only growth influence in the Canadian economy will be the nebulous and hard to pin down productivity growth that economists calculate. Mr. Poloz stated “Productivity growth fluctuates around a long-term trend, tending to be weak during recessions and the early stages of a recovery, and stronger in periods of economic expansion. It follows then that the weakness in productivity growth since the financial crisis may be a symptom of a post-crisis hangover. Indeed, in Canada, the latest data show a pickup in productivity in the second half of 2013, to around 2 per cent, which is very promising.”
Let’s look south of the Canadian border to look at long-term trends of productivity growth in the US. According to Jeremy Grantham, of the money management firm GMO, for forty years after WW II economists calculated productivity growth of around 1.8% per year. Unfortunately the following thirty-year period saw US productivity growth slowing to 1.3%. With some economists seeing a trend of lower productivity growth in the foreseeable future. This is in the United States, the most productive and inventive society on earth.
Mr. Poloz points to a short-term spike in productivity in the Canadian economy over a certain period of time but no one – at least not me – really believes that Canada will out do the US in terms of productivity growth. And remember productivity growth is really hard to measure, if at all.
So, do the math. The CDN labour force is contracting say, 0.1%-0.2% per year. Productivity growth, let’s just say, it’s the same as the US – big assumption, in that productivity is growing 1.3% per year. So the maximum growth rate in Canada over the foreseeable period of time will be 1% per annum – if we are lucky!
Going one-step further inflation in Canada has been falling like all industrial countries all over the world. Inflation last year in Canada according to Mr. Poloz was 1.2%. The goal of the Bank of Canada is to have 2% annual inflation. So there will be no real growth in Canada for the foreseeable future!
Mr. Poloz states “the global economy may not be just suffering through a hangover from the financial crisis. There are other, longer-term forces at work as well. Some analysts are suggesting we may be facing a long period of secular stagnation. On this alternative view, the economy could perform well below normal, leaving many out of work or underemployed for a long time to come.”
Candid hard-hitting stuff!
3. Mr. Poloz cites the Club of Rome! “Over 40 years ago, the Club of Rome published a book entitled, The Limits to Growth. To the global think tank, those limits were about finite natural resources and the environment. Although the timing remains uncertain, its arguments remain relevant today.”
This, my friends is jaw dropping. For a central banker to cite the Club of Rome, in a public address is unheard of. If Janet Yellen, the new Chairperson of the US Federal Reserve, had made this reference, and maybe she will in the future, the US would be in a full-scale panic with both public and private debates on how the US economy can exceed these “Limits to Growth” and reference the presidential years of one Jimmy Carter.
4. There are other items in his speech that are interesting. Including statistics on where Canadians are allocating an ever-increasing and significant portion of their wealth over the last 10 years. Interested? My lips are sealed in hopes that you will read the speech.
Shocking speech and a must read. Mr. Poloz wasn’t on my radar screen but he is front and center now. The investment implications of this speech are quite real and should be considered by all investors.
So “What if” Mr. Poloz is right?
My interpretations are:
1. The Bank of Canada rate – similar to the Fed Funds rate – is still around 1%, leaving Canadian chartered bank prime at 3%. The US Fed Funds rate is 0 – 0.25%. The Bank of Canada still has room to drop interest rates, if need be. When, not if according to this speech, the Bank of Canada starts to reduce short-term rates look for GIC’s and other short-term debt instruments to follow suit squeezing retirees and savers even further.
2. We have already seen a decline in the value of the Canadian dollar under 90 cents to the US dollar. The weakness is probably making Mr. Poloz happy, in that a weak CDN dollar is giving the Canadian economy, especially Ontario; a must needed boost (cheaper exports) and higher short-term import inflation. The economic impact of the lower CDN dollar does take time. I’m sure the Bank of Canada will be monitoring export growth, import inflation and interest rates very carefully in the future however this speech is confirmation to me we are probably in the early stages of a secular decline in the CDN dollar vis-a-vis the US dollar. (Something I have been professing over a year and a half ago.)
3. Interest sensitive Canadian equities will probably have another bull rally to valuations higher than their previous stated valuation highs – EBV Levels – as income investors scramble for higher dividend and income returns that are lacking elsewhere or when the Bank of Canada starts to reduce the Bank of Canada rate.
4. Canadian companies that have any growth, say high single-digit or low double-digit growth, in any Canadian or international economic market sector will have a high valuation (EBV Level) as investors will pay any price – valuation – for growth in a no-growth country (maybe world).
5. Assuming all the above happens, this will increase the valuation of the S&P/TSX Composite from currents levels to EBV+3. See chart below. This will imply an upside of approximately 35% from current levels.
S&P/TSX Composite Index with monthly price bars and EBV Lines (colored lines).
If the S&P/TSX Composite did achieve this valuation level, EBV+3, in any future time period this would represent full value for this Canadian Index and much needed caution for Canadian equity investors.
Just a normal weekend my friends, alone with my investment thoughts!
“What if?” indeed!