THIRD QUARTER 2017
Unhedged European and EM Equities Bargain Priced For Limited Time
by David Wolf, Portfolio Manager, and David Tulk, CFA, Institutional Portfolio Manager, Fidelity Investments Canada
An abrupt hawkish shift in tone from the Bank of Canada has culminated in the first increase in the overnight lending rate in nearly seven years, causing both the Canadian dollar and bond yields to reprice higher (see Exhibit 1). The Bank’s decision reflected a considerable upgrade in their assessment of Canada’s economic prospects. Our own outlook has been far more cautious, and has been reflected in a material underweight to Canadian assets across our multi-asset class funds. The Bank’s recent actions, and the financial markets’ response to them, make it more likely that the downside risks to Canada’s economy we’ve been concerned about will be realized on the visible horizon. As a result, we are diversifying further from the domestic market into unhedged foreign assets. We discuss the rationale for this decision below.
The addition of Bank of Canada tightening as a headwind to the Canadian economy has strengthened our conviction in the risks to the performance of domestic assets, and the resulting short-term squeeze higher in the Canadian dollar has made unhedged foreign assets that much cheaper on a relative basis.
The combination of very accommodative monetary policy and a sluggish global recovery has left the Canadian economy severely unbalanced. Household spending, notably on housing and consumer durables, has been pretty much the only game in town in recent years, while more productive sectors of the economy such as business investment and exports have stagnated (see Exhibit 2). The ratio of household debt to personal disposable income in Canada remains near its record high, while the valuations of the Toronto and Vancouver housing markets – together representing roughly half of the national housing market by value – have become increasingly detached from local fundamentals.
Both the U.S. and Europe have demonstrated in recent years that the balance sheet repair that is required following a debt boom can represent a multi-year headwind to economic growth. That process still lies ahead in Canada, and its beginning looks to be coming into focus. The combination of tighter regulations from the federal, BC and Ontario governments (including those targeting foreign capital) and emergent concerns surrounding lower-tier mortgage lenders had already begun to affect the price and availability of credit in Canada, and more broadly to shift the psychology in the housing market. The recent jumps in longer-term interest rates around the Bank’s rate hike will add to the pressure.
In our view, it is likely that this cocktail of tightening will bring to an end the outsized contributions of household spending to Canadian growth. The housing market doesn’t have to go down for that to happen – it just has to stop going up. And there is clearly risk of a much worse outcome, as the reaction of a levered market to even a small shift in conditions is inherently unpredictable. Since the Bank last tightened, house prices nationally are up 50%, and households have added more than $580 billion to their debt loads, even as credit creation has increasingly moved into the shadows in response to prior government attempts to curb excesses in the more regulated areas of the financial system.