Are You Ready To Stand Up And Fight Against V.U.C.A.?

 

By Dr. Sherry Cooper

V.U.C.A. = Volatility. Uncertainty. Complexity. Ambiguity.

The future is something that I spend my life looking at; economists get a bum rap because we ‘re often teased for incorrect forecasting. The truth is no one knows the future, no one, no one can time the markets, in fact I ‘ve never met anyone who ‘s met anyone who can time markets and I ‘ve been in the business. What is important about the economy and what economists do, is to put it into perspective, to give you a sense of what has happened and where things are trending. But please keep in mind that there will be random shocks, inherently unpredictable events, many of them with very low probability but often having enormous consequence and these are the things that though we cannot predict them. We can protect ourselves, always looking for Plan B.

 

Right now the US economy is growing more rapidly than the Canadian economy, the US stock market is doing better than the Toronto stock market, that follows what was a period of nine consecutive years, until just about a year and a half ago when Canada outperformed. Do you know that Canada went through a 16-year period without a recession? And in addition to that, when we did have the financial melt down of the global economy, triggered of course by the sub-prime lending in the US housing market. Though the US had the deepest, longest recession since The Great Depression, Canada ‘s recession was short and mild.

 

The Turning of the Tides
But now the tides have turned, from very, very weak levels, the US economy is turning around. Of course there remain risks to the outlook, there always do, but the important thing is that there ‘s enormous pent up demand in the United States. The housing market having collapsed 32% in price at a national average basis, down 50% in price in places like Florida, Nevada, Arizona and parts of California; there is now a rebound.

 

Canada, on the other hand did not experience the melt down in housing or commercial construction, quite the opposite. So for Canada, we ‘re at a more advanced stage in the economic recovery, and in fact, as you know from reading the newspapers, the government of Canada, be it the Prime Minister or Minister Flaherty or even the Governor of the Bank of Canada, are so concerned about excess spending, excess borrowing, that they have meaningfully tightened mortgage markets. Now when you look at the numbers you see that my forecast is that US economy will grow at about 2.25% this year and the growth in the second half of the year it will accelerate to close to 3-3.25%.

 

For Canada on the other hand, we will continue to experience less than 2% growth. The real culprits in this were the big, big contributors of the past, things have slowed in the energy and industrial material sectors. The oil sands are now in a period of great upheaval, thanks to the environmentalists that are prohibiting the gateway pipeline, going east to west that would allow Canada to export oil to China but also thanks to the energy boom in the US.

 

Now for the United States, the big headline news is fiscal policy, government ‘s attempt to reduce the enormous budget deficit in the US, and as you know there has been tremendous consternation between the Republicans and the Democrats. Everyone is in favor of deficit reduction, but no one can agree to how it will happen. The truth of the matter is that there has already been a substantial tightening in fiscal policy: increases in tax rates and reductions in government spending, in addition, what we see now is that the reduction in the US federal budget deficit. This improvement in the US debt picture is the biggest it has ever been on an annual basis since the demilitarization after World War II. This, by definition, slows economic activity, as you can imagine, the government now faced with furloughs and layoffs of its workers at the local levels, the state levels and the federal level, the huge cuts in defense spending, as well as the increase in payroll tax rates, has led to a slowing in the economy and that ‘s why the federal reserve is intent on keeping interest rates low.

 

The Leaders of the G20 Agree to Encourage Spending
Now looking around the world at debt levels, debt ratios, you see that Canada is in an enviable position. Now to be sure, our debt to GDP ratio has risen since 2008, just like it has in virtually every other country of the world, but our debt levels are low and the increase in Canadian debt relative to GDP was intentional. It was intentional, by the way, everywhere in the world. The reason is, right after Lehman Brothers went bankrupt in September of 2008, and stock markets were crashing, and there was a risk of a run on all the American and global banks. The leaders of the G20 got together and agreed that they stimulate their contracting economies and they would do whatever it takes to prevent a global systemic meltdown in the banking system.

 

For countries like Ireland they nationalized the banks, the banks of Ireland were bigger, many multiples times the size of the economy, so the government took on enormous debt and the people of Ireland took on enormous tax burden. Unlike Greece or Cypress or Portugal, the Ireland situation has now turned around and pretty soon the Irish banks will be able to borrow again in the open market. Now for Canada, we were blessed with a very strong regulatory environment one in which, in fact, the Canadian banks were deemed to be the strongest in the world. Not a single Canadian bank took a dollar of government money, not a single Canadian bank cut dividends, even though dividend yields rose to 10% because of the plunge in stock prices.

 

Bank of Montreal, for example, stock price went from $63 a share to $24 a share in March of 2009. Everyone was fearful that the Canadian banks would be forced to cut dividends; they didn ‘t do it. They didn ‘t do it because they didn ‘t need to do it, because their capital stores were very strong. No Canadian bank has cut it ‘s dividend since 1930 and no Canadian bank has gone under since 1918, unlike the
American story with the huge collapse after the 1929 stock market collapse and of course hundreds and hundreds of small American banks went under just in the recent crisis.

 

The Fastest Growing parts of the Global Economy are the Emerging Economies
Now when we look at the G7 as a whole you see that North America will be the strongest region in the world this year among the developed economies. Europe of course is under an enormous blanket of debt and tremendous instability in many of the banks. We also see though, that the fastest growing parts of the global economy are the emerging economies, countries like China, India, Brazil, countries that have experienced tremendous growth and the emergence of a middle class. Opportunities of course to trade with these countries has been a strong boon for Canada, as well, with the strength in this part of the world we ‘ve seen the pressure on commodity prices, which helped the Toronto stock exchange to outperform. However, in the last year and a half there has been a slow down in economic activity in the emerging world. Commodity prices have come down, even gold prices have fallen and that ‘s the reason why the TSX has underperformed, or at least one of the reasons.

 

Now the Canadian dollar has risen since 2002, in fact I think some of you in this room might remember when the Canadian dollar was a basket case currency. The Canadian dollar fell to as low as 58 ¢ US and while the exporters might have liked that and while it made our manufacturing sector very productive, the fact of the matter is the money we earned as Canadians and the money we invested was worth less. So now that our currency is just shy of parity, the truth is that all of us are wealthier; however, it also means that wage rates in Canada have risen vis-a-vis the rest of the world and most importantly the United States, and so it has become less competitive to manufacture in this country compared to the US. As a direct result, we have seen the Canadian trade balance move from a record surplus to a record deficit and at the same time the American economy has become much more competitive to the point where the US trade deficit has diminished significantly.

 

Another reason why the US is outperforming Canada, is that net exports in the US are stronger and in fact real wages in the US have not increased for a decade, in fact real wages are down. The reason of course is the major recession that occurred.

 

Now consumers in Canada are tightening their belts at the same time that United States ‘ consumers are more willing to spend. Consumer confidence in Canada is still above the level in the US, but the trend is down, whereas it ‘s up in the United States and retail sales growth is a lot stronger in the US than it is here. In addition, one of the strongest sectors in both countries remains the automotive sector. There is huge pent up demand. Do you know that the average age of an automobile in this country now is 8.7 years? Now to be sure autos are better built today than they once were, but the fact is an aging auto stock does spur additional sales and in this province in particular, automobile production is very important. In the US and Canada auto sales now have returned to close to pre-recession levels.

 

The drag on the US economy, however, remains the very slow growth in jobs, though the unemployment rate has fallen from a peak of 10% to 7.6%, it has been accompanied by a record decline in labor force participation.

 

In Canada our jobless rate never increased that high and in many sectors in Canada, we ‘re actually seeing labor shortages, the trouble is, however, that in the two countries the measurements are different. In the US, in order to be considered unemployed you have to be actively seeking work, which means that you have to have been on job interviews and sending out resumes. With the average duration of unemployment in the States now at a record high level of nine months, and that ‘s the average duration, you can understand why many people have given up the job search. Many of the boomers that found themselves laid off over the course of the credit crisis and beyond, not only have been unable to find employment but when they do find employment, they will be paid at markedly less salaries than the jobs they once had. This, of course, has been a devastating fundamental for the overall economy.

 

Now in Canada you ‘re unemployed if you say you are, you don ‘t have to be sending out resumes or going on job interviews, which means our number is higher. But when you look at other countries of the world, the jobless rates in places like Greece and Spain and Portugal are in excess of 25% and the unemployment rate for youth in those countries is 50%. Now, in North America, household balance sheets are improving. In the United States we ‘ve seen a dramatic decline in household debt, even relative to personal income, and net worth is beginning to move up again thanks to the rebound in the housing market.

 

Housing Markets
In Canada, our government is very concerned about the fact that Canadian household debt is at a record high level relative to income. The reason is this case is because mortgage rates are at record low levels, obviously you can borrow a lot more on your mortgage when interest rates are at 3% than when interest rates were at 15%, but the government is concerned, so they have tightened considerably the CMHC restrictions on mortgage insurance. It wasn ‘t that long ago, in 2006, you could borrow a 40-year amortization with only 5% down and get a CMHC loan. Now obviously that was an accident waiting to happen, they ‘ve subsequently tightened those conditions, but the banks themselves are indeed qualifying people based not on today ‘s mortgage rates alone but also on the prospect for higher mortgage rates over the next 10 years.

 

US housing is finally improving from rock bottom lows, year over year house prices are up 7.5%, for some parts of the country house prices are up even 20%. In Canada the opposite is the case, housing starts have slowed, existing home sales are not growing the way they were and home prices now in Canada have been roughly flat on average for the country as a whole for more than a year. But of course all real estate is based on location and there ‘s a very different story depending on the region of the country.

 

Foreign Money Pushing up Housing Values in Major Centres
For Canada, as I mentioned, prices are flat on average. In Toronto, year over year they ‘re up only 1.6%; in Vancouver they have been declining now for more than a year. It ‘s very interesting what has happened to real estate in this country, largely as a result of the massive net inflow of foreign capital. Back in 2001 house prices in Canada on average were three times the average income, today they ‘re at five times average income. In Vancouver they ‘re at ten times average domestic income. Why? Because the money that ‘s poured into the housing market is coming from foreign sources, literally all over the world and their income is not included in domestic income. It means that many young Canadians have been priced out of the market. In Toronto house prices today on average are seven times income, on average, up from four times in 2001. Not as high as in Vancouver, but certainly high by historical standards and certainly high in comparison to what has now happened to the major city home prices in the United States.

 

The Future of Interest Rates
Now what does all of this mean? Financial markets have been volatile, enormously volatile. The Bank of Canada has had interest rates at very, very low levels, the Bank of Canada saw a new Governor on June 1, but in my view policy will not change. With the US economy still struggling with high unemployment, the federal reserve has told us that they will keep interest rates low for as long as it takes to get unemployment below 6.5% and they ‘re not concerned that this will be inflationary. So the federal reserve along with central banks in other parts of the world are buying government debt, monetizing the debt, particularly long term debt, to drive mortgage rates down and you see that mortgage rates have fallen sharply. Now this looks at average mortgage rates, as you know, depending on the type of mortgage you take (the variability, the term, etcetera), interest rates could be lower still.

 

I believe that long-term interest rates will be edging upward as economic activity accelerates in the US, but we will not see that kind of rise in interest rates that we had experienced back in the 70s or 80s, because inflation remains exceedingly low. Also you can see here just how well the stock market has done. The US stock market is back to the pre-recession highs, we ‘ve also seen a similar performance in Europe but look at the Toronto stock exchange, though it is up, certainly from the lows in March of 2009. You see that it is down from the peaks earlier this cycle; there are three fundamental reasons. One: our bank stocks didn ‘t crash the way they did in the US, so the rebound hasn ‘t been as dramatic. Two: oil, gold and the other material sectors loom larger in our stock market than in the United States and they have been underperforming. And three: I can tell you in two words, it ‘s RIM vs. Apple. So again, this is the stage in the cycle where stocks, though still rising, are not performing as well as they once were.

 

Volatility, Uncertainty, Complexity and Ambiguity
Now I want to conclude with one idea its called V.U.C.A. V.U.C.A. is a term that was developed by the military establishment after 9/11. It is a term that represents what I believe applies not just to the military situation and terrorism around the world but to every aspect of financial activity, and that is Volatility, Uncertainty, Complexity and Ambiguity. These fundamentals are with us and they will continue to be with us, driven in large measure by the increasing globalization, by the vast expanse of the powers of the Internet, by the fact that the climate changes around the world appear to be triggering Category 5 hurricanes and earthquakes and other very strange and unexpected environmental changes. As well, we see change happening faster than it has ever happened before. Who could have imagined the development in job categories related to digital technology, or to the application of digital technology to the life sciences, to all of the different aspects of our world that we now see today?

 

I was just at a seminar a couple of days ago about a venture capital fund that was investing in a company that is developing MLS on a global basis. In other words, it created the ability to look at the detailed real estate listings in every city in every region of the world and take virtual tours on your computer at home. What does that say about how small the world has become? Now these are significant challenges, but in my view challenges are opportunities. they ‘re scary, fear is something that can paralyze many of us, but it is also something that can drive initiative and innovation and a new way of doing things.

 

I urge you for yourselves, for your careers, for your investments, for your children, for the future, to understand that the world is ever changing, that it is essential that you be ongoingly educated, though no longer is it good enough to have gotten your degree and then stop. The world changes so rapidly that everyone must have an ongoing MBA program created by themselves and that need to continue to innovate and to change will not stop. As Charles Darwin said it ‘s not the strongest of the species, or the biggest of the species that survive, it ‘s the most adaptable. It ‘s the willingness to change and that ‘s something that I think all of you need to consider as you move forward.

 

If you’re looking for more real estate education and analysis like this, you need to be at the North American Real Estate Summit on August 24 in Edmonton. Tickets and more information are available here.

 

Dr. Sherry Cooper is in constant demand as a speaker and writer because of her ability to simplify and de-mystify the complex subjects of economics and finance. Sherry is also very good at what she does. She received the Lawrence Klein Award for U.S. forecasting accuracy in 2010, beating out a panel of 50 economists predicting the four-year period from 2006 to 2009. This was no mean feat, as the period encompassed the U.S. housing bubble, financial crisis, recession and recovery.