Investors and market watchers continued their attempts to predict the likelihood of a recession, the path of inflation, and central bank moves in April amid ongoing volatility in the banking sector. And while bond markets clung on to hopes that we’ll soon return to two per cent inflation and ultra-low rates, the bond managers at Canso Investment Counsel Ltd. say they’re not sure we are nearing the end of this ride.
“We believe that monetary policy and the credit cycle are powerful forces, but we suspect that things on the inflation front will be a lot more difficult than the fashionable market crowd suspects,” Canso experts said in the firm’s April 2023 Canso Market Observer.
“The consensus believed for a very long time that excess money supply would not result in excess inflation. Now that we’ve had runaway inflation after the extraordinarily excess pandemic money supply after the pandemic, they still can’t bring themselves to believe that the current restriction of money supply is not disastrous.”
With Canadian CPI at 5% by the time the Bank of Canada started rising rates in the second quarter of 2022, and now holding at 4.3%, a 10-year Canada bond yielding 3% means “the holder basically locks in a real rate of return that is -1.3%.”
“The good news is that central bankers seem to have recognized their error. The large amount of money they created has unleashed an inflation storm they weren’t contemplating, expecting, or prepared for,” Canso says in the newsletter.
“(But) have central bankers done enough to get inflation under control?”
In the U.S., all the extra money pumped into the system led to nominal GDP rising again, but it also led to higher prices, and the Federal Reserve has now started reducing that money supply – something Canso believes could get the country back to “normal inflation” by July 2024, if nothing else changes.
In Canada, money supply jumped when the Covid pandemic began. Canadian GDP dropped then recovered, but still remains below pre-pandemic levels. And while the U.S. has reduced money supply from its peak levels, Canada is still increasing it – which suggests it’s unlikely to return to “normal” money supply any time soon.
Complications no one was banking on
The last few months brought the added complication of banking sector volatility into this economic picture, after a string of regional bank failures in the U.S. (and the deeply discounted acquisition of long-troubled Credit Suisse by their domestic rival, UBS) shook investor confidence in the stability of the overall system.
While experts seem to agree the impact is limited to small, regional banks, and that Canadian banks are once again faring better than their U.S. counterparts, where Canso sees the most risk to the Canadian banking sector is around mortgage debt.
“In the aftermath of the Silicon Valley Bank and Credit Suisse bank runs … the main argument against Canadian banks centers around Canada’s inflated housing market and the banking sector’s exposure to residential mortgages,” the newsletter says.
“If home values fall and defaults rise, banks will inevitably experience losses.”
Canso has worried about the Canadian residential real estate market since 2013, warning back then that it was overvalued and falling home prices would negatively impact the economy. For years, ultra-low interest rates have kept that from happening – which begs the question, what will happen now that interest rates have gone up?
“Things are actually worse now than in 2013 in terms of Canadian bank exposure,” Canso said. “The long-predicted setback in Canadian real estate now seems to be happening … (and) given Canadian banks’ increased exposure to uninsured residential mortgages, their residential loan losses will increase, and their profits will suffer.”
But, they add, Canadian banks continue to earn significant risk-free profits on the portion of their mortgage book that’s insured, and the Federal government, which has extended support to the banks in the past, is likely to do so again, if the need were to arise.
Read the full April 2023 Canso Market Observer here.
DISCLAIMER: The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.