Research Update: Canada’s Debt in Context
CANADA’S DEBT IN CONTEXT
Buy now… pay later! That is the message being telegraphed by most governments as they engage in an unhindered and unprecedented spending spree. Supported by central banks’ quantitative easing, ultra low interest rates and a sense of urgency to support individuals and small businesses during pandemic lockdowns, rising debt levels have become politically palatable.
That latter point has been a contentious issue for individuals whose definition of fiscal prudence has been challenged. The debt hawks have raised concerns about runaway inflation and the fear that rising rates could cause irreparable damage to industrialized economies and saddle future generations with unacceptable levels of taxation. And while we are not sure the concern is warranted, it bears discussion.
Long before COVID, global governments have been redefining fiscal prudence. Moderating inflation provided a backdrop for low interest rates allowing governments to expand deficits while reducing debt servicing costs. Note the European Central Bank (ECB) has been engaged in quantitative easing (i.e., expanding the money supply) since the 2007-2009 financial crisis to prop up the weaker members within the European Union.
One could argue that the ECB’s unbridled support for fragile member states has weakened the European Union’s competitive position. While that may be true, competitive pressures took a back seat to COVID relief efforts sending the euro printing presses into hyperdrive with no end in sight. Depending on the inflationary impact, this strategy may emotionally fracture relationships between have and have-not states, rattle the bloc’s economic union and eventually dismantle the great European experiment. But I digress!
The question at hand is whether Canada is going down the same path. On the surface it appears to be a catastrophe in the making, but dig a little deeper, there are signs that it may not be as bad as we think. To gain some perspective, it is helpful to examine Canada’s debt level in terms of 1) its sustainability, 2) the inflationary impact, 3) its burden to current and future taxpayers and 4) the impact on economic activity should interest rates rise.
Pre-COVID, Canada’s federal debt was reasonable relative to members of the G-7 community. The surge in Canada’s post-COVID debt, while dramatic, was in line with other G-7 States engaged in similar fiscal and monetary policies to protect the integrity of their economies. Without collective government support, there was a real risk that the global economy would collapse leading to a major protracted depression.
On the positive side, global debt, while expanding, has been buttressed by central bank intervention. Which is to say, much of the new debt found its way onto central bank balance sheets making the cost of the burden less intrusive. Effectively, governments have been able to retire higher cost longer term bonds with the issuance of low interest Treasuries.
This strategy is the foundation of Canada’s fiscal response. The interest rates on new debt issuance are substantially less than the rate that was charged on Canada’s long-term liabilities. So, while the debt increased, the cost of carry has declined.
For example, suppose the government borrows $1 million in short term treasuries at 0.25% interest to buy back and retire $1 million in 30-year bonds with an interest rate of 5%. This simple transaction reduces the annual cost of carry by 4.75%. What had cost the government $50,000 annually to finance $1 million in debt, now only costs $2500.
Of course, this simplistic explanation only scratches the surface. In reality, the government issues additional debt well beyond the $1 million required to retire the longer-term bonds.
To that point, let’s assume the government issues $10 million in new debt, uses $1 million to retire the longer-term bonds while the remaining $9 million finances COVID relief programs. The government now has 10 times the original debt ($10 million in new debt, versus the initial $1 million in long term debt) but the cost of carrying the new debt is only $25,000 (i.e., 0.25% cost of carrying $10 million) versus $50,000 for the original $10 million in long term debt (see figure 1).
The burden from government debt is generally measured as a percentage of debt relative to GDP. As seen in Figure 1, debt to GDP is expected to continue increasing until the economy either grows at a rate that is greater than the percentage increase in new debt issuance, or the economy returns to its pre-COVID trajectory allowing the government to reduce its current debt load.
On a global basis, Canada’s current fiscal position was buttressed by the fact that pre-COVID the country had the lowest net debt-to-GDP among the G-7 countries. With the surge in COVID related spending, the federal debt-to-GDP ratio went from 31% in 2019-20 to 49% in 2020-21, but still ranks at the lower end of G-7 members (see figure 2).
Figure 2 G-7 General Government Net Debt for 2019 and 2020
While the numbers are better than most, there are risks! The first is a rise in interest rates. It is one thing to say Canada was able to retire longer term high-rate debt with short term treasuries at much lower interest rates. But what happens when rates begin to rise?
To buffer that risk The Canadian government is canvassing its primary dealers to re-structure its’ longer term cost-of-carry by issuing new 30 year bonds in today’s lower rate environment.
Politicizing Canada’s debt to GDP ratio is sure to be one of the issues during the Fall election campaign. We will likely witness fiscal hawks making the case about potential damage from rising rates by comparing the pain homeowners feel when renewing their mortgages.
However, government debt re-financing is very different from the reality homeowners face. At least at the federal level! The federal government has access to a printing press through the auspices of the Bank of Canada (BOC). In short, the federal government can manage its debt in a circular fashion through the BOC.
To understand the circular formation, let’s return to our hypothetical example. About 50% of the $10 million in new debt that the government uses to finance COVID relief programs was purchased by the BOC (we refer to this as quantitative easing). The BOC collects 0.25% interest on say $5 million of the new debt issuance. The interest earned on this debt is returned to the Government of Canada Treasury effectively eliminating any cost of carry. In short… much of the new debt issuance is free money!
The other advantage is that the BOC could theoretically hold this debt for a very long period. In fact, the BOC could eliminate the debt by allowing it to simply flow unencumbered into the economy. This would result in a massive increase in the money supply which will not damage the economy if inflation is muted. The risk is that the inflation we are currently experiencing is not as transitory as central bankers believe.
Our view is that inflation, so far at least, is transitory. But we are monitoring events carefully, notably looking for abnormal spikes in wage demands, which could have a longer-term impact on economic productivity. Anything that calls into question the transitory argument will have economic consequences that would impare financial markets.
THE INFRASTRUCTURE DEBATE
The US Congress is currently debating a massive infrastructure bill that cleared the US Senate. Passage in its current form is not guaranteed.
The Democrats want to up the spending to include items that many Congressional Republicans believe is not related to infrastructure. Notable among the list of liberal extravagances is free college tuition, expansion of Medicare and childcare. Both of which passed the Senate but along purely partisan lines.
All of this has put house leader Nancy Pelosi in a tight spot. In her effort to placate left wing Democrats she is holding up the US $1.2 trillion bipartisan infrastructure bill hostage to a more aggressive US $3.5 trillion budget resolution that has no Republican support.
President Biden has put forth a strategy to pay for an infrastructure compromise (i.e., somewhere between US $1.2 trillion and US $3.5 trillion) through increased taxes on US corporations and wealthy individuals. More on that in a moment!
The challenge is that Americans are fearful that inflation will not be transitory, and any largess in the infrastructure package can only make matters worse. Simply stated, average Americans see inflation firsthand as they pay up for basics like groceries, gasoline, and rent. To them, the idea that all these concerns are related to supply chain challenges is, at best, a political stretch.
Americans also like the idea that bipartisan compromises advance ideas in the fairest way. The US $1.2 trillion infrastructure bill that Utah Senator Mitt Romney helped craft is a rare example of cooperation in the modern, hyper partisan age. Its passage in the Senate was a big deal.
Adding to Pelosi’s woes is the wide dispersion of opinion among Congressional Democrats. Left wing Congressional Democrats won’t vote for the smaller infrastructure bill unless the larger budget resolution passes first. But nine moderate Democratic House members have sent a letter to Pelosi saying they won’t vote for the larger resolution unless the smaller bill is put to a vote. Average Americans, nervously eyeing their thinning pocketbooks, are not impressed by these shenanigans, which have implications for the 2022 election.
That brings us back to how the US government intends to fund the infrastructure bill by taxing wealthy Americans and increasing corporate tax rates. Everyone agrees on taxing the wealthy, but no one has put forth an effective way to do it.
Individual taxation around the globe rests on taxing income. But the wealthiest Americans do not usually draw much from employment income but rather make their money through dividends and capital gains from their massive investment holdings, which are taxed more favorably.
The asset-based income model is fraught with “loopholes” as defined by left wing Democrats or, from the Republican perspective, “shrewd tax planning” using policies engrained in the US tax code. For example, I recall an interview that Larry Ellison gave to CNBC in which he talked about using his vast holding in Oracle to establish a personal credit facility with his banks.
In short Mr. Ellison created a US $4 billion line of credit backed by his personal holdings of Oracle shares. As he said in the interview, he pays no tax on the funds drawn from the credit facility because his shares were not sold but merely pledged. Drawing on the credit facility is extremely tax efficient because he can write off the interest expense associated with any drawdown. As an example, he could buy a basketball team with the credit facility with zero tax implications.
Mr. Ellison was a good friend of Steve Jobs and for a time was a member of Apple’s Board of Directors. He shared these insights with Mr. Jobs. Those of us with many years under our belt remember that Steve Jobs was paid US $1 per year for his role as Apple’s CEO.
The most recent approach is to initiate a wealth tax. The problem with this approach is how to deal with the variability of the wealth on which the tax is predicated. Say you want to apply a 3% tax on Elon Musk’s wealth. His fortune is based on his holdings of Tesla’s stock, which could rise or fall by 50% in any given year. What about Donald Trump’s real estate holdings, which are valued independently based on any number of metrics? The complexities of a wealth tax are significant and will face massive challenges from some very powerful lobbyists.
Increasing the corporate tax rate is another matter. Based on recent surveys, Americans are aware of the pitfalls of this strategy. Average Americans understand that corporations do not pay tax. To protect profit margins, corporations will either pass along price increases or reduce expenses (i.e., wage controls) to manage their tax burden. Even utility companies like Hydro One and BCE Inc. have lobbied for federal protections that allow them to increase prices to maintain a specific profit margin.
All this sets up an interesting Fall session. The Republicans are not inclined to raise corporate taxes and any attempt to tax the US wealthy seems doomed to failure. These factors have amplified a point of view that draws into question the likely passage of any enhanced infrastructure bill. In fact, some analysts believe that is the reason broad-based stock market indices continue to set new highs.
They may be right!
ARE STOCKS OVERVALUED?
There is a wide chasm among analysts about stock market valuations. Are stocks overvalued or reasonably valued when measured against current economic conditions? Which side of the debate you come down on depends to a large extent on what valuation metrics you choose to employ.
One that has recently gained attention is the so-called “Buffett Indicator.” It came to light during an interview Buffett had with Carol Lewis in December 2001. In that interview, Mr. Buffet shed light on his favorite approach to quantifying stock valuation on a macro level. His approach was to calculate the ratio of stock market capitalization (SMC) by what today would be described as US GDP. Mr. Buffet equated the stock market’s future potential based on the current ratio. In his view, if the current SMC / GDP was 130% he would expect the stock market to return approximately 7% annually over the next ten years.
If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% as it did in 1999 and a part of 2000, not so good! At present the ratio is above 250%. Signaling at a minimum, heightened risk, or depending on one’s perspective, a dire warning (see figure 3).
The question is whether the indicator is still relevant. We are, after all, talking about the world’s pre-eminent value investor who, until recently, did not hold what are now some of the biggest growth names in the Berkshire Hathaway portfolio.
In fairness though, the Buffett Indicator is meant to be a quick temperature check on a market’s valuation. It was never designed to be a timing tool as it only purports to tell you how the market’s general valuation compares to historical norms. It doesn’t say what’s going to happen over the short to medium terms.
The Buffett Indicator seems to show value over very long time periods, which itself makes the indicator fallible.
What we know is that as a broad predictor for future returns over a long enough period, the Buffett Indicator has a decent track record. Hold a position long enough, and markets will eventually correct to an appropriate level. We are reminded, however, of an old Wall Street maxim: stocks can stay overvalued for much longer than an investor can remain liquid.
As with any indicator, broad valuation measures are only a useful input and should not be viewed as the gospel of investing. They may have worked historically, but unprecedented conditions – such as extended periods of low interest rates, globalization, pandemics, questionable inflation, and economic growth metrics – can diminish the value of inputs, implying that indicators may not work in the same way. On the other hand, when an indicator becomes severely overextended, it is most dangerous to believe “this time is different.”
To that point, we look at several metrics when calculating a “fair value” for say, the S&P 500 composite Index. In the end, it comes down to four basic principles: the return that investors require; the current earnings and dividend level; the expected growth in earnings and dividends; and the probable P/E ratio that the index can be expected to be sold for at the end of a reasonable holding period of say 10 years.
USING OPTIONS TO DOLLAR COST AVERAGE
I have always been proud of the fact that Croft Financial Group is one of the leading option houses in Canada. We utilize options in a variety of ways depending on the objectives of our in-house pools.
Our proprietary option writing pools are deigned to provide regular tax-advantaged monthly income from dividends and the sale of covered calls or cash-secured put options. Some of our growth pools utilize options to enter new positions.
The latter strategy is premised on the concept that financial markets are efficient in that all known information has been considered when valuing a security. If we like Apple Inc. which was recently trading at US $149.10 (close on August 15th, 2021) per share, we assume for purposes of entering a new position that the current market price reflects publicly available information.
That said, market participants recognize that stocks can become over- or undervalued. Professional money managers recognize that daily variations in a stock’s price are not predictive of longer-term trends and effectively represent noise. How many times have you heard so-called experts in the financial media talk about the positive aspects of a particular company but recommend waiting for a pullback to enter a new position at a lower price.
Unfortunately, if we are correct in our initial assumption that current prices represent a reasonable value given all available information, it stands to reason that waiting for a pullback will only work 50% of the time.
A common approach to mitigate market noise is to dollar cost average entry into new positions. Take an initial position today and buy an equal dollar amount of additional shares later. Dollar cost averaging is a disciplined approach that strikes a balance between going “all in” versus making strategic bets that increase the odds of success.
We employ options to enhance the discipline inherent in the dollar cost averaging strategy. By using options, we can define specific entry points and timelines, which enables us to enter initial positions today rather than waiting for a pullback that may never materialize.
Options allow us to engage in a cohesive strategy that synchronizes our core belief that markets are efficient. To that point, we extend our efficient market thesis to the derivative markets by assuming the current price of the option contracts on Apple quantify the risk as to the accuracy of the public information that supports the price of the underlying security.
Options quantify risk via the volatility estimate used to value a call or put. The volatility input in the option pricing formula quantifies a reasonable trading range for the underlying security. This so-called “implied trading range” measures the variation around a reasonable entry point for the stock.
The technical indicator that is generally used to graphically depict an implied trading range is the so-called Bollinger Bands, which were developed and copyrighted by famous technical trader John Bollinger. They were originally designed to discover opportunities that give investors a higher probability of properly identifying when an asset is oversold or overbought.
While not the original intent of Mr. Bollinger, we use the bands to define an implied trading range using trendlines that are plotted two standard deviations above and below a simple moving average based on the timing of the options being employed to set up entry and exit points for new investments.
Figure 4: Fourteen-day Bollinger Bands on Apple Inc.
Note from figure 4 that Apple Inc. is near the top of its 21-day trading range with the top Bollinger Band striking at US $151.99 per share and the bottom Bollinger Band at US $131.38 per share. That defines our entry points if we were to take a position between now and September 3rd, 2021.
Rather than buying say, 1000 shares of Apple Inc. at the current US$149.10, we prefer to average into our 1000 share position over the next three weeks. We do this by purchasing 500 shares of Apple Inc. at US $149.10 and selling 5 Apple September 150 calls (these options expire on September 3rd, 2021) and 5 Apple September 145 puts.
By way of example, assume the following prices exist for XYZ options as of August 14th, 2021:
Three potential scenarios will play out over the next three weeks set out below:
We earn a three week return of 1.91% if the stock remains unchanged at the September 3rd expiration. If the stock rises, we earn 4.10% and should the stock decline below US $145, we will buy an additional 500 shares at the strike price of the short put option giving us an average entry point of US $145.63.
Richard N Croft