Betting on Vancouver's House Price Crash

A (thinly-traded) bet on prediction market Intrade is as follows: "Monthly House Price Index for Vancouver to be 121 or less before the end of 2013". The "House Price Index" is the Teranet HPI. The Vancouver Teranet HPI is currently 170, roughly at its all-time high. To hit 121 means a 30% drop in about 16 months for this bet to pay.

If Vancouver were to follow the US's trend the chart below showing HPI changes from peak gives some indication at how precipitously Vancouver's HPI could drop below 121. Note that the US cities did not experience house price crashes at the same time -- Seattle most notably was delayed by about a year or so -- but look at how closely the brunt of the price drops were aligned from peak, roughly 12-24 months after.

The graph below includes two measures for Vancouver, one with the peak at June of 2012, the other with a "shifted" de facto peak of August 2011. This was done because as one can see from the US cities the peaks were followed by about a year of mulling near or at peak prices before dropping significantly. If one assumes that the actual "peak" for Vancouver was August 2011 and the HPI is now at the advent of that "Wile-E-Coyote" moment, the pregnant pause before the big push downwards, one could think Vancouver has a fighting chance to hit the "121 or less" threshold before EOY2013 target.

Betting on the Intrade contract being true looks to be in effect arguing that Vancouver's "peak" was actually last year and that Vancouver is set for a US-style house price crash. Place your bets.

A Rare Post Worth Reading

Asset manager, blogger and twitterer (?) Morally Bankrupt wrote some thoughts on the factors affecting US house prices over the next few years.

"With mortgage rates near record lows, due both to low inflation and negative real rates, the leveraged purchasing power of real wages is near historic maximums. Additionally, for the most part, it looks like the bottom is in for housing price declines. Does this make it a good time to buy leveraged real-estate to capture future price appreciation while financing it at low rates? I do not think it's as clear as many people think it is."

I encourage "housing analysts", both professional and amateur, (me being the latter) to read the post to understand why. One of the big takeaways is on how mortgage payments that vary linearly with debt amounts relate to changing rates that affect affordability geometrically:

"For home prices to sustainably exceed inflation, wage gains have to outpace inflation by more than the increase in rates over that same time period... [P]urchasing power increases at an increasing rate as rates decline... [A]t a fixed interest rate, purchasing power increases at a stable rate with payment. This means that for home prices to sustainably increase, growth in wages not only has to outpace inflation, but it has to outpace it by a margin wide enough to compensate for losses in purchasing power from any changes in the mortgage rate during that same period."

This has implications for the Canadian housing situation as well. The conclusion:

"Depressed real estate prices and low financing rates are leading many to see the current climate as a golden opportunity to buy leveraged real-estate, but price increases are not guaranteed, and the pay-out on a leveraged bet on housing is dependent many different factors. While affordability remains high and payments as % of income are near historic lows due to the Fed's extremely accommodating policy, an economic recovery can put an end to Fed accommodation and suspension of the Fed's MBS reinvestment program would be reflected on both, the risk-free interest rate and the spread at which MBS trade, turning a tailwind into a headwind for price appreciation. Leveraged buyers also run the risk of near-term price declines or inflation rates below the rate priced in by nominal rates. Leveraged real estate requires price appreciation and/or profits from rents to outpace the rate of inflation built-in to interest rates, which as we already saw, is not near lows. 

"I don't have an opinion on whether residential real-estate is a good or bad investment, it's not my line of work, but I think many investors are failing to see that a leveraged bet on real-estate price appreciation is, indirectly, a bet on inflation exceeding current inflation expectations and future wages increasing at a rate faster than inflation. Under an inflationary environment, increases in the real price level of real estate would require a mix of an increase in the % of income spent on housing and real wages in order to allow growth in outlays to outpace the loss in purchasing power created by any increase in real-rates, inflation expectations, or mortgage spreads."

Case Shiller and Teranet HPIs: Follow Up 1

Following a previous post where I aligned house price index troughs to determine relative valuation, I put in a few caveats, one that Vancouver's trough (which I assumed occurred in 1998) may not have been its trough -- even in the 1990s Vancouver may not have touched its bottom and was riding the coattails of previous speculative excess. The issue faced here is that the data don't go back far enough to the previous trough in the mid 1980s. Nonetheless we can re-scale Vancouver's data set with its trough pulled back to 1990, the start of the Teranet HPI. Below are the two graphs under the two scenarios for Vancouver:

Wowzas, that makes a difference, but I reiterate the caveats here, that the Teranet HPI data don't extend back far enough to garner a complete picture if markets like Vancouver's had speculation in the 1990s. Likewise other cities, most notably Calgary, are likely understated due to lack of data in the mid-1990s. To flesh out this we would need to turn to historical non-HPI data to augment this data series or simply use a different dataset altogether.

Below are the trough-aligned graphs with Vancouver under two scenarios, including the nominal appreciation scenarios.

What do we do with these graphs? The biggest takeaway, for me, is to evaluate the conditions in Vancouver in the 1990s and determine why the city was on a secular growth trend since the 1980s, which is somewhat at odds with experiences in other cities graphed above. Were conditions in the late-1990s the true "baseline", a point relative to which we should gauge future growth, or should we look further back to the 1980s where prices were lower still. If the latter, valuations in Vancouver are disturbingly high.

I do not normally concentrate much on directly comparing cities' relative valuations for a host of reasons, not least demonstrated by the sensitivity of the results by slightly changing assumptions. I prefer to look at earnings and prices, the so-called price-rent and price-income ratios, when formulating valuation metrics. But here are the data graphed in all their glory.

Case Shiller and Teranet HPIs: A Comparison

To gain some perspective I decided to overlay the Case Shiller and Teranet house price indexes for direct comparison. The CS and Teranet HPIs use similar methodologies, tracking same-sales pairs to formulate an aggregate house price index, that is mostly independent of sales mix. The two measures are, for the most part, apples to apples and one of the best gauges available for house prices.

The Teranet and Case Shiller indexes are assigned the value of 100 at a particular date, however housing market cycles between regions and countries can be advanced or delayed based on local and macroeconomic factors. Here I propose rescaling the indexes based on their trough values and, for clarity of graphing, aligning the price peaks as shown below along with a nominal 2%, 3%, and 4% trendlines.

Why would we look at troughs? In this particular case most price troughs occurred in the 1990s, an era of positive real rates and, according to Professor Shiller's long-term analysis, a period where house prices are aligned with their century-long trend. Canada, arguably, due to similarities in its economy to the United States, would have had similar sentiment in its housing market under capital conditions at the time. 

The graph above indicates that speculative excesses can exceed by multiples the trough, therefore using a median or mode measure of the long-run average given there was obviously mis-pricing during that time, would tend to skew any data used as a baseline. A trough, on the other hand, I argue is governed more by rentier-seeking investors and relatively little in the way of speculative activity.

The above graph indicates that while Vancouver (and Montreal too!) is now above any current valuations of presented American markets, it has achieved nowhere near the excesses wrought by said markets. It could be argued that Vancouver's trough is lower than presented (its "trough" presented here occurred in 1998) but even so this would not significantly move its rank to the likes of San Diego, San Francisco, or Los Angeles.

Are Canadian and American markets directly comparable? I would argue, as presented, yes they are, insofar as the investment climate in these locales are roughly similar: if it's true that troughs are governed by baseline investor interest we would expect similar floors and the tax treatments and inherent risks of properties for investors are roughly equivalent. Las Vegas, Phoenix and Miami have oversupply problems and were hit particularly hard, to the point where they are approaching undervaluation; the markets of LA, San Diego, and Seattle -- coastal cities with growing metro populations -- have been slower to fall and would have appreciation higher than inland areas due to increasing land utility.

A note about comparing HPIs. Price levels do not tell us much without knowing their earnings potential. Vancouver has always had a high price-income ratio, in part due to future land utility improvements. Looking at aggregate market prices through HPIs is useful but won't directly tell us much about individual property profitability.

In summary, while Vancouver's appreciation from trough is significantly above inflation, it did not experience anywhere near the amount of price distortions in certain US markets. Vancouver and Montreal are currently the most highly priced metropolitan areas in North America based on that measure and while not achieving the insanity we saw Stateside, now find themselves the leaders.

Bank of Canada - Working Paper on Housing Prices, Turnover and Bubbles

Thought this was an interesting read:  http://www.bankofcanada.ca/wp-content/uploads/2012/02/wp2012-03.pdf

This paper develops and estimates a model to explain the behaviour of house prices in the United States. The main finding is that over 70% of the increase in house prices relative to trend during the increase of house prices in the United States from 1995 to 2006 can be explained by a pricing mechanism where market participants are ‘Fooled by Search.’ 
Trading frictions, also known as search frictions, have been argued to affect asset prices, so that asset markets are constrained efficient, with shocks to liquidity causing prices to temporarily deviate from long run fundamentals. In this paper a model is proposed and estimated that combines search frictions  with a behavioural assumption where market participants incorrectly believe that the efficient market theory holds. In other words, households are ‘Fooled by Search.’ Such a model is potentially fruitful because it can replicate the observation that real price growth and turnover are highly correlated at an annual frequency in the United States housing market. A linearized version of the model is estimated using standard OLS and annual data. In addition to explaining over 70% of the housing bubble in the United States, the model also predicts and estimation confirms that in regions with a low elasticity of supply, price growth should be more sensitive to turnover. Using the lens of turnover, a supply shock is identified and estimated that has been responsible for over 80% of the fall in real house prices from the peak in 2006 to 2010.

Another One Bites the Dust

Bubble Blogger "Tim" from Seattle just bought the detached house pictured above. I would recommend not looking at the price. Remember: Vancouver is different. It has to be or a great many people will be in for some major hurt.

San Diego Affordable Again

I have found Rich Toscano's posts over at Prof. Piggington's interesting over the years. Rich had correctly called the San Diego bubble -- the first major US market to experience price weakness -- and has been tracking its distress all the way down.

As a bit of an epilogue to San Diego's terrific bubble experience, Toscano has summarized the city's housing market conditions in his latest post Shambling Towards Affordability: Year-End 2010 Edition.

Why is Toscano such a great read? He has continually concentrated on the true "fundamentals" of real estate investing, including:

• price to income ratios
• price to rent ratios
• construction and real estate sector employment
• loan arrears
• rent and wage growth
• months of inventory
  

Save a handful of bloggers like CalculatedRisk and others, understanding what truly drives house prices in the long term seems oddly absent from discussion. Toscano has presented both relevant fundamental data as well as poignant analysis of them. Some of Toscano's important contributions have been:

• Even through the severe recession, he quickly understood rental growth continued to track CPI inflation even as wages and house prices were dropping and inventory was high.
• Prices per square foot closely tracked the Case-Shiller house price index, allowing a 3 month sneak-preview into apples-to-apples price movements. (The CS-HPI is released with a 3 month delay.)
• Construction and real estate-related employment distress portended a significant increase in foreclosure activity.
• Higher quality houses tend to be more "downwards sticky" compared to lower quality stock; likewise detached property prices fell slower than condos and apartments.

The biggest takeaway from Toscano's work is that, in San Diego -- a city with a growing population, a reasonably diverse economy, and desirable climate -- fundamentals eventually mattered. As 2010 drew to a close, San Diego's house price bubble has been summarily bookended with prices approaching fundamental values again, a process that took 5 years from their peak in 2005.

San Diego and Toscano ftw.

What a Difference 5 Years Can Make

Time Magazine cover stories are marvelous contrary indicators.

Time Magazine cover from June 13, 2005.

Time Magazine cover from September 6, 2010.

Underwater, but Will They Leave the Pool? NY Times

http://www.nytimes.com/2010/01/24/business/economy/24view.html

Economic View
Underwater, but Will They Leave the Pool?
By RICHARD H. THALER
Published: January 24, 2010
Even if they owe more on their mortgages than their homes are worth, many people feel obligated to repay their loans. But what if those borrowers walked away?

Vancouver - Decline From Peak

Here is Vancouver's decline in house prices plotted in comparison to US cities since their respective price declines began. The Case Shiller indices track sales pairs much like the Teranet methodology and have been shown to be the most accurate house price tracking methodology.

Case Shiller data is as of April 2009 - data released June 30.
Vancouver REBGV data is as of June 2009 - data released July 3.
Vancouver Teranet data is as of April 2009 - data released June 19.



Dallas, Charlotte and Denver are 20 months into correction mode compared with Detroit, Boston, and San Diego which are over 40 months into the correction. In comparison, Vancouver is only 9 (Teranet) months or 14 months (REBGV) into its correction.

Time will tell if the latest uptick in prices has staying power but I would hazard a guess that we haven't seen the end of price declines. If we are 40 months from peak and we haven't decreased from current levels by then I will count myself as being wrong. Until then, I'll watch and wait.

The Spring Bounce

We have been hearing reports about Vancouver house prices stabilising in recent months. Are we at bottom or is this a bear market rally, the so-called "spring bounce"? The Pope put up an interesting graph of Sacramento house prices, where there were two such spring bounces before a regression to more price drops. It appears there are other markets that have exhibited a temporary bounce up in sales before returning to falling prices. Below is a graph of some notable American markets' prices:


Cities with some semblance of a bounce include: Seattle, Portland, San Diego, and San Francisco. Cities that did not have a spring bounce include: Miami and Phoenix. Note Vancouver's bounce looks sharp because we are using the benchmark where the other cities use the Case-Shiller HPI, which averages 3 months' worth of data.

There is no credible evidence to make me believe we are NOT witnessing a "spring bounce". The fundamentals point to lower prices and, while Vancouver may not see as meteoric a fall as did Miami, I am expecting more price weakness in the second half of 2009.

Money Hole: Pros and Cons

In The Know: Should The Government Stop Dumping Money Into A Giant Hole?

Canadian Banking - Up for Discussion

Video here. http://www.cnbc.com/id/15840232?video=926680705

TORONTO, Nov 12 (Reuters) - Canadian banks should be able to get through the financial crisis without relying on the kind of government aid that is being deployed to financial institutions in other countries, Toronto-Dominion Bank's top executive said on Wednesday. While the Canadian government just announced an increase in the size of its bank mortgage buyback program -- boosting the program to C$75 billion from C$25 billion -- the federal government is actually making money on that program, TD Bank President and Chief Executive Ed Clark said.

"This is a pretty good deal from the government's point of view," since it gets paid to buy mortgages from banks that a government agency has already guaranteed, he said. Canadian banks, with strong balance sheets and healthy mortgages on their books, are using the government buyback program to fund themselves at rates comparable with, or better than, what banks elsewhere in the world can get, he said. Clark was speaking at a financial conference in New York organized by Merrill Lynch.

"We would like to get through this crisis without government bailouts, there have been no bailouts of the Canadian banking system," Clark said. TD, which has grown substantially in the United States through acquisitions in recent years, does not have to make another U.S. purchase to fulfill its business objectives, he said. The bank acquired New Jersey-based Commerce Bancorp earlier this year, and privatized TD Banknorth in 2007.

"We can grow organically, if you take a look at the average bank in the U.S. and strip out acquisitions, it's not obvious that there's a lot of organic growth there," Clark said. But TD, Canada's second largest bank, would consider U.S. acqusitions if certain conditions were met -- that is, if a potential deal were in its existing East Coast footprint, if it were cheaper to buy than build out its branch network, and if it involved minimal asset risk.

"You're not going to see us suddenly move up the risk curve in this environment," Clark said. He also said it seems "inevitable" that a U.S. recession will spread to Canada, where the bank's loan book is more retail oriented. TD expects provisions for credit losses to rise in the next few years, but from a low base, Clark said.

Canada faces housing bust: Shiller

Jacqueline Thorpe, Financial Post Published: Wednesday, October 01, 2008

The Canadian housing market could face a similar housing bust to the United States, particularly in more bubbly markets as Vancouver and Calgary, said Robert Shiller, the University of Yale professor who predicted both the 1990s stock market boom and bust and the US housing slump.

Mr. Shiller, co-founder of the S&P Case/Shiller Home Price Index, said psychology is the primary driver of bubbles and it appears that Canada has been caught up with home buying fever just as the United States and other countries around the world.

Asked whether that meant Canada could face a similar bust Mr. Shiller said: "Yes, especially in places that went up a lot like Vancouver and Calgary. I don't think Toronto has been quite as extreme."

Mr. Shiller said there was a natural connection between the United States and Canada.

"I would be surprised that the bubble that appeared in the United States and elsewhere didn't appear in Canada," he said in an interview with the Financial Post. "It's psychology, I think that drives it.

Mr. Shiller, whose book Irrational Exuberance came out in March 2000 just as the tech bubble peaked, said it was essential for the U.S. government to pass a financial bailout, though he believes the United States is facing a "severe recession," regardless.

"I'm concerned problems are deeper than can be handled by the bailout but that doesn't mean the bailout doesn't do some good," he said.

He said a bailout might help restore some confidence to the stressed financial system.

"What creates a crisis is a lack of confidence," he said.

He said the housing crisis was primarily a policy failure by U.S. authorities.

The U.S. government was "totally blind" to it, regulators failed to monitor the mortgage industry properly and the U.S. Federal Reserve had very low interest rates at a time of the greatest housing bubble of all time.

While homeowners should take some personal responsibility for the debacle, they were being goaded into the fevour by an establishment that endlessly pushed an ownership society.

"They were doing what was considered right at the time," Mr. Shiller said.

Mr. Shiller said human nature seems to predispose people to spectacular excess, fanned by a voracious news media.

"Until we had newsapers and other media we had no bublbles, he said.

While ups and downs in the market can lead to creative destruction the current housing crisis has morphed into a system problem.

"The problem is that perfectly good firms are in trouble," he told the Financial Post in an interview at the Ontario Economic Summit.

A bailout may not be palatable, government assistance is required when the system fails.

The trick is to reduce conditions that fan bubbles.

In his current book, "The Subprime Solution," Mr. Shiller proposes several measures to reduce bubble conditions in the housing market including better information for prospective buyers and broader markets that trade risk better, such as the housing futures he has developed on the Chicago Mercantile Exchange.

There should also be new retail products such as "continuous workout mortgages," that go up and down with the value of the home equity and mortgage equity insurance.

Mr. Shiller, who would not give a precise forecast on the outlook for U.S. home prices, nevertheless said futures markets are predicting more price declines of 10% or more. His Case/Shiller index earlier this week showed home prices down 16.3% year-over-year this summer.

He expects things to get worse for the U.S. economy in the short-term.

"We're going to have a severe recession, most likely," he said. How quickly the economy recovers depends on policy.

"Unfortunately the bailout has hit a snag," he said. "There is resentment of rich Wall Street people. I am worried that the sense of trust, in confidence of each other is being damaged."

Mr. Shiller said he does not have another bubble in his sights as the U.S. economy will be "damaged for years."

"The housing bubble was of record proportions," he said. "Maybe the next big bubble will be your children's or grandchildrens...The excitement we had in the 1990s and in 2000 in the housing market is a fragile thing and it won't come back for some time."

US Financials Falling Like Dominoes

Sept. 14 (Bloomberg) -- Lehman Brothers Holdings Inc. prepared to file for bankruptcy after Barclays Plc and Bank of America Corp. abandoned talks to buy the U.S. securities firm and Wall Street prepared for its possible liquidation.

Lehman and its lawyers are getting ready to file the documents for bankruptcy protection tonight, said a person with direct knowledge of the firm's plans. A final decision hasn't been made, though none of the other options being considered appeared likely, the person said, declining to be identified because the discussions haven't been made public.

Sept. 14 (Bloomberg) -- Bank of America Corp. agreed to buy Merrill Lynch & Co. for about $44 billion, a person with knowledge of the deal said, after shares of the third-biggest U.S. securities firm fell by more than 35 percent last week and smaller rival Lehman Brothers Holdings Inc. neared bankruptcy.

Bank of America and Merrill reached a deal in principle, according to the person, who declined to be identified because the deliberations were private. A final merger agreement hasn't been signed yet, the person said. The boards of Merrill and Bank of America approved the transaction this evening, the Wall Street Journal reported, citing unidentified people familiar with the matter.

Sept. 14 (Bloomberg) -- American International Group Inc., the insurer struggling to avoid credit downgrades, is seeking a $40 billion bridge loan from the Federal Reserve as it tries to sell assets, the New York Times reported.

The insurer has turned down a private-equity investment because it would have meant handing over control of the company, the Wall Street Journal said on its Web site, citing unnamed people. AIG may get access to the Fed's borrowing window in an ``extreme liquidity scare,'' Citigroup Inc. analyst Joshua Shanker said in a Sept. 12 research note.

TD Economics - The US Housing Market

HIGHLIGHTS

• U.S. home construction shows signs of life
• Global inflation and growth woes remain

In the 1980s, economist and Nobel laureate Amartya Sen found that famines tend to happen not because of a lack of food, but because of obstacles preventing those in need from acquiring the existing stores of food. This juxtaposition is center stage across the globe right now – an ongoing famine for liquidity in many financial and housing sectors versus the flood of petro-liquidity driving consumer and producer inflation higher worldwide. We have liquidity in spades, just not in the sectors that welcome it or need it most.

Why so serious?
Remember April and May? The leaves were returning. The flowers were blooming. The credit crunch was over. Well, the spring fling is over and markets have come to the realization – which incidentally has been TD Economics base case scenario all along – that the credit crunch will continue to slowly bleed for some time. While the market roller coaster saw increasing optimism early this week, apparently markets forgot that the U.S. housing market remains in shambles. There is some light. For the first time since the spring of 2007, the 3-month trend in new home sales and starts is positive. New home construction is what is captured in GDP measures of residential investment, and this same signal preceded rebounds in U.S. residential investment in each of the last three downturns. Existing home sales, on the other hand, make up the majority of the U.S. housing stock and mortgage market, and sales there dropped another 2.6% M/M in June and are down over 15% over last year. Critically, at this current pace of sales, it would take over 11 months to sell the inventory of unsold homes already on the market. And this doesn’t include other homes dumped on the market in coming months through foreclosure or voluntary sales. In the second quarter, one in every 171 U.S. households was foreclosed on – with Nevada showing a staggering one in 43 households and California one in every 65.

This is the heart of the liquidity famine. As more homes are dumped on the market, home prices fall further, driving further mortgages underwater, leading to further foreclosures, further homes dumped on the market, and further home price declines. Lather. Rinse. Repeat. At some point, lower prices will entice buyers into the market, but not until the expectation for further declines recedes. Why buy today when you can buy next year for 10% less? In the meantime, liquidity in the housing market is nonexistent. This feeds directly into the current dilemma for the financial sector. The smaller and more regional the bank, the more exposed to the mortgage market. Real estate loans account for 1/3 of all assets of U.S. commercial banks – over ½ of all assets for banks with total assets less than $1 billion – and nearly 2/3 of assets of savings and loans. This puts these institutions in a vise, and those like Fannie and Freddie that have bought or underwritten about half of all these mortgages in a bind. As a result, commercial banks’ average daily borrowing of $16 billion from the Fed’s emergency lending programs last week was the highest ever.

So the issue becomes what can be done to get that liquidity flowing again? In a perfect world, we’d let the market work itself out. Prices would fall to the point that buyers would move in, and larger banks would recapitalize by attracting investors. But current regulations limit the ability of buyout firms to move into the banking sector – an issue the Federal Reserve is reportedly trying to address – while large foreign investors that bought into large banks earlier have since lost money on their investments and may be once bitten, twice shy. The bill moving through the U.S. Congress right now hopes to help stop the self-fulfilling prophesies of doom, gloom, and liquidity vacuum. The government would increase its debt ceiling by about $800bn – about half of which could cover the expected 2008 federal deficit and the other half would be there just in case. This “just in case” would help cover, among other things, the federal government insuring approximately $300bn in mortgage debt belonging to 400,000 American households who will refinance their subprime loans into 30-year fixed-rate mortgages, $4bn in federal transfers to the states, and the ability of the U.S. Treasury to buy stock in Fannie and Freddie up to the federal debt ceiling. As banks continue to struggle, these two institutions are key to helping the U.S. mortgage market grind on. While not ideal, a government backstop may be just what is needed to avoid their failure and the vicious cycle in the mortgage market. Earlier this week, the Congressional Budget Office estimated the cost of the Fannie and Freddie rescue plan at $25bn. As with most of the estimates placed on the cost of credit crunch, this seems likely to creep higher, but is still much lower than the cost of doing nothing. In the worst case scenario – or even just the next incremental step because let’s be honest, there isn’t much of a difference between the first step off the cliff and the second – the costs to the Federal government could be ten times higher.

A horse with no name
The current U.S. predicament is core inflation and GDP growth both running at about a 2.5% pace over last year. For those unlucky few who need to buy gas and food on a regular basis, total inflation is running at twice that pace. Still, this is well short of the near 15% pace of core inflation and 1% Y/Y contraction in U.S. GDP in 1980 that saw the invention of the moniker “stagflation.” Nor are there signs inflation will come unhinged in the U.S. to that extent so the “stag” part is much more likely than the “flation.” Similarly in Canada, headline inflation is now running at twice the pace of core inflation (3.1% vs. 1.5%). In fact, on a global scale, the most likely scenario is further stagnation in advanced economies and further inflation for emerging markets, with very few of either seeing both on a sustained basis. The U.S. consumer is quickly running out of stimulus checks to spend. In Canada, retail sales for May showed an ongoing sharp deceleration in everything not being bought at a gas station. In Europe, surveys of the manufacturing and service sectors showed sharper than expected decelerations in Q2. The U.K. economy posted its weakest quarterly GDP growth rate in three years in 2008Q2 and is likely to contract before the year is out. And, the pace of exports from Japan and Hong Kong saw precipitous declines in June. So growth is likely to slow in these regions and exert a downward pressure on domestic inflation.
On the other hand, broad-based emerging market resilience and inflation worries remain. The pace of inflation-adjusted retail sales in China is the highest in 12 years. Korea’s economic expansion stayed constant in Q2 while inflation remains at a 10-year high. And across the EM universe (or at least averaging 57 EMs), inflation has accelerated from a 5% pace in June 2007 to 12% in June 2008. So while Malaysia this week hiked interest rates for the first time since 2006, and Brazil surprised markets with a larger than expected rate hike, the average pace of inflation across EMs is rising faster than the average interest rate. This is pushing down real interest rates and helping to fuel both faster growth and inflation in these markets. The same is not occurring in advanced economies, with average real rates still above zero in the G-7.
So in the immortal words of the modern philosopher Axl Rose, “Where do we go now?” Sluggish economic growth in advanced economies is likely to keep a lid on growth prospects in EMs, but not unbearably so. Inflation in EMs is likely to place upward pressure on advanced economy inflation, but not uncontrollably so. And we are likely to see more mirages in the desert before we finally find paradise and bring balanced liquidity back to the global economy.

Richard Kelly, Senior Economist416-982-2559

F Mac

Watch CBS Videos Online

US Mortgage Bailout

Fannie Plan a `Disaster' to Rogers; Goldman Says Sell (Update2)
By Carol Massar and Eric Martin

July 14 (Bloomberg) -- The U.S. Treasury Department's plan to shore up Fannie Mae and Freddie Mac is an ``unmitigated disaster'' and the largest U.S. mortgage lenders are ``basically insolvent,'' according to investor Jim Rogers.

Taxpayers will be saddled with debt if Congress approves U.S. Treasury Secretary Henry Paulson's request for the authority to buy unlimited stakes in and lend to Fannie Mae and Freddie Mac, Rogers said in a Bloomberg Television interview. Goldman Sachs Group Inc. analyst Daniel Zimmerman predicted the mortgage finance companies' shares may fall another 35 percent.

``I don't know where these guys get the audacity to take our money, taxpayer money, and buy stock in Fannie Mae,'' Rogers, 65, said in an interview from Singapore. ``So we're going to bail out everybody else in the world. And it ruins the Federal Reserve's balance sheet and it makes the dollar more vulnerable and it increases inflation.''

The chairman of Rogers Holdings, who in April 2006 correctly predicted oil would reach $100 a barrel and gold $1,000 an ounce, also said the commodities bull market has a ``long way to go'' and advised buying agricultural commodities.

Rogers, a former partner of hedge fund manager George Soros, predicted the start of the commodities rally in 1999 and started buying Chinese stocks in the same year. He traveled the world by motorcycle and car in the 1990s researching investment ideas for his books, which include ``Adventure Capitalist'' and ``Hot Commodities.''

Stocks Rise
Fannie Mae and Freddie Mac each surged more than 20 percent in pre-market trading today after Paulson moved to stem a collapse in confidence in the two companies that purchase or finance almost half of the $12 trillion in U.S. home loans.

``These companies were going to go bankrupt if they hadn't stepped in to do something, and they should've gone bankrupt with all of the mistakes they've made,'' Rogers said. ``What's going to happen when you Band-Aid and put some Band-Aids on it for another year or two or three? What's going to happen three years from now when the situation's much, much, much worse?''

Freddie Mac rose 22 cents, or 2.8 percent, to $7.97 at 10:13 a.m. in New York Stock Exchange trading, while Fannie Mae rose 73 cents, or 7.1 percent, to $10.98. Paulson's proposal, which the Treasury anticipates will be incorporated into an existing congressional bill and approved this week, signals a shift toward an explicit guarantee of Fannie Mae and Freddie Mac debt.
The Federal Reserve separately authorized the firms to borrow directly from the central bank.
Last Week's Slump

Washington-based Fannie Mae slid 45 percent last week, while McLean, Virginia-based Freddie Mac sank 47 percent on concern they may require a bailout that would wipe out shareholders.
Former St. Louis Federal Reserve President William Poole last week said in an interview that Freddie Mac is technically insolvent under fair value accounting, which measure a company's net worth if it had to liquidate all its assets to repay liabilities. Poole said Fannie Mae may also become insolvent this quarter.

Goldman's Zimmerman said today the U.S. government's plan to rescue Fannie Mae and Freddie Mac won't benefit shareholders. He lowered his share-price estimate for Fannie Mae to $7 from $18 and for Freddie Mac to $5 from $17.

Rogers said he had not covered his so-called short positions in Fannie Mae and would increase his bet if it were to rally. Short sellers borrow stock and then sell it in an effort to profit by repurchasing the securities later at a lower price and returning them to the holder.

The U.S. economy is in a recession, possibly the worst since World War II, Rogers said.
``They're ruining what has been one of the greatest economies in the world,'' Rogers said. Bernanke and Paulson ``are bailing out their friends on Wall Street but there are 300 million Americans that are going to have to pay for this.''

Is it time to buy stocks yet?

The major stock indices around the world have all come down a great deal in the past year and may be offering better investment opportunities now than 1 year ago.

I can't say whether stock prices will go up or down but as a student of market history I am interested in what the past can teach us. Have a look at this chart which tracks the Price to Earnings ratio of the 500 largest companies in the United States from 1950 to 2008. The index levels are significantly lower now and accordingly the P/E ratio is also lower now.


The US markets were down another 10% during June and more so far during July. Worry about the economy and the financial system is on every news channel and there are very few bright spots. Corporate earnings are expected to be under pressure over the next 12 to 24 months as it is likely that the US is in recession and the hangover from falling house prices bites into corporate profits. This will affect the 'E' part of the P/E ratio for the next while. Stock prices are also forward looking and are already pricing in the prospect of lower profits.

Personally, I have a long time horizon and I'm always buying as part of a systematic investment plan but I'm much happier buying today than 1 year ago.

Vancouver's Next - Watch Out!

This post is brought to you by a real estate crash near you and the letter "L" which stands for Losses, as in large equity losses in real estate.


Your average Sesame Street watcher could understand what the lines on this graph mean and why Vancouver is likely to folow the pattern set so clearly by cities like San Francisco, Los Angeles, Seattle, or Portland.



This chart is courtesy of Seattle Bubble Blog.

Let us, for argument's sake, say that the Vancouver House Price Index peaked in March 2008 and that our market will follow a similar trajectory to Los Angeles. One year from now house prices will be at 92% of their current value. This means that your average $500,000 townhouse will be worth $460,000. This is a potential savings of over $3,000 per month just for waiting on a very important purchase. Can you afford to lose $3,000 per month?

Let's go out another year from there and see where our $500,000 townhouse is now. 24 months from peak in a place like San Diego would mean that our $500,000 townhouse is now worth $420,000 which translates into a loss of $80,000 or just over $3,000 per month for two years straight and prices are not finished coming down yet.

I don't know about you but paying $3,000 per month in mortgage payments on a place that is losing value at a $3,000 per month clip means that you are 'spending' $6,000 per month for housing - that is an expensive house.