Macro Letter No 11 09-05-2014

Canada Australia New Zealand Commodities vs Housing

Commodity prices continue to decline due to slowing Chinese growth
Rising real estate prices in Canada, Australia and New Zealand ignore commodity demand
What does this mean for their stock, bond and currency markets?
Since the initial recovery in 2010 the price of Iron Ore and Coking Coal has declined due to lower
demand from China. Australian Coking Coal hit a six year low in April. This downturn in demand has
also been evident in the price of Copper and other industrial metals. Last year grain prices also
tumbled adding to the pressure on commodity exporting countries: although prices for New
Zealands Dairy Products remained firm.
Since Australia and New Zealand have similar major trading partners, and are geographically close
when compared to Canada, they tend to be considered together whilst Canada is grouped with
other NAFTA countries. I want to review these three countries together. To begin Ive constructed a
table which highlights some of the similarities and differences between these commodity
countries.
Country Main Exports Export Markets
Canada Oil, Wood Products, Chemicals USA (73%) EU (5%) UK (4%)
Australia Coal, Iron, Wheat, Aluminium China (30%) Japan (19%) S. Korea (8%)
New Zealand Dairy Products, Meat, Wool
Australia (21%) China (15%) USA (9%) Japan
(7%)

During the decline in commodity prices the currency markets have reflected these dynamics quite
accurately. The CAD and AUD have been steadily falling vs the US$ - although these trends may be
starting to reverse. The NZD by contrast has continued to appreciate not only against the US$ but
also against its commodity cousins.
The chart below shows the NZD Trade-weighted index up to mid 2013 it has continued to
appreciate since then.

Source: ricardianambivalance.com
The AUD Trade-weighted index chart is updated to the beginning of 2014 it continued to weaken
until last month.

Source: fxstreet.com
The third chart is of the CAD effective exchange rate it also shows foreign capital flows.

Source: Business in Canada
Plus a change, plus c'est la mme chose
The currency markets reflect Canada and Australias reaction to the weakness of Chinese demand,
the rising NZD points to other factors. Before I delve into the real estate market I thought the table
below might be useful, it looks at a number of economic indicators across the three countries. In
many respects these economies are quite similar.
Country GDP Unemploy CPI
Current
A/C Budget
Base
Rate 10 yr Debt/GDP
Canada 2.7 6.9 1.5 -3.2 -1 1 2.35 89.1
Australia 2.8 5.8 2.9 -2.9 -1.2 2.5 3.82 20.5
New Zealand 3.1 6 1.5 -3.4 -2.1 3 4.31 35.9

New Zealand is delivering the strongest GDP growth with the highest real interest rates, but all three
countries are suffering from twin budget and current account deficits. Considering the weakness of
commodity markets and their reliance on those export markets it is clear that other factors are
driving growth.


A quick review of the central bank policy reports reveals another common theme real estate.
Bank of Canada Monetary Policy Report April 2014
Inflation in Canada remains low. Core inflation is expected to stay well below 2 per cent this year due to the
effects of economic slack and heightened retail competition, and these effects will persist until early 2016. Total
CPI inflation is forecast to be closer to 2 per cent over the coming quarters and remain close to target
thereafter.

The global economic expansion is expected to strengthen over the next three years, as headwinds that have
been restraining activity dissipate.

In Canada, the fundamental determinants of growth and inflation continue to strengthen gradually, as
anticipated.

The Bank continues to expect Canadas real GDP growth to average about 2 1/2 per cent in 2014 and 2015
before easing to around the 2 per cent growth rate of the economys potential in 2016.

No mention of concern about an overheated real estate market in the highlights, however later in
the summary they do state: -
Recent developments are in line with the Banks expectation of a soft landing in the housing market and
stabilizing debt-to-income ratios for households. Still, household imbalances remain elevated and would pose a
significant risk should economic conditions deteriorate.
Perhaps the BoC dont believe its their job to reign in the housing market. The Canadian
government has imposed several rule changes to curtail the allure of property but, whilst price rises
have slowed the correction has yet to materialise. March 2014 house prices were unchanged for the
first time in 15 years its too early to predict the top just yet.
The Economist picked up on real estate earlier this month. They pointed out that Canadian
household debt has increased from 76% of GDP in Q3 2007 to 93% in Q3 2013. On their measure
Canadian property is 76% above its long-term average and on a rent to income basis, 31%
overvalued.
The BoC summary also ignores a dichotomy within Canada. Since the crisis of 2008 the populous
manufacturing heartlands, Ontario and Quebec (60% of Canadas population) have seen little
economic recovery. The commodity exporting Western states, by contrast, have rebounded -
although they are now slowing in response to weaker Chinese demand. Government energy policy
remains focussed on supplying the Chinese and Japanese markets with Oil and LNG. China has also
been a major investor in Canadian energy companies both directly and indirectly. Since 2007 China is
estimated to have invested C$119bln in this sector according to a recent Jamestown Foundation
report.
A sustained US economic recovery may insure that Canadian economic growth becomes more
balanced over the next couple of years - after all, 73% of Canadian exports are to the US however,
the Canadian government has a gaping budget deficit to plug. In 2008 they were in surplus - they
hope to balance the books once more by 2015/2016. This may be a tall order; at the provincial level
Ontario has the largest debt of any Canadian state and a debt to GDP ratio of 37.5% - the
outstanding amount, C$267.5bln, is significantly larger than the debt of California. Quebec, not to be
eclipsed, boasts the largest debt to GDP ratio at 49%, although its total is lower. The Fraser Institute
forecast that this will rise to 57% of GDP by 2022/2023 if they continue with their current policies.
Canadian real estate prices are also a concern for the international markets since six Canadian
financial institutions dominate the domestic mortgage market. They have combined financial assets
equivalent to five times Canadas GDP unlike the US Canada has a Too big to bail problem.
Reserve Bank of Australia Monetary Policy Committee Minutes April 2014
Recent indicators for the global economy suggested that activity in Australia's major trading partners in the
early part of 2014 had expanded at around its average pace...
...In China, data for the first few months of 2014 had suggested a continuation of the easing in economic
growth that had started in the latter part of 2013...The targets for inflation and money growth in China were
also unchanged for 2014.
Recent data for the United States were consistent with further moderate growth in the economy...
In Japan, domestic demand growth had remained strong, with activity picking up prior to the consumption tax
increase at the beginning of April...In the rest of east Asia, growth had continued at around the average of the
past decade, while economic conditions in India remained subdued...
Global commodity prices had declined since the previous Board meeting. The spot price for iron ore had been
volatile over recent weeks, while steel prices in China had declined and spot prices for coking and thermal coal
were well below current contract levels. The fall in the price of steel in China over recent weeks was consistent
with a softening in demand. At the same time, the supply of steel appeared to have been constrained by a
tightening in credit conditions reflecting the Chinese authorities' concerns about pollution. Base metals prices
had also declined, though rural commodity prices were a little higher.
Domestic Economic Conditions
Members began their discussion of the domestic economy with the labour market, which remained weak
despite a strong rise in employment in February and an upward revision to employment in
January...Meanwhile, a range of indicators of labour demand suggested a modest improvement in prospects
for employment, although the unemployment rate was still expected to edge higher for a time.
The national accounts, which had been released the day after the March Board meeting, reported that average
earnings growth over the year to the December quarter 2013 had remained subdued. With measured growth in
labour productivity around the average rate of the past two decades, nominal unit labour costs were
unchanged over 2013.
Members recalled that the national accounts reported that GDP rose by 0.8 per cent in the December quarter
and by 2.8 per cent over the year, which was a little stronger than had been expected. In the quarter, there had
been further strong growth of resource exports, while growth in consumption and dwelling investment picked
up a little and business investment declined. Public demand had made a surprisingly strong contribution to
growth, but planned fiscal consolidation at state and federal levels was likely to weigh on public demand for
some time...
Retail sales had increased by 1.2 per cent in January, continuing the pick-up in momentum that began in mid
2013. The Bank's liaison with firms suggested that, more recently, retail sales growth may have eased from this
strong rate. Motor vehicle sales declined further in February, as had measures of consumer confidence over
recent months, but the latter were still around their long-run averages.
Housing market conditions remained strong, with housing prices rising in March to be 10 per cent higher over
the year on a nationwide basis. Members noted that dwelling investment had increased moderately in the
December quarter, with a pick-up in renovation activity, and that the high level of dwelling approvals in recent
months foreshadowed a strong expansion in dwelling investment...
Business investment fell in the December quarter, driven by a large decline in machinery and equipment
investment and falls in engineering and non-residential building construction. While much of the decline
appeared to have been driven by mining investment, non-mining business investment was also estimated to
have declined in the quarter. More recently, non-residential building approvals had increased in January and, in
trend terms, were at their highest level since 2008, with increases evident across a range of categories,
including the office, industrial and other commercial sectors...
Conditions were not sufficiently robust to prompt a change in monetary policy. Perhaps this is
because the markets are focussed on next weeks deficit busting budget. What is clear is that
manufacturing continues to struggle. According to a report from the Boston Consulting Group,
Australia has the highest manufacturing cost of the top 25 largest exporting nations. This poor
performance is reinforced by a report from the Productivity Commission pointing to a -0.8% fall in
Multi-Factor Productivity (MFP).
The biennial IMF Fiscal monitor published last month placed Australia at the top of the list of
developed countries with the fastest deteriorating economies relative to forecast. They focussed on
the government budget deficit currently the third largest of all developed nations, behind Japan
and Norway. They urged the Australian government to take draconian measures to bring Debt to
GDP ratio down toward 70% by 2020.
There has been much discussion of potential changes to the tax treatment of mortgages which could
puncture the buy to let market, where negative gearing has been prevalent. The RBA
acknowledged that housing construction is now Strong vs Solid at its March meeting. The
Australian Bureau of Statistics - Trends in Household Debt was released this month showing
household debt is at the highest level in real term for 25 years. The Household debt to Income ratio
is currently the highest in the developed world at 180%, though Canada isnt far behind at 165%.
Before you rush to sell your second home down-under it is worth noting that on the basis of
Mortgage Interest to Income Australian property is not that expensive. The current ratio is 7% down
from 12% in 2008 - although still above the 50 year average of 5%, it reflects todays benign inflation
and lower interest rate environment.
Longer term commodities are still a major source of economic growth, but Australia is ranked 79 in
terms of Economic Complexity, with New Zealand at 48 and Canada at 41. All three countries have
falling productivity; Australias average is -1.3, New Zealand -1.2 and Canada -1.1. In the shorter
term, it seems that real estate is the main driver of growth and that growth is based on leveraged
household debt.
Reserve Bank of New Zealand Monetary Policy Statement March 2014
The Reserve Bank today increased the OCR by 25 basis points to 2.75 percent.

New Zealands economic expansion has considerable momentum, and growth is becoming more broad-based.
GDP is estimated to have grown by 3.3 percent in the year to March...

Prices for New Zealands export commodities remain very high, and especially for dairy. Domestically, the
extended period of low interest rates and continued strong growth in construction sector activity have
supported recovery. A rapid increase in net immigration over the past 18 months has also boosted housing and
consumer demand. Confidence is very high among consumers and businesses, and hiring and investment
intentions continue to increase.

Growth in demand has been absorbing spare capacity, and inflationary pressures are becoming apparent,
especially in the non-tradables sector. In the tradables sector, weak import price inflation and the high
exchange rate have held down inflation. The high exchange rate remains a headwind to the tradables sector.
The Bank does not believe the current level of the exchange rate is sustainable in the long run.

There has been some moderation in the housing market. Restrictions on high loan-to-value ratio mortgage
lending are starting to ease pressure, and rising interest rates will have a further moderating influence.
However, the increase in net immigration flows will remain an offsetting influence.

While headline inflation has been moderate, inflationary pressures are increasing and are expected to continue
doing so over the next two years. In this environment it is important that inflation expectations remain
contained. To achieve this it is necessary to raise interest rates towards a level at which they are no longer
adding to demand. The Bank is commencing this adjustment today. The speed and extent to which the OCR will
be raised will depend on economic data and our continuing assessment of emerging inflationary pressures.

By increasing the OCR as needed to keep future average inflation near the 2 percent target mid-point, the Bank
is seeking to ensure that the economic expansion can be sustained.
I have always been impressed by the hawkish credentials of the RBNZ, governor Graeme Wheeler is
taking a proactive approach to potential inflationary pressure. However, since these minutes were
published the RBNZ has announced that it will intervene on the foreign exchanges to stem any
excessive rise in the value of the NZD. The New Zealand currency is near to a 40 year high. Rather
than keeping interest rates artificially low to reduce the attraction of NZD as a destination for foreign
capital flows, they have chosen to intervene. Governor Wheeler identifies four economics risks
which might presage a reversal in NZD strength: -
1. Weakening of US growth
2. Fall in dairy prices
3. Fall in Chinese growth
4. Increase in financial market volatility leading to a Risk-Off environment
The RBNZ has also been courageous in articulating another problem with the current New Zealand
policy mix in relation to the High Immigration Policy. Board member, Michael Reddels working
paper The long-term level misalignment of the exchange rate - discusses this subject, it
observes that immigration does not guarantee rising living standards for everyone. He goes on to
suggest that Capital Deepening from immigration has failed to show up improved MFP. The
undesirable side-effects of the policy, however, can be seen in rising land and property prices due to
finite supply and increased demand from immigrants, together with foreign capital inflows which
have supported the NZD. This has led to a reduction in real incomes and an increase in real interest
rates.
The New Zealand government has established a housing affordability target of four time income -
this being the long-run average. The current level in Auckland is seven times.
It is worth noting that Australia has similar policies on immigration and similar problems with
housing affordability. The foreign buyers are often Chinese as the Chinese real estate bubble
implodes, one has to wonder how long this will continue.
Real Estate, Currency, Bonds or Stocks
The real estate markets in Canada, Australia and New Zealand are all at or near all time highs, their
levels of household debt are similarly extended. Given the illiquid nature of real estate as an asset
class now is not the time to buy. The trend is still upward, but when markets reverse those with poor
liquidity gap lower; the risks in real estate look asymmetric, now is a good time to reallocate to
more liquid assets.
Ive already reviewed the relative merits of the three currencies but, to reiterate, I continue to
favour NZD over CAD and, because Canada has a more balanced economy in terms of export
markets and economic complexity, I favour CAD over AUD although CAD/AUD is not a compelling
trade in itself.
Canadian 10 yr bonds made their highs in July 2012 yielding 1.56%, by September 2013 they had
followed US Treasuries lower to yield 2.83%. Now at 2.4% they are in a neutral range.
By contrast the TSX Index has made new highs this month. Momentum is slowing but the trend
remains firmly in tact remain long but be tentative if establishing new positions. The BoC are not
expecting a dramatic increase in growth in 2015/2016 thereafter they expect growth to slow
towards 2%.
Australian 10 yr bonds also hit their highs in July 2012 at 2.68%. In line with the weakness of US
Treasuries they declined until yields reached 4.50% in December 2013. Since then they have rallied
to 3.83%. The beginning of an up trend is in place, supported by expectations of an extended period
of unchanged policy from the RBA. The Australian governments decision to freeze fuel taxes last
month means they have an additional A$5bln shortfall in income the fiscal tightening required to
balance the budget is likely to stay the RBAs hand for some time to come of the three countries,
this is my favoured bond market.
With fiscal tightening on the cards it was surprising to see the ASX Index making new highs in April.
The momentum is stronger than in Canada and the trend is quite clear. Once the terms of the
budget are announced next week it may be easier to consider establishing new longs; I would prefer
to see the market make new highs by way of confirmation; if Canberra bites the bullet, Australian
stocks might bite the dust.
New Zealand 10 yr bonds made their highs in May 2013 at 3.17%, by December 2013 they had fallen
to 4.88%. In line with most other bond markets they have rallied this year to a current yield of
4.31%. The recovery looks weak and the recent interest rate hike by the RBNZ, together with their
more up-beat assessment of potential growth and inflation, makes NZ bonds the least attractive of
the three bond markets. The three markets have almost identical yield curve shapes (1.30/1.35 bp
positive) but, starting with structurally higher rates, I believe the New Zealand curve should be
steeper at this stage in the cycle. Ive tried to trade the Kiwi yield curve in the past and been burnt by
the pro-active policies of the RBNZ please dont regard this as a recommendation.
The NZ 50 Index, along with the Canadian and Australian indices, has made new highs in the past
month. The momentum is stronger than in the TSX or ASX, which is justified by the fundamental
assessment of the RBNZ. The negative impact of a strengthening currency should be tempered by
RBNZ intervention. This will also encourage capital flows into stocks, since the carry trade is
capped. RBNZ tightening in expectation of inflation is likely to encourage liquidation of bond
holdings, again favouring stocks.
The only cloud on an otherwise rosy horizon is the liquidity risk associated with New Zealand
markets in general. In the latest survey of GDP growth by The World Bank, Canada was ranked 11
th
,

Australia 12
th
whilst New Zealand came in at 55
th
. As RBNZ governor Wheeler pointed out, one of the
risks to the New Zealand economy is a reversal of foreign capital flows if financial market volatility
increases. Barring a return of the Risk-Off trade, I favour New Zealand Equities; hedged, but only if
you really need to, by a short position in New Zealand bonds.