Examining Canada's Debt Exposure

The country’s mounting debt is creating vulnerabilities that could make recovery more difficult in the event of another recession.

By GPF Staff


Canada’s economy looks to be chugging along nicely. Though low oil prices slowed it down in 2014-2015, it grew by 3 percent last year. But this growth has come at a cost: debt. Canada’s debt is piling up, creating vulnerabilities that could make recovery more difficult for the country in the event of another recession. In last week’s Deep Dive we investigated the scale of Canadian debt and whether its associated risks could spread beyond Canada. Here, we home in on other countries’ exposure to Canada’s banking system, and on Canada’s exposure to other countries.

The greater a country’s exposure to Canada’s banking system, the greater the likelihood that it, too, would face financial stress were the Canadian banking system to face a crisis. The top five countries with claims on Canada’s banking system – The United States, the United Kingdom, Japan, Germany and France – don’t have much exposure to Canadian banks. For example, the United States has $125.1 billion in claims on Canada, an amount that may seem formidable but comes to just under three-quarters of a percent of the total assets in U.S. commercial banks. These holdings are modest enough that even if Canada fell into a banking crisis on the scale of Italy’s meltdown – in which the ratio of nonperforming loans neared 15 percent – only 0.1 percent of U.S. banking assets would face a greater repayment risk. (Canada’s gross nonperforming loan ratio is in fact very low, at only about a half of a percent.)

Canada, on the other hand, is not quite as insulated from other countries. A full 25 percent of its financial system has cross-border claims on the U.S., in part because of the large trade volume between the two countries. So, while the U.S. would be more or less safe from a Canadian recession, the same would not be true for Canada in the event of a U.S. recession. That Canada derives about one-fifth of its gross domestic product from trade with the U.S. makes it all the more susceptible to fluctuations in the American economy. Its vulnerability to the United States has become more apparent than usual since Washington reopened negotiations on the North American Free Trade Agreement.

This Is How the “Everything Bubble” Will End

By Nick Giambruno, chief analyst, The Casey Report

I think there’s a very high chance of a stock market crash of historic proportions before the end of Trump’s first term.

That’s because the Federal Reserve’s current rate-hiking cycle, which started in 2015, is set to pop “the everything bubble.”

I’ll explain how this could all play out in a moment. But first, you need to know how the Fed creates the boom-bust cycle…

To start, the Fed encourages malinvestment by suppressing interest rates lower than their natural levels. This leads companies to invest in plants, equipment, and other capital assets that only appear profitable because borrowing money is cheap.

This, in turn, leads to misallocated capital – and eventually, economic loss when interest rates rise, making previously economic investments uneconomic.

Think of this dynamic like a variable rate mortgage. Artificially low interest rates encourage individual home buyers to take out mortgages. If interest rates stay low, they can make the payments and maintain the illusion of solvency.

But once interest rates rise, the mortgage interest payments adjust higher, making them less and less affordable until, eventually, the borrower defaults.

In short, bubbles are inflated when easy money from low interest rates floods into a certain asset.

Rate hikes do the opposite. They suck money out of the economy and pop the bubbles created from low rates.

It Almost Always Ends in a Crisis

Almost every Fed rate-hiking cycle ends in a crisis. Sometimes it starts abroad, but it always filters back to U.S. markets.

Specifically, 16 of the last 19 times the Fed started a series of interest rate hikes, some sort of crisis that tanked the stock market followed. That’s around 84% of the time.

You can see some of the more prominent examples in the chart below.

Let’s walk through a few of the major crises…

• 1929 Wall Street Crash

Throughout the 1920s, the Federal Reserve’s easy money policies helped create an enormous stock market bubble.

In August 1929, the Fed raised interest rates and effectively ended the easy credit.

Only a few months later, the bubble burst on Black Tuesday. The Dow lost over 12% that day.

It was the most devastating stock market crash in the U.S. up to that point. It also signaled the beginning of the Great Depression.

Between 1929 and 1932, the stock market went on to lose 86% of its value.

• 1987 Stock Market Crash

In February 1987, the Fed decided to tighten by withdrawing liquidity from the market. This pushed interest rates up.

They continued to tighten until the “Black Monday” crash in October of that year, when the S&P 500 lost 33% of its value.

At that point, the Fed quickly reversed its course and started easing again. It was the Chairman of the Federal Reserve Alan Greenspan’s first – but not last – bungled attempt to raise interest rates.

• Asia Crisis and LTCM Collapse

A similar pattern played out in the mid-1990s. Emerging markets – which had borrowed from foreigners during a period of relatively low interest rates – found themselves in big trouble once Greenspan’s Fed started to raise rates.

This time, the crisis started in Asia, spread to Russia, and then finally hit the U.S., where markets fell over 20%.

Long-Term Capital Management (LTCM) was a large U.S. hedge fund. It had borrowed heavily to invest in Russia and the affected Asian countries. It soon found itself insolvent. For the Fed, however, its size meant the fund was “too big to fail.” Eventually, LTCM was bailed out.

• Tech Bubble

Greenspan’s next rate-hike cycle helped to puncture the tech bubble (which he’d helped inflate with easy money). After the tech bubble burst, the S&P 500 was cut in half.

• Subprime Meltdown and the 2008 Financial Crisis

The end of the tech bubble caused an economic downturn. Alan Greenspan’s Fed responded by dramatically lowering interest rates. This new, easy money ended up flowing into the housing market.

Then in 2004, the Fed embarked on another rate-hiking cycle. The higher interest rates made it impossible for many Americans to service their mortgage debts. Mortgage debts were widely securitized and sold to large financial institutions.

When the underlying mortgages started to go south, so did these mortgage-backed securities, and so did the financial institutions that held them.

It created a cascading crisis that nearly collapsed the global financial system. The S&P 500 fell by over 56%.

• 2018: The “Everything Bubble”

I think another crisis is imminent…

As you probably know, the Fed responded to the 2008 financial crisis with unprecedented amounts of easy money.

Think of the trillions of dollars in money printing programs – euphemistically called quantitative easing (QE) 1, 2, and 3.

At the same time, the Fed effectively took interest rates to zero, the lowest they’ve been in the entire history of the U.S.

Allegedly, the Fed did this all to save the economy. In reality, it has created enormous and unprecedented economic distortions and misallocations of capital. And it’s all going to be flushed out.

In other words, the Fed’s response to the last crisis sowed the seeds for an even bigger crisis.

The trillions of dollars the Fed “printed” created not just a housing bubble or a tech bubble, but an “everything bubble.”

The Fed took interest rates to zero in 2008. It held them there until December 2015 – nearly seven years.

For perspective, the Fed inflated the housing bubble with about two years of 1% interest rates. So it’s hard to fathom how much it distorted the economy with seven years of 0% interest rates.

The Fed Will Pop This Bubble, Too

Since December 2015, the Fed has been steadily raising rates, roughly 0.25% per quarter.

I think this rate-hike cycle is going to pop the “everything bubble.” And I see multiple warning signs that this pop is imminent.

• Warning Sign No. 1 – Emerging Markets Are Flashing Red

Earlier this year, the Turkish lira lost over 40% of its value. The Argentine peso tanked a similar amount.

These currency crises could foreshadow a coming crisis in the U.S., much in the same way the Asian financial crisis/Russian debt default did in the late 1990s.

• Warning Sign No. 2 – Unsustainable Economic Expansion

Trillions of dollars in easy money have fueled the second-longest economic expansion in U.S. history, as measured by GDP. If it’s sustained until July 2019, it will become the longest in U.S. history.

In other words, by historical standards, the current economic expansion will likely end before the next presidential election.

• Warning Sign No. 3 – The Longest Bull Market Yet

Earlier this year, the U.S. stock market broke the all-time record for the longest bull market in history. The market has been rising for nearly a decade straight without a 20% correction.

Meanwhile, stock market valuations are nearing their highest levels in all of history.

The S&P 500’s CAPE ratio, for example, is now the second-highest it’s ever been. (A high CAPE ratio means stocks are expensive.) The only time it was higher was right before the tech bubble burst.

Every time stock valuations have approached these nosebleed levels, a major crash has followed.

Preparing for the Pop

The U.S. economy and stock market are overdue for a recession and correction by any historical standard, regardless of what the Fed does.

But when you add in the Fed’s current rate-hiking cycle – the same catalyst for previous bubble pops – the likelihood of a stock market crash of historic proportions, before the end of Trump’s first term, is very high.

That’s why investors should prepare now. One way to do that is by shorting the market. That means betting the market will fall.

Keep in mind, I’m not in the habit of making “doomsday” predictions. Simply put, the Fed has warped the economy far more drastically than it did in the 1920s, during the tech or housing bubbles, or during any other period in history.

I expect the resulting stock market crash to be that much bigger.

When Blue Chip Companies Pile on Debt, It’s Time to Worry

Fueled by cheap credit, American corporations have been gorging on acquisitions. The party may soon be over.

By William D. Cohan

AT&T headquarters in Dallas. With about $183 billion of debt outstanding, it is one of the most indebted companies on the planet. / Dylan Hollingsworth for The New York Times 

Corporations, like people, are pretty simple: They do what they are rewarded to do. So when the Federal Reserve, by keeping interest rates very low for nearly a decade, rewards companies for borrowing money by making it historically inexpensive to do so, it can’t be a surprise to anyone that that’s exactly what they did.

In 2008, in the wake of the financial crisis, the Fed began its “quantitative easing” program, a determined effort to buoy the economy by lowering the cost of borrowing. It bought up trillions of dollars in Treasury and other debt securities, effectively reducing long-term interest rates. Debt issuance exploded. In the last decade, the amount of corporate bonds outstanding nearly doubled to $9 trillion, from $5.5 trillion.

Much of that surge has come in the form of bonds rated BBB, near the riskier end of the investment-grade spectrum — meaning that the money borrowed remains at some danger, albeit low, of not being paid back. There is now nearly $2.5 trillion of United States corporate debt rated in the BBB category, close to triple the amount of 2008, making up half of the investment-grade bond market.

It’s been quite a party. Now comes the hangover.

In the last decade, well-established companies including G.E., AT&T, CVS Health, Sherwin-Williams and Campbell Soup went on acquisition binges fueled largely by cheap borrowing. As interest rates rise and the economy appears to be slowing, they are in not-insignificant danger of defaulting on the debt, a fear that has started to cause disturbing ripples in the debt and equity markets.  
G.E. has $115 billion of outstanding debt, about $20 billion of which is due within a year, and it is “burning cash,” according to a recent report by a JPMorgan analyst. Its pension plan has gone from a surplus to reportedly being underfunded by some $29 billion; in October, S.&P. lowered G.E.’s credit rating to BBB, and the cost of buying insurance against a default on G.E.’s bonds, so-called credit default swaps, has soared in November. That’s a sign of investors becoming nervous that G.E. might default.
While he has been careful not to play down the company’s financial difficulties, G.E.’s new chief executive, H. Lawrence Culp Jr., pointed out this month that G.E. still has plenty of assets to sell and $39 billion available under a revolving credit line.

Then there is AT&T. With about $183 billion of debt outstanding, it is now one of the most indebted companies on the planet, thanks to its recent acquisitions of DirecTV and TimeWarner, which were paid substantially with debt. AT&T’s debt is also rated BBB, although only about $11 billion is coming due within a year. The company’s chief financial officer has said that AT&T will be able to “manage its obligations” from the cash it is generating.

But the heavy debt load leaves little margin for error, making a tricky merger — combining a legacy phone company with a major content provider — even more difficult. “I’m not even sure what AT&T is anymore,” said Christopher Whalen, the founder of Whalen Global Advisors, an advisory and economic research firm. “It’s kind of a resurrected zombie.”

Debt is very unforgiving. And yet in the last decade the debt has piled up, especially at companies that bulked up through mergers and acquisitions. Campbell Soup borrowed more than $6 billion to buy Snyder’s-Lance, the potato chip and pretzel maker, and the company’s debt is now more than five times its cash flow. After Keurig Green Mountain and the Dr Pepper Snapple Group merged, the combined company’s debt reached $17 billion, nearly six times its cash flow. Bayer now has around $40 billion of net debt outstanding after its acquisition of Monsanto; CVS Health issued $40 billion of bonds to help pay for Aetna; and Sherwin-Williams sold $6 billion of debt when it bought Valspar. By one estimate, IBM will issue around $25 billion in new debt to complete its $34 billion acquisition of the software company Red Hat.

There’s a lot at risk here. If these BBB-rated companies get downgraded further into “junk” status — a distinct possibility if a slowing economy makes a dent in their profits or if their big acquisitions do not pay off — a vicious cycle is nearly inevitable. That means higher borrowing costs when it comes time to refinance or to obtain a new credit line and an increasing risk of default.

When bellwether companies such as G.E., AT&T and IBM get into financial difficulty, that’s bad news for the rest of us. When credit markets feel nervous about the biggest corporations, it’s a good bet that it will be harder for ordinary Americans to get or refinance a mortgage, or get a car loan or credit card. It is a scenario that became very familiar a decade ago; the sequel may be upon us son.

William D. Cohan is a special correspondent for Vanity Fair and the author of, most recently, “Why Wall Street Matters.”

The Lost Lessons of World War I

A combination of willful blindness, utter complacency, and intense stubbornness on the part of Europe’s leaders subjected their countries to two devastating wars in the twentieth century. With nationalism and populism once again flourishing across the West, the risk of another large-scale conflagration is rising fast.

Dominique Moisi  

wwi soldiers

PARIS – It has been 100 years since World War I ended, and the centenary was commemorated this month with great pomp in Australia, Canada, France, and the United Kingdom. Germany sent high-level authorities to France to mark the occasion, reaffirming the reconciliation between the two countries. But the fact that Franco-German reconciliation did not occur until Europe had suffered another devastating war demonstrates how fragile peace can be, especially when political leaders are as shortsighted as they often are.
The Cambridge historian Christopher Clark aptly titled his 2012 book on the origins of WWI The Sleepwalkers. Through a combination of willful blindness, utter complacency, and intense stubbornness, Europe’s leaders subjected their countries to a conflict that shattered an entire generation.

By the time WWI erupted, it should have been clear that industrialization and the transportation revolution had transformed warfare. The Crimean War of 1853-1856 had over one million casualties; the American Civil War of 1861-1865 resulted in over 600,000 deaths.

Despite these experiences, Europe’s leaders clung to the nineteenth-century military theorist Carl von Clausewitz’s dictum that, “War is the continuation of politics through other means.” So politics continued in the form of war, resulting in 20 million military and civilian casualties.

Yet not even that was enough to wake up the sleepwalkers. In the years following the Armistice, Europe’s leaders failed to transcend the divisions that WWI had laid bare, with the tensions between the French and Germans being particularly destabilizing.

This failure was reflected in the Armistice itself, which imposed excessively harsh requirements on Germany, including billions of dollars in reparations payments, due at a time when the country faced a deep economic crisis. Meanwhile, international oversight was too weak, with the League of Nations remaining largely silent in the face of dangerous developments, such as Adolf Hitler’s remilitarization of the Rhineland. The US Senate’s rejection of the League of Nations in 1919 – and thus of the principles of internationalism and multilateralism that President Woodrow Wilson had promoted – certainly didn’t help matters.

More fundamentally, WWII erupted because nationalism was allowed to continue to fester. French Prime Minister Georges Clemenceau, for one, remained deeply nationalistic and, in particular, vehemently anti-German. But while behaving like Clemenceau might win the war (especially if a power like the United States shows up to offer crucial help), it cannot win the peace; hard nationalism naturally leads to conflict.

Yet, today, a major world leader, US President Donald Trump, is behaving very much like Clemenceau. This holds serious implications not just for the US, but also for Europe. To be sure, French President Emmanuel Macron embraces the “Wilsonian principles” that Trump rejects. But, as the interwar period starkly showed, if core rules and principles are not accepted by all, the institutions they underpin cannot be sustained.

WWII accomplished what even WWI could not: it ended the era of European global dominance. While Europe has grown and prospered since 1945, it has not regained the global leadership status its major countries once possessed. This leaves today’s European Union at the mercy of a US that has rejected multilateralism and embraced nationalism.

Of course, plenty of the risks Europe faces lie within its own borders. In France, for example, many are brushing off the warnings issued by Macron – or, more concretely, by their history books – as they push back against their president’s efforts to take up the mantle of multilateralism.

The risk today is that generations that have not known war will reproduce the chain of events that lead to it. This risk is exemplified by the recent “yellow vest” protests in France against an environmental tax on fuel. The protests were also intended to be a broader rebuke of Macron, whom many blame for their declining spending power.

The protesters probably think that they are acting in the spirit of the 1789 French Revolution, a spirit that the French periodically revive in their country’s politics. But they are actually reenacting the 1930s, with its right-wing protest movements and militias.

This is not to say that French citizens – and, in particular, young people – have nothing about which to complain. Unemployment has remained too high for too long, and while France has largely escaped the spike in income inequality seen in other countries, such as the US, systemic inequalities are pervasive.

But the fact is that the emotional rejection of any person or institution even remotely associated with established “elites” – including mainstream political parties and trade unions – lends itself to exploitation by populist demagogues. And history could not be clearer about the risks generated when such demagogues secure power.

The world has changed profoundly over the last century. Our economies are more deeply intertwined than ever before, and the sheer scale of destruction that could be wrought by today’s weaponry may invite some semblance of restraint.

But, as Trump’s erratic presidency – including his challenges to longstanding alliances and reckless nuclear posturing – starkly demonstrates, the structures we have created to preserve peace are far from foolproof. With populations across the West embracing nationalistic and populist ideas, we are again dancing on the rim of a volcano.

Dominique Moisi is Senior Counselor at the Institut Montaigne in Paris. He is the author of La Géopolitique des Séries ou le triomphe de la peur.