The Canadian economy is in the nascent stages of a recession that could easily become a vicious cycle of self-validating declines. Capital and real estate markets could fall, feeding into an economic contraction -- which would then translate back into an even greater market selloffs.
I'm basing my fears of a "perfect storm" for the Canadian economy on the possibility of three key events happening:
A housing bust
The first problem is a housing bubble that sent values soaring on both Canadian coasts to a greater degree than the United States experienced almost a decade ago.
The Canadian bubble was driven by cash buyers rather than loose underwriting, so the likely plunge in values probably won't be as catastrophic for the banks there. But there will be similar consequences for the overall economy, as Canadian home prices will probably see peak-to-trough declines greater what we had here in the States.
The U.S. peak-to-trough drop averaged about 35% in nominal terms, and that was bad enough to mean that almost all mortgaged properties had no net equity. The Canadian decline will probably be closer to 50%, and that will cause most mortgaged properties there to have no net equity, either.
Lower commodity prices
The second issue facing Canada is a decline in demand for its commodities due to China's economic problems.
That's already helped drive energy prices down to levels that make Canadian oil unprofitable to produce. The entire Canadian energy industry is now at risk of insolvency, with lenders on the hook to absorb any resulting losses.
Even without housing declines, that alone could push Canadian banks into insolvency, requiring either a government bailout or outright nationalization.
The third issue facing Canada is the Iranian nuclear deal, which will soon allow Iran to begin freely exporting oil for the first time in decades.
Iran desperately needs money and will probably choose to quickly "monetize" its oil stocks regardless of the negative impact that will have on energy prices. It's also likely that Iran will place its cash needs above its membership in the Organization of Petroleum Exporting Countries and not abide by any OPEC production quotas.
I'll address in a future column how Saudi Arabia -- a key OPEC member and Iran foe -- will likely respond, and what that means for oil prices, OPEC's future and U.S.-Saudi relations. But for now, it's worth noting that Saudi Arabia's Prince Bandar bin Sultan has already threatened unilateral military action against Tehran's nuclear program regardless of the recent U.S.-Iranian deal.
Iran's traditional oil buyers have been China and Japan, and it's logical to assume that they'll want to negotiate long-term, fixed-price contracts that could prove very problematic for U.S. and Canadian producers even after global energy demand rebounds.
The problem for Canada is that it has almost no ability to respond to a further economic slowdown or oil-price contraction by lowering capital costs. After all, the Bank of Canada just cut its overnight lending rate to a paltry 0.50% from 0.75%.
What investors should do
The three sectors that will bear the brunt of this storm are real estate, banking, and energy.
Unfortunately, there are few easy ways for U.S. investors to speculate or even hedge on the those market segments. For example, there's no inverse ETF on Canadian residential REITs.
However, there's a small inverse ETFs for energy called the HorizonsBetaPro S&P/TSX Cap E Bear+ ETF (HED.TO) that trades on the Toronto Stock Exchange. For financials, there's the HorizonsBetaPro S&P/TSX Cap F Bear+ ETF (HFD.TO).
You could also short Canadian banks. The five largest ones traded in the United States are (in order of market capitalization) the Royal Bank of Canada (RY), Toronto-Dominion Bank (TD), Bank of Nova Scotia (BNS), Bank of Montreal (BMO) and Canadian Imperial Bank of Commerce (CM).
But I'd be cautious about shorting those stocks, as they've already lost 20% to 30% over the past year and have 4% to 5% dividend yields.
In my view, the best way to play Canada's woes probably involves taking a position on the broader impact to the Canadian markets, as well as to either U.S. oil companies or American firms with significant Canadian exposure. I'll write more about those plays in a separate column.