As a CPA and Licensed Insolvency Trustee, I had a front row seat during the Great Recession of 2009 – 2011. I saw the devastating impact it had on the lives of ordinary Canadians.

These were everyday people who were for the most part honest, hard working, and played by the rules. Yet they found themselves on the short end of the stick when the Great Recession started 10 years ago: some lost their jobs, some had their financial portfolios decimated, some lost their homes and quite a few experienced losing all three.

It’s been more than 10 years since the onset of the Great Recession and Canadians are more indebted than ever. Therefore, in anticipation of the next recession, I thought it timely to write this piece for the readership of Boomer & Echo, which Robb has graciously allowed me to do.

This post will be divided into the following sections:

1. Is a recession imminent?
2. Assessing your economic vulnerability.
3. What can you do to prepare?
4. What are the available solutions if you’re seriously impacted?

Part 1: Is The Next Recession Imminent?

The following current events suggest that another economic downturn is imminent. Let’s examine them.

It’s been more than 10 years since the last recession

We are therefore due for another one. Why do recessions historically occur every 5 to 7 years? This is due to the phenomenon of the short term debt cycle. Here’s a simplified explanation of how it works:

• As individual actors in the economy, we borrow now to purchase or invest in something today. Consequently, as credit expands in the economy so does economic growth.
• However, what we borrow today has to be paid back tomorrow. And as we pay back our debts (also known as “deleveraging”), we have less money to purchase and invest in stuff. Consequently, deleveraging leads to an economic contraction.
• To get the economy going again, the central bank lowers interest rates and makes it cheaper to borrow. So we borrow, spend and invest in goods and services which again triggers economic growth thus starting the next short-term debt cycle. Rinse and repeat.
• We’re in year 10 of the most recent economic expansion. The problem is, because interest rates are already so low, the central bank will have run out of bullets in fighting the next recession unless it employs more unconventional monetary tools such as negative interest rates and Modern Monetary Theory. Some commentators have suggested that the global economy is coming towards the end of the long-term debt cycle. When that happens, standard monetary policy will no longer effective in restarting the economy.
• Here’s why that next recession hasn’t happened yet – interest rates in Canada (as well as in the United States and Europe) will remain low for the foreseeable future – because consumers are so indebted, even a slight increase in interest rates can wreak havoc on household finances and hence the broader economy. For example, the household debt to income ratio in Canada during September 2019 was 177.1 percent. Consequently, central banks in Canada and throughout the Western world are gun-shy about raising rates.
• However, external factors outside of the control of central banks may trigger the next recession. We’ll examine these factors next.

The United States is in an economic war with China

“Trade dispute” is a euphemism for what’s really happening between the U.S. and China, which is a full blown economic war. As of this writing, the Trump Administration is considering the possibility of delisting Chinese companies from U.S. stock exchanges. This is in addition to the tariffs it has already imposed on Chinese imports.

The U.S. intelligentsia sees China as a rising power which must be curtailed because China does not share America’s values. The model that is being used to describe this relationship between a waning U.S. and a rising China is called Thucydides’s Trap. Thucydides’s Trap is the dangerous dynamic that occurs when a rising power threatens to displace an established power. It usually leads to war, which in the case of the U.S. and China, is an economic war rather than a military war – at least for now.

Why is this economic war bad for the Canadian and global economies? Here’s a simplified analysis:

• The United States is our largest trading partner and as American consumers and businesses pay more for Chinese imports (which includes just about everything), they have less money to spend on everything else, including Canadian exports to the U.S. Moreover, Chinese businesses and consumers have less money to purchase Canadian imports because of the negative impact U.S. tariffs have on their economy.
• Because the U.S. and Chinese economies are so hegemonic and our globalized economy is so intertwined, countries throughout the world are similarly affected like Canada. For example, Germany is currently entering into a recession. One of the underlying causes of Germany’s recession is the U.S. – China trade war which has led to a decrease of industrial exports to China.
• Since our other global trading partners are affected the U.S. – China trade war, Canada has less customers for its exports, leading to Canadian eventual business closures, job losses and economic contraction.

Economic inequality and the rise of political extremism

Why has economic inequality exacerbated over the past 10 years?

Are you familiar with the term “quantitative easing“? If you watched the financial news during 2009 – 2011, you couldn’t avoid hearing it. It apparently saved the global economy and staved off the next Great Depression.

What is QE? It’s a euphemism for money printing. The U.S. Federal Reserve increased the supply of U.S. dollars (the global reserve currency) by $4 trillion starting in late 2008 in the hopes that it would get Americans to start spending.

While it did just that, it also created massive inflation. But wait – isn’t inflation at historical lows? That’s what economists and the mainstream media keep telling you, right?

Well no, not really:

• Yes, consumer goods are still relatively inexpensive, but that’s because almost all consumer goods are manufactured in China, which can crank up its manufacturing base on a dime and produce an almost infinite quantity of consumer goods. Hence, the quantity of consumer goods bought and sold globally can keep up with the expansion in the U.S. money supply, which I remind you, is the global currency used to pay for goods internationally. Hence, no inflation in consumer goods.
• Not so with real estate: do you really think that Vancouver and Toronto are the only real estate markets with insane housing prices and rents? Check out Amsterdam. Take a look at Berlin. They have insane housing prices as well. Unlike consumer goods made in China, there’s a limited amount of land available upon which to build real estate but a seemingly unlimited demand for it, particularly from China’s burgeoning middle class of 400 million. The result is asset inflation in the global housing market, both in sales prices and rent, due to all these U.S. dollars chasing a limited supply of real estate around the world.
• Similarly, stock markets throughout the globe have been on a tear since 2009. For example, the Dow Jones index now stands at 26,820 as of this writing. It was at 7,223 in March 2009 during the depths of the Great Recession – an increase of 271% over 10 years. Did the companies on the Dow suddenly become 271% more profitable during that time? Of course not – like real estate, there’s a limited quantity of publicly listed companies being chased by trillions of U.S. dollars, leading to another form of asset inflation.

If you were one of the Fortunate Few (let’s say “The 10%”) who owned real estate and financial assets during the last decade, then you probably made out like a Bandit. Your net worth probably likely increased significantly.

However, if you were one of the Less Fortunate Many (let’s say “The 90%”) who didn’t own real estate or financial assets and didn’t see a significant rise in your income during this past decade, then you probably feel like you got robbed by the Bandits in The 10%. Your net worth likely hasn’t changed or may have even gotten worse; since your income hasn’t increased, you probably took on more debt just to meet your basic living expenses.

Therefore, The 90% are understandably pissed. And in democratic countries like the United States and those in Europe, they appear to have expressed their frustration by voting in political extremists. In the United States, The 90% have elected Donald Trump on the Right (who has initiated a global trade war with China). Likewise, in the United Kingdom The 90% are likely to elect Jeremy Corbyn as Prime Minister. In that event:

A Labour government would confiscate about £300bn of shares in 7,000 large companies and hand them to workers in one of the biggest state raids on the private sector to take place in a western democracy, according to analysis by the Financial Times and Clifford Chance. The UK’s 2.6m landlords would also face a moment of reckoning if Labour won the next general election after shadow chancellor John McDonnell said he wanted a “right to buy” scheme for private tenants as well as higher taxes on landlords.

It goes without saying that today’s political extremists and their economic policies may very well trigger a global recession.

At the risk of using the past as a prediction of the future, I remind the reader that the U.S. stock market crashed in 1929, which led to the worldwide Great Depression. Within the following ten years, fascism rose in Europe resulting in the democratic election of Adolf Hitler as Chancellor in Germany. This led to the subsequent invasion of Poland by Nazi Germany in 1939 which started the Second World War.

Similarly, the Great Recession started in 2009 and events similar to the 1930s have played themselves out so far, so “take that as you will”.

Part 2: Assessing Your Economic Vulnerability

How vulnerable is your employment in the event of a recession? In my opinion, these are the economic sectors that will be hardest hit:

1. The resources sector, such as the oil and gas industry. Alberta in particular will be hit hard as it’s still recovering from the end of the commodities boom.
2. The entire building and real estate industry as well as its suppliers such as lumber, steel and cement companies since demand from domestic and foreign purchasers will dry up.
3. The entire banking sector, including retail, commercial and investment banking due to a decrease in demand for loans and business capital.
4. The retail sector, particularly “brick and mortar” retail which has higher overhead costs due to commercial rents, which are currently at historical highs.
5. The media industry, as advertising revenues dry up. The Toronto media industry was hit hard during the last recession with numerous layoffs.
6. The vehicle industry, including manufacturers and dealerships.

If you’re employed in one of these sectors, I suggest that you take my advice in the next section.

Part 3: What Can You Do To Prepare?

If you’re concerned about losing your job during a recession and being unable to pay your debts, then there’s no better time than now to start repaying your debts now:

1. Create a budget and see where your money is going. Cut out discretionary expenses and use the surplus to pay off your debts.
2. Prioritize your debt repayment by paying off the debt with the highest interest rate while maintaining the minimum payments on all your other debts.
3. Once you’ve paid off the debt with the highest interest rate, repeat Step 2 for the debt with the next highest interest rate until you’ve paid off all your debts.
4. Once you’ve tackled your unsecured debts, try to bring down the balances of your secured debts like your mortgage. Most banks will allow you to double up on your mortgage payments and will also allow you pre-pay up to 15% of your mortgage balance annually.
5. Once you’ve paid off your debts, start saving money in a High Interest Savings Account (HISA) for an emergency fund should you need it. You should save enough to pay for at least six months of living expenses if not more.

In terms of financial investments, speak to your professional financial advisor and ask her to review your investments to make sure that they align with your risk tolerance in light of an impending economic downturn.

Related: What you can do about the upcoming stock market crash

Part 4: Solutions If You Are Seriously Impacted

Let’s suppose that you’ve tried to pay down your debt as described in Part 3 but are unable to pay it all off before the next recession hits and you lose your job when it does.

If that event, there are a few options available to you if you cannot pay your debts as they become due. For the purpose of this discussion, we will focus on unsecured debts (as opposed to secured debts like a mortgage or vehicle loan):

1. You can consult with an accredited credit counsellor who will put you on a Debt Management Plan (DMP). A DMP will allow you to pay off your debts over a longer period of time – usually 60 months. The counsellor may also be able to negotiate a reduction in the interest rate. Despite all these positives, a DMP will have a negative impact on your credit.
2. If you are unable to pay off all your debts under a DMP, the next step is to attempt to settle with your creditors through a consumer proposal. A consumer proposal is a legal settlement with your creditors facilitated by a Licensed Insolvency Trustee under the Bankruptcy & Insolvency Act. Such a settlement can be paid either in a lump sum payment or by periodic payments over a maximum period of 60 months. Upon filing a consumer proposal, the interest stops accruing on your debt and your creditors cannot commence or continue any legal action to recover their debts. Upon paying the settlement in full, you are discharged from the balance of your debts. Like a DMP, a consumer proposal will have a negative impact on your credit.
3. If you’re unable to even settle with your creditors, then your last line of defense in dealing with them would be filing for personal bankruptcy with the assistance of a Licensed Insolvency Trustee. Like a consumer proposal, once a bankruptcy is filed, the interest stops accruing on your debt and your creditors cannot commence or continue any legal action to recover their debts. However, your assets may have to be liquidated by the Trustee depending on the province in which you reside or where your assets are located. Also, you may be required to contribute a portion of your income to your bankruptcy estate – the amount payable (called “surplus income“) would be determined by your net monthly income and the number of dependents you have to support. Upon obtaining your discharge from bankruptcy, a record of your bankruptcy will remain on your credit history for either 6 or 7 years depending on your province of residence.

Conclusion

As the saying goes, “History doesn’t repeat itself, but it often rhymes”. In my view, we are facing a world analogous to that of the 1930s – a financial collapse followed by rapid money-printing, rising inequality, a discontented populace, and the election of political extremists that promise simple solutions to complex problems. We live in dangerous times – I hope that you found this article informative so that you can better prepare yourself and your family for what happens next.

Victor Fong, CPA, CMA, LIT is the founder and President of Fong and Partners Inc., a Licensed Insolvency Trustee based in Toronto, Canada.

I’ve written before about my modified pursuit of FIRE (Financial Independence, Retire Early). The twist is that I’m striving for FIE – to be a Financially Independent Entrepreneur. It’s an idea that I haven’t been able to get out of my head lately. Here’s why:

For as long as I’ve been writing this blog I’ve had a goal to achieve financial freedom by age 45. I’ve also declared a goal of reaching $1M in net worth by the end of 2021, the year I turn 41.

I’m on pace to achieve that, perhaps slightly ahead of schedule. More importantly, though, is a realization that my so-called side hustle – the online income earned from blogging, freelance writing, and financial planning – has far surpassed my full-time salary. Simply put, I could leave my day job tomorrow and still pull in enough income to meet our spending and savings goals.

So what’s holding me back? A few things. The security of a full-time job with benefits. A wife and two children who depend on my income. A $200,000 mortgage. The angst of where my next freelance contract will come from (and when it will be paid). Navigating the constantly changing online world while trying to earn a living. Having enough of a cushion in the bank in case things go sideways.

I think about all of those things. But the reality is my business has grown by nearly 50 percent this year. I’ve never been busier, and I know there’s plenty of opportunities I’m leaving on the table because I can only do so much on evenings and weekends.

If you’re familiar with Dragon’s Den pitches, the dragons always ask the entrepreneurs if they’re into their venture 100 percent, or if they’re still entrenched in their day job just in case their big idea doesn’t pan out. Invariably, the dragons pass on pitches where the entrepreneur isn’t fully committed to his or her venture. They want the founder to be all in.

I’m not saying that I’ll be taking my talents to Dragon’s Den anytime soon. The point is, as an entrepreneur, there comes a time when you need to be all-in to realize your full potential. It’s funny, but I’m scared to go all-in right now, even though I know that I earn enough income on the side to replace my salary and continue to live the same lifestyle.

What I’m trying to wrap my head around is the additional earning potential if I can dedicate even 10-15 more hours a week to my online business. The more I think about that, the more sure I am that I can make this work financially.

I like to wrestle with big financial decisions by talking them out here on the blog. It’s a great platform for these kinds of discussions. And while I won’t throw out a date or deadline as to when I plan to make this transition, know that it’s been on my mind for some time and I’m getting very close to pulling the trigger.

Financially Independent Entrepreneur. I like the sound of that.

This Week’s Recap:

This week I collaborated with Erika Toth, a director at BMO ETFs, to dispel the myth that passive investing is in a bubble.

Over on the Young & Thrifty blog I shared a beginner’s guide to index funds.

I went to Seattle this week to explore the city and take in the Seahawks vs. Rams game (which was an amazing game to see live!).

My wife and I are off to Vancouver next week to celebrate our anniversary. Hopefully we luck out with the same great, sunny weather!

Promo of the Week:

Interest rates on savings accounts have been ticking down at most big banks and credit unions. Once a market leader, Tangerine recently dropped its interest rate to a pitiful 1.15 percent. If you want to earn a higher rate on your savings then you need to look outside the big banks and consider an online bank.

EQ Bank has offered one of the best interest rates in the country since it launched in 2016. Its EQ Bank Savings Plus Account, which has also has some chequing account functionality, pays a healthy 2.30%* interest. That’s double Tangerine’s savings account and nearly triple what some of the big banks currently offer (short term promos aside).

What I like about EQ Bank is that it doesn’t mess around with short term promotions and teasers. It pays an everyday high interest rate – currently 2.30%* – on every dollar (up to a maximum of $200,000).

If you’re the type of person who likes to hold a large amount of cash, whether it’s an emergency fund or a short-to-medium term savings goal – do yourself a favour and start earning higher interest on that savings. Sign up for an EQ Bank Savings Plus Account here.
*Interest is calculated daily on the total closing balance and paid monthly. Rates are per annum and subject to change without notice.

Weekend Reading:

Stephen Weyman at Credit Card Genius shares the best credit card offers, sign-up bonuses, and deals for October.

Are wealth taxes a good idea? Here’s Nick Magguilli on the pros and cons of a net worth tax.

Some big thinking here by Morgan Housel on the three most important forces shaping the world:

“Find something that’s important to you in 2019 – social, political, economic, whatever – and with a little effort you can trace the roots of its importance back to World War II. There are so few exceptions to this rule it’s astounding.”

Speaking of FIRE, here’s why this couple ditched the FIRE movement and couldn’t be happier.

Advisors say this is the biggest behavioural bias driving investment mistakes.

Melissa Leong explains how to give yourself a fall money makeover.

Million Dollar Journey blogger Frugal Trader answers a reader question from a low income senior trying to decide between a TFSA and RRSP.

Erica Alini tackles the best way to generate cash from your investments in retirement.

In this video, PWL Capital’s Ben Felix offers his own take on the index investment bubble theory:

One of the biggest myths in investing is that you need to beat the market. You don’t — and you probably couldn’t if you tried.

The Evidence Based Investor blog offers five strategies that are better than timing the market:

“In summary, timing the market — while superficially an attractive idea — is fraught with danger. If you get lucky, great, but there’s no method to it. We’ve seen that not even the gurus are much good at it.”

A good piece by Ben Carlson on resulting: our tendency to equate the quality of a decision with the quality of its outcome.

The classic question of whether you should keep your company pension, or take a lump-sum pension buyout and invest it yourself.

Should you pay for your child’s university education? The Blunt Bean Counter blog explains how to tackle this problem.

Finally, Canadian Budget Binder explains how hoarding affects your children when you’re gone.

Have a great weekend, everyone!

There have been many ridiculous statements made about passive investing over the years. None have garnered as much media attention as hedge-fund manager Michael Burry’s claim that passive investments such as index funds and ETFs are the next bubble. He said these index-tracking investments are “inflating stock and bond prices in a similar way that collateralized debt obligations did for subprime mortgages more than 10 years ago.”

“When the massive inflows into passive vehicles reverse, it will be ugly.” – Michael Burry

Such a bold claim from someone who correctly called the subprime mortgage crisis is certainly cause for concern. But when you peel back the layers, Burry’s statement doesn’t make much sense. Looking for a smarter take than that, I reached out to Erika Toth, a Director of ETFs at BMO Global Asset Management, to explain why passive investing is not in a bubble.

Take it away, Erika:

Debunking Michael Burry’s Passive Investing Bubble Claim

I may not have had Christian Bale play me in a movie, and I did not make millions during the financial crisis, but I have spent years now studying market structure and eating, sleeping, and breathing ETFs. Burry’s comments that sparked a media frenzy (and let’s all agree that the financial media loves to sensationalize) echo some of the most common myths and misconceptions I have encountered on the ETF wrapper.

This “passive investing is in a bubble” argument assumes that all the money invested in passive indices has flowed in to the same indices, that hold the same stocks, in the same proportions. However, there are many different types of passive funds and ETFs – some track the S&P 500, some track indices built around low volatility, quality, value, or momentum filters. Some track specific sectors.

Related: What’s not to love about ETFs?

Different investors have different investment objectives and motivations. Some want to buy the market. Some require higher cash flow. Some require lower volatility. Some are searching to exploit market inefficiencies in order to generate alpha. Pension funds have to make sure their liabilities are funded. Some investors are searching for companies that meet the highest environmental, social, and governance standards. Some require certain tax efficiencies or credit qualities to be met. Therefore, it is impossible that the entire world stock and bond markets would move to 100% passive.

It’s also important to note that individual stock ownership by households (domestic and foreign) accounts for just over half of the equity market – the largest share, by far. Mutual funds (active and passive) own about 24%; ETFs own about 6%. Pension funds would represent about 10% (government and private); and about 8% is owned in other vehicles such as hedge funds. (This is according to data put together by the Federal Reserve Board – see here).

ETFs themselves are too small a slice of the overall pie to be able to cause a crash in the prices of the stocks they hold; they simply reflect those prices. Those statistics are for the equity market. ETF ownership of the global bond market is even smaller, roughly 2-3% by most estimates.

The theory that everyone will run to the exits at the same time in the event of a major downturn is incorrect, and 2008 is a good example of that. My favourite example comes from Ray Kerzehro, who is Director of Research at independent firm PWL Capital, in the still-very-relevant white paper he published in 2016.

Kerzehro examines how high yield bond ETFs in the U.S. traded during the height of the financial crisis. Keep in mind that high yield bonds are NOT a large cap equity index made up of the largest and most liquid stocks in the world – they are a riskier asset class of lower credit quality and are less liquid as well. So, even in this riskier and less liquid asset class, there was actually no massive exodus from those ETFs.

What happened is that trading VOLUME actually spiked. Buyers & sellers of the ETF units had different views for different reasons, and the ETF structure actually provided price discovery to an asset class where many of the underlying bonds had gone no-bid.

Another key point to make is that large ETF providers, who hold the majority of the market share both here and in the U.S., establish minimum trading volume criteria for every security they hold. This ensures that they will be able to offer a liquid market on that security.

The market makers themselves (the plumbing behind the whole ETF eco-system) are also in competition with each other to offer the most competitive bid-ask spreads, which helps keep markets liquid. They make money on transaction volume.

The ETF Liquidity Myth

Another common misconception is surrounding ETF liquidity. ETFs are like stocks in the sense that they trade on the stock exchange. For individual stocks, the higher the trading volume, the more liquid that stock is.

However, with an ETF, liquidity is best measured by its bid-ask spread. In general, an ETF’s liquidity reflects the liquidity of the underlying stocks or bonds it holds.

Related: VEQT – My new one-ticket investing solution

A good way to think of it is that the number of the ETF’s units you see trading are only the tip of the iceberg. The true liquidity is the trading volume of all the securities it holds.

Bid-ask spreads

The bid-ask spread is the difference in what you are able to buy the ETF for, versus the price you would be able to obtain if you are selling it.

This is the best indicator of how liquid an ETF is. A very liquid ETF will have a minimal difference between the two.

The spread represents the compensation to the market maker for assuming the risk and making a liquid market for that security. It is a component of the total cost of ownership of an ETF and is sometimes overlooked by investors. In general, the longer the holding period, the less significant this entry/exit cost is as a component of total cost. If you are more of a longer-term, buy and hold investor, in other words, this should not matter that much. However, if you trade more actively, this is something you should be more aware of.

*An important consideration, especially if the price per unit of that ETF is $50 or higher, is to calculate the bid-ask spread as a percentage of Net Asset Value (NAV). An ETF trading at $50 per unit may be just as liquid as an ETF trading at $25 per unit, even though it appears to have a bid-ask spread that is wider (3-4 cents, compared to 1 or 2 cents on a $25 NAV).

Bid-ask spreads on large, liquid markets such as the S&P 500, S&P/TSX or the FTSE Canada Universe Bond Index – will be very tight at all times.

When you start looking at overseas markets that may be closed during our market hours, it is normal to have spreads that are a bit wider. For European equities, the best time to trade would be between 10 and 11 a.m. Eastern Time. For Asian markets, there is actually no overlap with our market hours.

The best practice is simply to avoid trading too close to the open or the close, and to always use limit orders.

In more volatile markets, it is normal to see spreads widen.

Spreads will also be wider on less liquid areas of the market and on more “niche” exposure ETFs.

Market-weighting versus Equal-weighting

Market cap weighting tilts your exposure towards the largest companies within the index. Equal weighting will give you more of a tilt towards the smaller companies within the index, versus owning the market-cap weighted index.

Over the long term, smaller- and mid-cap stocks may outperform since the risk level is higher. In times of market duress, one may prefer to have a market-weight orientation.

For certain areas of the market that are less diversified, such as Canadian sector equities, investing in a cap-weighted index may result in a very concentrated position in 2-3 stocks. In these situations, it may be preferable to access that sector with an equally-weighted approach.

Related: 3 ways to build an investment portfolio on the cheap

Some portfolio managers and investors prefer market-cap weighting on the other hand, as it provides “truer” exposure to that sector. It is a matter of preference.

Either way, it is important to look under the hood of an ETF and understand what you are owning and why. If you are considering taking an exposure to a particular sector, compare the market weighted version with the equal weighted version in order to determine the differences: long term performance, risk level (standard deviation), dividend yield, how it behaved in negative markets, and identify any concentration issues in certain stocks or sub-sectors.

Final Thoughts

Thanks so much to BMO’s Erika Toth for going under the hood to dispel ETF myths and misconceptions, and to explain exactly why passive investing in ETFs won’t cause a bubble. Bold claims from famous investors make for great headlines, but when we look to the evidence we often find these statements don’t hold water.

Here’s some further reading to help educate investors about the myths and misconceptions of ETFs:

• Debunking the Myths on ETFs
• ETF Due Diligence Checklist
• Understanding ETFs Part 1 – the Basics
• Trading and the True Liquidity of an ETF

BMO Global Asset Management – Understanding ETFs video series: