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There is a specific sequence of events where high levels of Canadian household debt can lead to a deflationary, recession-ridden period for the economy that resembles Japan after 1990. The Bank of Canada, having learned the lessons of Japan’s experience, will use everything in its arsenal to prevent it. In all probability, it will be successful.

Still, a discussion of how debt can lead to deflationary downward spirals is a useful exercise that makes interest rate policy and asset price performance more intelligible.

“The global economy has never been more leveraged,” wrote Morgan Stanley strategist Hans Redeker in a July 18 research report. Mr. Redeker noted that debt levels reduce future economic growth rates unless productivity or the size of the working age population climbs significantly.

The strategist believes that the extent of global debt exceeds the ability of productivity, or labour force growth, to compensate. And that means central bank policy rates will have to remain low for debt levels to remain sustainable.

Japan was in a similarly indebted situation in 1990 and now provides a cautionary tale for governor Stephen Poloz and other central banks.

“The BoJ failed to boost Japan’s inflation rates above the rates of its trading partners. Consequently, Japanese real yields were too high for its leveraged economy. As a result, Japan’s private sector went through a painful balance sheet consolidation process," said Mr. Redeker.

For Canadians, it’s not difficult to see how high interest rates might cripple growth for a consumer-driven economy. Every hike in borrowing costs would result in more mortgage defaults for households already struggling with high debt loads. As it is, the domestic economy saw its 16th month in a row of declining year-over-year auto sales in June, likely a sign debt levels are already crimping spending.

I believe the Bank of Canada will be able to prevent a decades-long, Japan-like scenario with appropriately low rates. Otherwise, the risk is that high inflation-adjusted borrowing costs cause bankruptcies and declining consumer spending, which in turn causes unemployment and yet slower growth.

The Bank of Canada is handcuffed by high household debt levels to some extent. Record debt levels means that any rate hike has a disproportionately large negative effect on national growth. So rates stay low because they have to, which encourages Canadians to strap on even more debt, making the economy even more sensitive to borrowing costs. And on we go.

Investors can hope and expect that interest rates will remain low for the foreseeable future and this will continue to provide support for income-generating asset values. Where all this ends I’m not sure, but hopefully not like Japan where deflationary pressure remains almost 30 years after the economy peaked.

-- Scott Barlow, Globe and Mail market strategist

This is the Globe Investor newsletter, published three times each week. If someone has forwarded this e-mail newsletter to you or you’re reading this on the web, you can sign up for the newsletter and others on our newsletter signup page.

Stocks to ponder

Equitable Group Inc. Jennifer Dowty profiles this financial services stock, whose share price has climbed over 32 per cent year-to-date, closing at a record high on Monday on high volume. Management is firmly committed to returning capital to its shareholders, announcing dividend increases for the past three consecutive quarters. The stock has a current dividend yield of 1.6 per cent.

The Rundown

Anger builds over lack of reforms to early-withdrawal fees on mutual funds

Investor advocates are expressing frustration that fund companies are still able to charge early-withdrawal fees on mutual funds, nearly a year after securities regulators concluded they should be banned. The renewed calls for action come after fines were levied against certain advisers who improperly sold the products to senior citizens who had no idea they were subject to the fees. Clare O’Hara reports

Four steps investors can take to prepare for the next market downturn

With stocks hitting new record highs and the bull market nearly a decade old, it may seem like an odd time to think about the next downturn. But as the old saying goes, hope for the best and prepare for the worst. John Reese outlines four steps investors can take to help prepare for the next downturn, even though markets are riding high right now.

Investors are paying a high price for ‘safety’

Risk is arguably the most important yet least understood concept in investing. Many investors tend to focus on volatility or beta as a way to assess the risk of a portfolio or a given security. While these metrics can be useful to some extent, they are completely inadequate when it comes to the real risk that matters most to investors – the risk of losing money. Graeme Forster of Orbis Investment explains.

An investor’s take on a hot trend in advice fees: ‘The value added is negligible’

If your investment adviser hasn’t yet switched you over to a fee-based account, just wait. It’s almost certainly going to happen. Rob Carrick explains

Protect your retirement portfolio from ‘drawdown’ erosion.

For Canadians who rely less on government sources to fund their retirement, it’s important to ensure that the cumulative effects of market declines do not erode their retirement nest egg. In investment circles, this is referred to as portfolio “drawdown.” It is essential to first understand the various characteristics of portfolio drawdown – depth, duration and frequency of market declines. Sam Febbraro of the Investment Planning Counsel explains.

Others (for subscribers)

Short sales on the TSX: What bearish investors are betting against

Wednesday’s analyst upgrades and downgrades

Wednesday’s Insider Report: Chairman invests over $500,000 in this small-cap stock

Tuesday’s Insider Report: Company president invests over $4-million in this dividend stock

Others (for everyone)

Top Canadian stock picks for socially responsible investors

Number Crunchers (for subscribers)

Outperforming 15-stock Canadian portfolio built of analysts’ recommendations

Ask Globe Investor

Question: You recently recommended the Mawer Balanced Fund. I like the fund and own a lot of it. Do you have a couple of other balanced funds that you like and recommend that I could invest in along with the Mawer fund? Do you endorse this approach, or should an investor simply put all their funds in the one company’s balanced fund? – John L.

Answer: The only reason to own two funds in the same category (in this case Global Neutral Balanced) is if they use a different investment approach to achieve superior results.

The best fund I can find that would complement the Mawer fund in that way is Dynamic Power Global Balanced Class Series A, managed by Noah Blackstein.

As of June 30, it showed a 10-year average annual compound rate of return of 10.1 per cent.

The asset allocation is about the same as the Mawer fund (60 per cent equities, 40 per cent bonds and cash). But the geographic and sector allocations are very different.

For example, the Dynamic fund has more than a third of its portfolio (36.6 per cent) invested in information technology stocks. The Mawer Balanced Fund has an IT weighting of 13.7 per cent according to the company website. The Dynamic fund has 57.4 per cent of the portfolio invested in U.S. and international stocks, compared to 37.8 per cent for Mawer. Canadian stocks make up only 2.7 per cent of the Dynamic portfolio.

The Dynamic fund is more aggressively managed, and the result is larger performance swings then you’ll see with Mawer. For example, in 2016 the Dynamic fund lost 8.1 per cent. It then turned around and gained 32.5 per cent in 2017 before losing 9.4 per cent in 2018. The comparable numbers for Mawer were up 3.2 per cent, up 10 per cent, and down 0.3 per cent, respectively. Clearly, the Dynamic fund is higher risk but when it does well it can shoot out the lights.

Over the past decade, however, there is not much daylight between the funds in total returns. So, if you’re looking to spread your money around, this is an option to consider.

--Gordon Pape

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What’s up in the days ahead

Tim Shufelt does some number crunching and discovers a list of stocks with perfect analyst ratings but fall outside of the S&P/TSX Composite Index. Be prepared to hear about some lesser-known names the Street loves.

Click here to see the Globe Investor earnings and economic news calendar.

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Compiled by Darcy Keith

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