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A bet against Canada is not so far-fetched

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Our Saturday story about hedge fund manager Vijai Mohan's bet against Canada generated an intense and sharply divided response from readers: He's either absolutely right in predicting a sharp drop for the value of the loonie and Canadian banks, or foolish to doubt their staying power. My own view is the currency prediction is likely correct. The bank short is a riskier call, but that doesn't mean it won't work.

Mr. Mohan's central argument boils down to a belief that Canada will be hit by two shocks in short succession: a housing bust, and an emerging-markets crisis. Let's start with the latter.

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A crisis akin to the Russian debt default of 1998 is a daring call, until you consider that time and again over the past two centuries, emerging markets booms have ended in tears. There are enough signs to suggest this could happen again in the not-too-distant future, Mr. Mohan argues.

Such a crisis is hard to call, and dangerous to predict … but consider Russia's overdependence on declining resource prices or the risk of an outright credit collapse in the mother of emerging markets, China. Don't believe that could happen? Read this deeply unsettling white paper by Jeremy Grantham's asset management firm GMO LLC about where China could be heading: "China scares us because it looks like a bubble economy," the authors argue, with a ballooning credit system that is fraught with "acute financial fragility."

Until now most China watchers have been worried about a slowdown in growth; an actual economic collapse would be an entirely different beast. Such an outcome would devastate already weak commodity prices, the value of the loonie and no doubt weigh heavily on Canada's economic output.

But setting the doomsday scenario aside, we've already seen the Canadian dollar – whose performance is largely linked to commodities – soften in recent months, and hedge funds have been increasingly lining up against the currency. Even without a full-blown emerging-markets crisis, that seems like a smart bet if growth from China and commodities prices continue to flag.

Setting aside a potential emerging-markets crisis there are reasons to worry about Canadian housing: Personal debt as a share of disposable income is at record levels, home prices have risen to unhealthy levels by most measures and household starts have steadily outpaced the growth of total households for years. That's not sustainable, particularly if incomes get squeezed in a deteriorating economy.

That doesn't necessarily spell serious trouble for the banks, even if prices fall more sharply than the soft landing many predict. The banks are well insulated from the unlikely event of a rise in defaults thanks to a high degree of government mortgage insurance, while even the spectre of potential regulatory changes forcing banks to raise more capital probably won't have much effect if changes are phased in gradually.

But if the economy turns sharply lower, the banks could be hit with a spike in loan losses. And while Canadian banks stocks have delivered sold long-term returns, there have been some very sharp corrections along the way – a 50-per-cent-plus selloff during the credit crisis, drops of between 25 and 45 per cent following Russia's 1998 default, and falls of between 25 and 50 per cent for some banks during the housing corrections of the early and late 1980s. Canadian bank stocks are coming off a long period of growth – largely fuelled by increasingly indebted Canadians – that will likely tail off.

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In short, bank stocks don't seem to have much potential downside risk priced in. If Canada does indeed sustain a worse-then-expected downturn or feel the impact of a global shock, bank stocks will likely take a sharp hit. The effects may be temporary – but that's all it would take for a contrarian bet to pay off.

Sean Silcoff is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Sean on Twitter at @seansilcoff.

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