Canadian Cool Down

Canadian Cool Down

Bricklin Dwyer - Market Economics
US Daily Spotlight | 09 May 2013 00:20 |

The housing market in Canada continues to be the most significant risk facing the economy. While the economy is closely tied to both US economic (mostly autos and housing) growth and global commodity prices, the Canadian consumer has been the driving force behind economic growth, making up over 54% of GDP. In spite of the lacklustre 0.7% q/q saar and 0.6% rates of GDP growth in Q3 and Q4 last year, personal consumption expenditures contributed 1.5pp to growth each quarter and kept the economy expanding. Despite this persistent strength in consumption, growth in disposable income and residential investment has slowed substantially – pointing to vulnerability in consumer demand.

Residential investment contracted by 0.2% over the final three quarters in 2012. The decline picked up steam in Q1 with housing starts contracting at a 44.8% q/q saar pace, while April starts suggest that Q2 has begun on weak footing with a rebound of just 0.3%. The drop in residential investment has had a muted effect on home prices thus far; however, if demand and values fall further, consumers will likely slow their consumption. The drop in residential investment comes at a time when growth in disposable income is slowing (now just 1.3% q/q saar), and consumers have dipped into their savings in order to continue to spend at the same pace (the savings rate was 3.8% in Q4, down from 4.5% in Q2 2012).

The cooling in housing has been engineered by policymakers. Tighter lending standards that have been imposed on four occasions by the federal government and the national bank regulator (OSFI) over the past three years have resulted in more high-quality loans that are explicitly backed by the government’s mortgage insurance (CMHC).

Aggregate home prices, residential mortgage credit growth, sales-to-new listings, months of inventory, credit lending standards and loan-to-value ratios have all shown the effects of the end of the housing boom.

However, a few hot spots remain. In 2012, home prices relative to disposable personal income increased at the fourth fastest rate relative to income in the past 22 years – with the average home price 1.73 times the average income. The Teranet – National Bank measure of national home prices, our preferred index, slowed to 2.5% y/y in March, which is the slowest pace since November 2009, and substantially off the most recent cycle peak of 7.4% in September 2011. However, in Calgary, Quebec and Toronto, prices are still increasing at around a 5-6% pace, while prices in Vancouver have begun to fall. Some markets may be cooling, but others still have a way to go. Toronto looks like a market that is more stretched than others; given the boom in condo construction, we see the greatest potential for oversupply and correction here. However, many of these condos were purchased by foreigners with cash, suggesting less vulnerability for the domestic economy and banking sector to a correction.

The best-case scenario that has been playing out thus far is a slow correction in housing demand and prices that does not shock personal consumption. However, the risks are to the downside. Consumers have a debt-to-disposable income ratio of 167.1%, pointing to risks of a larger and more painful correction if prices decline more substantially.

This Friday, we will get the April employment report where we expect to see a small bounce-back after the 54.5k plunge in March. Construction employment has been an area of strength as of late, contributing nearly 55% of total jobs created in the last six months. This sector has averaged 6.7k new jobs over the past six months, in spite of the 9.3k decline in March. We expect the strength in construction employment to slow in line with the reduction in housing starts, and the question becomes whether another sector takes its place or whether job and income growth slows further.

The Canadian banking system functioned during the 2008-09 global financial crisis, and the drastic 425bp reduction in the overnight rate kept consumers and businesses borrowing. This contributed to the housing boom, and now the Bank of Canada and the government are faced with the task of taking away the punch bowl. We expect the BoC to leave interest rates unchanged and watch the housing market evolve. The Bank is pleased with the orderly cooling in housing brought about by macroprudential measures. The BoC stands ready to tighten policy if housing reaccelerates, but they are also ready to implement unconventional easing measures if the economy slides into recession. Our base case is that neither of these risks will materialize, and we continue to expect the BoC to leave its accommodative monetary policy in place until at least mid-2014.

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