Of late, I've been arguing that there is a pervasive notion afoot that Canadian real estate is overvalued. But an exclusive focus on valuation could lead market participants to overlook other, more decisive, factors. I've mentioned, for example, the RBC Housing Affordability Measures indicator. But another is inflation.
People who lived through the 1970s know about this one. Back then the annual change in the Consumer Price Index soared above 10%-as did mortgage rates. Severe recessions also struck. Yet, homeowners still did very well-house prices registered double-digit gains in most years. People without hard assets had a difficult time maintaining real purchasing power and living standards.
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We seem to have forgotten about the inflation-hedging properties of real estate. Perhaps it's due to the experience over the last decade of low inflation.
Inflation risk now much more elevated
Yet, the risk of a resurgence of inflation now appears to be at its most elevated level in nearly three decades. That's due to the accumulation of crushing levels of public debt: the financial burdens of welfare programs, military spending and trillion-dollar bank bail-outs have combined to push public debt-to-GDP ratios in most developed countries to heights not seen since the World War II era.
Don't look to the taxing power of governments to bring sovereign debt back in line. As the latest Annual Report from the Bank of International Settlements states: "In most advanced economies, the fiscal budget excluding interest payments would need 20 consecutive years of surpluses exceeding 2% of GDP just to bring the debt-to-GDP ratio back to its pre-crisis level."
Central banks under pressure
When taxing capacity falls short of financial commitments, central banks usually end up printing money to buy up government debt. This is the easiest way out from under the debt mountain. Doubling or tripling taxes certainly won't win any popularity contests; neither will financial default and plunging the global economy into chaos.
When central banks print dollar bills, it increases the supply of money in an economy-which usually generates a feel-good surge in economic growth (after a lag of varying length). This is typically followed by a pick-up in inflation. Central banks may then tighten up and slow the economy down, but with so much debt lying around, they are restricted in how much they can pull back.
Moreover, the fear of triggering a depression usually pops up soon after the printing presses are dialled down, and central banks feel pressured to quickly resume debt monetization. The end result is that fresh rounds of stimulus are often administered at successively higher levels of inflation.
After a few years of such stop-and-go policies, central banks may be faced with a choice between sanctioning hyperinflation or depression-like the Federal Reserve faced in the early 1980s under Chairman Paul Volcker. He took a chance on the latter option. But debt levels are now much more substantial, leading some analysts to speculate that hyperinflation may be the choice next time.
Some things to do
I'm not predicting a return to inflation, only that it is a scenario against which people might want to hedge. Gold bugs like Eric Sprott, head of Sprott Asset Management, have for years recommended owning precious metals for this reason. For ordinary folk, homeownership can provide similar protection.
Some believe stocks can play an inflation-hedging role. But this appears to only be the case if inflation is low, as recently highlighted in an analysis, If You Fear Inflation, Should You Buy Real Estate?, performed by minyanville.com columnist Andrew Jeffrey. Real estate protects better when inflation is high. Besides, the volatility of stocks is often too much for unseasoned investors, and they end up selling during a market plunge.
Even in inflationary environments, renting a house can still make sense in certain situations. For example, people who have careers that call for moving frequently to other locations may be better off renting because the high transaction costs of buying and selling real estate can eat up gains.
Retirees could also consider downsizing to a rental, especially if they want to live in overvalued places like Vancouver. Alternatively, it might be advantageous to buy a smaller dwelling where prices are low, like in the United States or parts of Canada such as New Brunswick.
Real estate may have inflation-hedging properties, but it shouldn't be the only holding. Hopefully, monthly mortgage payments leave some income left over to diversify into assets that can hedge against other scenarios. For example, fixed-income securities, defensive stocks and blue-chip companies paying dividends can afford protection in deflationary environments.
Perhaps another way to boost diversification is for first-time buyers to purchase properties with income suites. Homeowners with space might generate extra income by subletting a part of their home.
Peering into the future is a notoriously imprecise art. Many variables are involved and sometimes the ones in the spotlight are overturned by those in the shadows. Making an all-or-nothing bet on one anticipated outcome, such as a housing crash, could pay off big but also lose big. A better approach may be to diversify bets and hedge against several scenarios. With one of those scenarios being inflation, real estate could come in handy as a hedge.