By David Rosenberg and Alena Neiland
Canada’s housing bubble has burst. The MLS house price index is now down nine per cent from last February’s peak en route to a 30 per cent or so decline, which we view as consistent with deteriorating affordability and the uber-aggressive tightening of monetary policy by the Bank of Canada.
We estimate the negative wealth effect associated with such a price slump will pull down gross domestic (GDP) growth by about 2.5 percentage points. Add to this the deleveraging effect of higher interest rates on consumption and investment, and the hit to trade from the expected downturn in the United States and global economy, and it’s not difficult to see why Canada’s upcoming recession could be deeper than what Bay Street folks are expecting.
The last time all these factors were at play was the early 1990s, when Canada entered a Bank of Canada-induced recession
Individuals spend more when the value of their assets (for example, equities and houses) rises because they feel they are getting wealthier. This occurs through several channels: there is a behavioural aspect that translates into spending more of one’s earned disposable income, as well as an increase in credit access, a theme that has dominated in the face of persistently low borrowing costs over the past decade-plus. As homeowners continue to make regular payments on their mortgages, their credit scores improve, making them better candidates to pile on more debt.
But with the Bank of Canada’s overnight target rate having risen 350 basis points since March (with more to go), the theme of rising wealth is bound to fade as credit access dries up and real estate prices collapse. The MLS house price index is already down nine per cent from last February’s peak and the correction is far from over.
Households are being hit with a confluence of factors heading into this recession: rapid restrictions on credit access, higher debt-servicing costs on near-record-high household debt levels and inflation limiting disposable income. This is all being compounded by wealth depletion in both equity and residential markets, which also weigh on sentiment.
The last time all these factors were at play was the early 1990s, when Canada entered a Bank of Canada-induced recession and residential property prices fell by almost 30 per cent from their peak between 1989-1996.
This housing drawdown is just getting started
While consumption is set to slow because of the multitude of factors mentioned above, the wealth effect will also contribute negatively. If home prices end up falling 30 per cent from the peak — which we view as consistent with deteriorating affordability and the uber-aggressive tightening of monetary policy by the Bank of Canada — consumption would fall about five per cent (using the central bank’s estimate of nearly six cents per dollar of marginal propensity to consume due to changes in housing wealth), and this translates to a hit of roughly 2.5 percentage points to annual GDP growth.
Even if you assume Canada Mortgage and Housing Corp. is right about a more modest 15-per-cent peak-to-trough decline in home prices, the GDP hit from the wealth effect will be around 1.3 percentage points, which is still significant. Worse, there is reason to believe the overall economic impacts will be further skewed to the downside, because this analysis does not even consider the deleveraging effects of higher interest rates on consumption and investment.
While acknowledging the housing-induced negative wealth (albeit not necessarily the extent), the Bank of Canada is not about to drop its hawkish stance amid still-hot and above-target inflation. With further policy tightening in the pipeline, the overnight swap market is now pricing a peak rate of 4.25 per cent by year-end, so this housing drawdown is just getting started. And given consumers’ sensitivity to the pullback in real estate prices, Canada’s recession is likely to be deeper than what many Bay Street types are expecting.
As such, the Canadian dollar is bound to have many more months and quarters of weakness and not just because of the bear market in commodities, but also because of the serious repercussions surrounding the economic outlook from the escalating weakness in home values and the multiplier impacts on the consumer broadly speaking.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. Alena Neiland is an econoimist there. You can sign up for a free, one-month trial on Rosenberg’s website.