The Canadian economy is double exposed regarding a downturn ahead. First, there is the impact that this year’s surge in interest rates will exert on debt-heavy household balance sheets. Big hit here to domestic demand.
Then tack on the high and rising prospect of a global recession — a double whammy since we export 33 per cent of our gross domestic product versus 12 per cent in the U.S. The Bank of Canada has hiked 400 basis points since March. In the past, such a massive rate shock triggered eight recessions, and just one soft landing.
The yield curve has now inverted to the tune of 90 basis points for the 2s/10s spread. This is the best leading economic indicator there is. Historically, this presaged eight recessions; again, just one head fake.
We went into this rate shock with the most leveraged household balance sheets of all time… $72,000 per capita versus $67,000 a year ago and $24,000 two decades ago. The consumer price index has risen 21 per cent while household debt has ballooned 274 per cent since the early 2000s, so this is not about an inflation debt build-up. It was about jeopardizing the consumer balance sheet, borrowing today for conspicuous consumption, and speculative fervor in residential real estate at the expense of future economic growth. The time to pay the piper begins in 2023.
One last item to note: the Bank of Canada just published a report on the labour market … and it is amazing it got printed. The report concluded that the U-rate will go up by 1.5 percentage points from its current level of 5.2 per cent — again, eight recessions, just one head fake when this has happened in the past (will be equivalent to 150,000 job losses next year). So let’s call it a 90-per-cent chance of recession in 2023.
Massive debt and housing bubble
Consumer debt is so out of control that even with a 3.75 per cent policy rate, the amount that Canadians spend on total debt service drains more than 14 per cent out of after-tax income. And that was before the central bank hiked rates by 50 basis points again on Wednesday.
It’s not the interest as much as the level of the principal payments, but let’s just point out that the total debt service-to-income ratio was only 12.3 per cent in the third quarter of 1990 when John Crow had the policy rate pegged at 12.75 per cent. Yet that is what a 3.75-per-cent rate feels like today because of these super-stretched balance sheets.
The entire debt-servicing burden today is higher than it was back in 1981-82 when mortgage rates topped 20 per cent. Again, this attests to the massive principal payments that have gone along with the surge in these past several years (decades) in household indebtedness.
Let’s assess the extreme degree of the bubble that exists in Canada, both on the consumer balance sheet and in the overextended residential real estate market:
1. Homeowner affordability is the most stretched since 1990. Remember what happened when that condition bumped against a vicious rates cycle? Consider this to be a two-standard-deviation (SD) event. In other words: extreme. To mean revert this affordability ratio, we would need to have either a drop of 200 basis points in mortgage rates or a 25 per cent plunge in national home prices (or some combination).
2. The home price-to-rent ratio at 146 per cent compares to the historical norm of 78 per cent — another two-SD event. By comparison, the peak in the United States during the mid-2000s bubble was 128 per cent.
3. The home-price-to-disposable-income ratio is now at a nosebleed 135 per cent. The long-run average is 89 per cent; the U.S. peak in the mid-2000s bubble was 134 per cent. Once again, a two-SD event. Mean reversion here means a 23 per cent decline in home prices.
4. It now takes 11 years of median income in Canada to afford a single-family home. That compares to eight years in the U.S. today, and is yet another in the long line of two-SD events in this country.
5. What about household debt-to-income? Among the highest in the world at an incredible 169 per cent. The historical mean is 125 per cent. The peak in the U.S. that presaged the bubble-burst of 15 years ago was 134 per cent.
6. Residential construction as a share of GDP is at nine per cent, yet another two-SD event. That’s a near-record level and far above the norm of six per cent. It’s also double the current U.S. ratio, which hit a lower peak of seven per cent when homebuilding went rampant in the mid-2000s.
7. As for housing as an asset on Canadian household balance sheets, try this on on for size: 55 per cent of total household net worth is in residential real estate, versus 30 per cent in the U.S. now and 39 per cent at the 2006-07 bubble peak. Yet again, a two-SD event.
Not a housing supply problem, but supply relative to demand
Here is the truth as opposed to the myth we constantly hear about “supply shortages” in Canadian housing (how can that be when residential construction relative to GDP, at nine per cent, is near an all-time high and is far above where this ratio is in the rest of the world?).
Canada spent almost twice as much on housing ($145 billion) in the past year than on business capital spending ($74 billion). That’s a near-record gap, and approximately three times the historical norm.
There has been no growth in the productive capital stock for the past decade while the residential capital stock is up 14 per cent. No growth in the private-sector, non-residential business capital stock; no capital deepening since 2011.
As a result, productivity in Canada (with little capital deepening) has been flat or down in eight of the past nine quarters and is near a three-year low. That has pushed the Bank of Canada to steadily reduce its estimate of potential real GDP growth to a puny 1.75 per cent for 2022. That’s it? What we do have is population growth of 1.6 per cent. In other words, potential growth would be negative given the trend in productivity. What an economy.
Everything in the Canadian economic story boils down to population growth, but even here, the population would be declining absent the unprecedented immigration boom. The immigration influx is now running at twice the annual average of the past 30 years. With natural population growth in decline, the immigration boom has exerted an enormous offset, and it’s also exerting strains on the housing market.
Consider this: population growth this past year in Canada is 1.6 per cent, which is higher than the U.S. (0.1 per cent), Australia (less than one per cent), the United Kingdom (0.6 per cent), Italy (-0.5 per cent), Japan (-0.5 per cent) and so on. Of all industrialized countries, only Iceland, at 2.4 per cent, has stronger population growth than Canada.
Here is what we have on our hands: Canadian birth/fertility rates are at 30-year lows, so there’s no natural growth in the population. Yet the immigration boom has boosted annual population gains to 703,000 people, 190,000 higher than the 513,000 average of the past 20 years. No wonder we have a housing bubble of record proportions (aided and abetted in years gone by due to super-accommodative Bank of Canada policy).
If you want the best cure for the housing affordability crisis, outside the huge run-up in mortgage rates, maybe the federal government should consider cutting immigration by 190,000. Looking at the supply side, housing starts have averaged 270,000 units annually in the past two years, which is a record. Starts just don’t get higher than those in Canada — that is 1.6 million in comparable U.S. terms. Canada also has 1.5 million construction workers gainfully employed — also a record and 100,000 higher than was the case five years ago. In the past five years, employment in construction is up seven per cent, while it’s flat in manufacturing and grew less than one per cent in the resources sector. A record eight per cent share of employment is devoted to construction; the average is closer to six per cent. Similarly, residential construction expenditure represents nine per cent of Canadian GDP compared to the long-run norm of six per cent and the current 4.5 per cent share in the U.S.
Here’s a question for our beloved government officials: Are we importing any construction workers in this massive immigration inflow? After all, while we do have record construction, we still somehow have an alleged supply shortage.
The bottom line
We have a situation where Canada has stagnant-to-negative productivity growth because of years of neglect in the private-sector, non-residential capital stock and a lack of business investment. This has forced the Bank of Canada to reduce its estimate of potential non-inflationary growth to barely more than one per cent. All the growth on the supply side and then some is coming from population growth, not natural growth, but record immigration, which causes housing demand to instantaneously rise since the first thing immigrants need is a roof over their heads.
Looking at the numbers, if we are to curb the housing bubble outside of using aggressive interest rate increases, which just produces a different sort of affordability problem, then we either need to double the level of housing starts from their already record high levels to 550,000 units, or we need to cut our immigration targets, which would still leave them at record highs but reduce the demand growth that has generated this price bubble.
All that said, by more than doubling the inflow of immigrants, while laudable on many fronts, notably the humanitarian aspect, the government has ended up aggravating the home-pricing bubble, which has left the Bank of Canada in the unenviable position of pricking this bubble.
The good news? Renters who have been forced to sit on the fence for years will finally have their chance to hop into the housing market at much cheaper levels … and this time next year, the central bank will be forced to cut rates again to combat the recession and ensuing deflation that will come with the downturn.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website.
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