Canada's Housing Bubble

Dec 16, 2010 Ben Rabidoux financialinsights.wordpress.com

After Canada’s GDP posted a ‘surprisingly’ low 1% annualized growth rate in Q3, with September readings turning negative, economists went back to the drawing board to update their economic forecasts.

Yesterday TD released its updated quarterly economic forecast.  It provides some interesting thoughts, though I certainly don’t agree with all of their views.

Here’s their GDP forecast:

You’ll note that they believe the economy will continue to grow and will post remarkably stable GDP readings in the 2.5-3% range despite the recent volatility.  I have a hard time believing that such stable GDP readings are likely.  As I’ve often noted, the pronounced jump in GDP in late 2009 and early 2010 is almost entirely attributable to three factors:  House price increases, which created additional wealth effect spending and expanded credit; stimulus spending by the government; and inventory restocking by businesses.  You can see that consumer spending and government spending were the main catalysts that propelled GDP back into positive territory.

The problem is that these are not sustainable going forward and it’s why I see significant economic weakness set to manifest itself in the broader economy.  I’m predicting that once consumer spending turns lower, HELOC growth normalizes or turns negative, governments embrace more austere budgets, and housing starts normalize, we’ll see negative quarterly GDP growth.  I expect this later in 2011, though if demand for housing and mortgages continue to show a strengthening trend, that may be pushed back by one or two quarters.  As is so often the case in economics, the end result can be fairly obvious, but as the trend is driven by the animal instincts of mass psychology, nailing the timing is the tricky part.  Nevertheless, I’m standing by my prediction of negative quarterly GDP growth later in 2011.

Let’s look at the big drivers of economic growth one by one to see where the problems lie:

Consumer spending:

TD forecasts consumer spending to grow at a 2-3% annualized clip over the next 9 quarters.

I view that as highly unlikely, though certainly not impossible.  My conviction is that consumer spending will begin to slow markedly as consumers wrestle with their significant debt burdens, now measuring nearly 150% of personal disposable income.

The growth in consumer debt levels is not sustainable.  They are now well above any other prior peak and must be repaid.  This implies that demand and spending must be reduced as income is diverted back towards debt repayment.  Societal credit expansions that outpace income growth and inflation have the net effect of pulling demand forward, leaving an inevitable demand gap at some point in the future.

Consumer spending currently makes up over 65% of GDP though the long-term average is closer to 55%.  A reversion to that mean would virtually assure negative economic growth and higher unemployment unless spread out over a long period of time in which other components of GDP pick up the slack.  Given the propensity of the masses to think as a collective, the risk of a large-scale abandonment of the consumer mentality is significant.

The slowing in consumer spending will likely be initiated in one or a combination of three ways:

1)  Consumer debt reached extreme levels (possibly as high as 160% of PDI) if interest rates stay low and consumers stay dumb.  Demand fatigue sets in as servicing costs consume increasing proportions of disposable income.2)  The Bank of Canada raises interest rates more than a token amount.  I doubt this will happen as the Bank knows it will choke off the ability of businesses to borrow on the cheap.  In addition, it’s quite unlikely that CPI will trend above the 2-3% target.  Carney also knows that raising interest rates would cause capital inflows, raising the Canadian dollar and further restricting out hurting exports.  Technically that’s not supposed to play into their decision, but I have a hard time believing they wouldn’t consider it.3)  Consumers experience an ‘asset shock’ whereby their net worth unexpectdedly constricts.  Downward pressure from commodities prices if China moves to rein in inflation would certainly hit the TSX hard.  Likewise a significant decline in one of the big US exchanges, which continue to show signs of over-extension, would likely pull on Canadian net worth.  Far more likely is a drop in home prices.  Real estate makes up 50% of the net worth of Canadians and substantially more for newer homeowners.

I see the third possibility as the most likely, and I see the most likely shock coming in the form of a decline in house prices from current lofty levels.  Remember that the ‘wealth effect’ is strongest with real estate appreciation, estimated at 9 cents additional spending per dollar increase.  A small drop in house prices as is being predicted by the big banks will have the effect of reducing home equity extraction via HELOCs, which has added almost 9% to average household income in the past year.  A more substantial drop in house prices as I suspect is in the cards will have a much more significant effect in choking off HELOC demand, which is highly correlated with home price increases as can be seen in this graph of home equity extraction in the US.  You’ll note that the peak US house price was in 2005.

home equity extraction US HELOC

Demand for lines of credit here in Canada has soared as house prices have increased, giving people access to cheap, secured sources of funding via HELOCs.

I’ve had people argue that home equity extraction is benign as it is likely being spent on home renovations, which should add equity.  It’s a moot point within the context of a discussion of GDP growth and employment prospects.  First, while there is evidence that a portion (though certainly not all) of the funds have been spent on renovations, particularly with the tax incentives offered earlier in the year, it doesn’t change the fact that these funds entered the economy, artificially buoyed growth and employment, and now must be repaid.  This is the feedback mechanism that I often discuss.  It looks benign until it works in reverse.

The bottom line is that while TD sees consumer spending continuing to boost economic activity over the next couple years,  I view that as highly unlikely.  Given that this represents the lion’s share of GDP growth, the entire debate about future growth prospects hinges on this point.

Government Spending

Extrapolating the trend in GDP growth during a period of record peace-time deficit spending gives highly misleading results.  Austerity is in our future, either willingly or forced on us by the bond market.  Recent remarks by Jim Flaherty and the recent surge in popularity by the newly conservative Conservatives suggest that mild austerity measures are as close as the next budget.  Needless to say, government spending will have a negligible effect on GDP growth going forward.  On this point, I am in complete agreement with TD.

As an aside, Glen Hodgson, Chief Economist for the Conference Board of Canada recently wrote an  article titled, “Welcome to the New Age of Fiscal Austerity“ where he noted the following:

“A serious and credible voluntary plan to balance the books inevitably means fiscal austerity in some form – a combination of spending cuts and tax increases — even if this means a withdrawal of fiscal stimulus while economy is still fragile.”

“But an involuntary solution to high and rising public debt is even uglier. Without a clear and credible plan to address the issue, financial markets may eventually take control and force countries into fiscal shock therapy…”

“Canada is not immune to the new age of fiscal austerity; re-balancing the books federally and provincially will be extremely challenging, involving tight spending measures and in some cases, tax increases…So the new age of fiscal austerity has arrived, for all of us.”

Those in the public sector may wish to take note:  Lean times are coming.

Inventory Restocking

After the great credit crisis in 2008-2009, businesses (wisely) predicted a sharp decline in demand for their goods and services and cut back accordingly.  They were caught flat-footed when the Bank of Canada was able to rekindle consumer spending by cratering interest rates.  As a result, there was a surge in production and a restocking of inventory.

This is clear in the Q3 GDP data where business inventory investment totaled $17.5 billion, up from $15 billion in Q2 and $4.8 billion in Q1.  While this has added some nice buoyancy to recent GDP readings, this restocking phase will last only until inventories are replenished and/or consumer demand once again shows weakness.  It is likely that the inventory readings will be more muted in Q4 and should return to their baseline by mid 2011.

Bright Spots for the Economy

1)  A weaker loonie?

The biggest bright spot I see for economic growth is the prospects for a short-term reversal in US dollar weakness.  As I’ve said many times, the overwhelming consensus is that the USD will continue to weaken with the Canadian dollar sitting near or above parity.

Given the ongoing fiasco in Europe, I think a capital flight out of the Eurozone is likely once people finally concede that the Eurozone experiment is doomed in its current form.  That capital flight will likely find its home in the defacto safe-haven currency the USD.

This should make our exports more attractive, though the strengthening of the USD and the associated decline in commodity prices will affect the value of some of our exports.

2)  M&E investment by businesses

In the aftermath of the credit crisis, businesses investment plunged.

As demand has rebounded and interest rates have remained low, businesses have been quick to up their machine and equipment spending.  This has provided a nice goosing in GDP readings of late, as it has surged almost 29% quarter-over-quarter and 17% year-over-year in Q3.  M&E investment should remain relatively strong in the coming quarters, though  I question how much business spending will retrench if consumer demand dwindles.  Therefore, TD’s prediction that M&E investment contribution to GDP growth will continue to increase at 1 to 2% annualized over the next couple years may be a bit generous, but we’ll see.

In general, I am far less optimistic about the economic prospects for Canada than many economists are.  By far my biggest concerns centre around current consumer debt levels and how these debt levels are congruent with sustained consumer spending at 65% of GDP.  It should be obvious that debt levels that outstrip income gains are in-congruent with an increasing share of GDP growth being borne by the consumer.  How consumer debt levels can normalize without putting significant strain on economic and employment growth is a mystery to me.

Cheers,

Ben