Canada's Housing Bubble

Sep 02, 2011 Ben Rabidoux theeconomicanalyst.com

Canadian GDP contracts for the first time in two years:

The big news of the day is that the Canadian economy contracted slightly in the second quarter of 2011.  While in recent weeks it's been widely suspected that GDP may come in flat to negative, that was not the case last year when most economists were predicting annual GDP growth in the 3% range.

In a post from December, I said annual GDP growth will likely come in close to 1-1.5% with GDP recording negative growth later in 2011:

"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."

So far, the weakness is being driven by slumping exports and, to a lesser degree, weakening consumer spending here at home.  Most people look abroad for the source of Canada's current economic weakness.  My concern is that, while foreign economic malaise will certainly impact Canada, the real threat lies in Canada's over-dependency on real estate to directly and indirectly drive and sustain employment and GDP growth.

Let me highlight a comment made in yesterday's comment section:

"Being underwater but hang(ing onto) a job to pay the bills is what matters. Focus on job loss, not how people spend"

This mentality is prevalent, unfortunately.  It implies two things:  1)  A real estate correction is unlikely because of Canada's strong job market, and   2)  Even if there is a housing correction, it won't be bad since employment is strong.  I would take a decidedly different perspective.

Housing's direct role in supporting Canadian GDP:

The graphs below speak for themselves.  The Canada's housing obsession has seen housing starts outpace demographic demand only to be absorbed by a rising ownership rates across all demographics.  In other words, there has never been a higher proportion of Canadians buying and owning real estate.  As a result, real estate-related industries now drive a disproportionate share of economic growth in the country.  Note that all of these measures experience marked deviation from their long-term mean starting around 2003.  We'll come back to that in a moment.

This boom is itself a product of rising house prices, evidenced by the rise in per-capita home sales and mortgage loan approvals, both of which sit at historic highs, and both of which also began their deviation from long-term trends around 2003.  House prices are pro-cyclical.  They experience feedback loops whereby rising house prices encourage more market participants, create an expectation of future price gains based on extrapolating current trends, and drive up demand and willingness to throw one's self headlong into a lifetime of debt servitude.  This in turn drives up prices.  Rinse, repeat.  This increased market participation can be seen in the following graphs, taken from a recent post on the psychology driving Canada's real estate obsession.

But understand this:  These unprecedented readings are driven and sustained by rising house prices.  Note the rise in house prices starting in 2003:

Housing's indirect role in boosting GDP:

In addition to the direct role that real estate has in boosting GDP, it also has very significant secondary effects.

Most significantly is wealth effect spending, which we have discussed here many times.  Rising house prices and rising equity levels buoy consumer confidence and in turn encourage consumer spending.  Estimates place wealth effect spending at as much as 9 cents for every dollar increase in housing values.  The Bank of Canada recently discussed this phenomenon in some detail.

A portion of this spending is driven by home equity lines of credit.  In Canada, it's been estimated that home equity withdrawals add as much as $5,500 to the annual after-tax income of the average household.  That's far from an insignificant sum.  Once again, the point here is very clear:  This additional spending filters into the broader economy, supporting GDP growth.  Much more importantly, it is a form of consumption that is driven and dependent on rising house prices.  Few people are willing to withdraw home equity to support their spending if their house is falling or stable in value.  The experience in the US is a stark reminder of this, as they have seen home equity withdrawals turn negative in the aftermath of their housing correction.

Source.

For more on this topic, check out, 'Lessons from Texas' or 'BMO on HELOC growth'

In addition to wealth effect spending, we can also see the role that rising house prices have played in boosting home renovation spending, now at unprecedented levels relative to GDP:

And, as I have discussed recently, this spending occurs primarily when people feel that there will be an excellent return on their renovation 'investment', but slows in the aftermath of a real estate correction as home equity shrinks, limiting access to the lines of credit often used to fund these investments, and as home owners become unwilling to put money into their depreciating asset.

Housing's role in boosting employment:

We can't quantify the level of employment directly supported by additional wealth-effect spending.  I'd suggest it is significant, but it would be difficult, if not impossible, to quantify.  However, we can examine the proportion of employees working in the construction industry.  And we have.  We've shown that housing starts are correlated to house prices for all the reasons mentioned above.

And we've shown that construction employment is at or near record high proportions in all provinces.

Let's now combine the construction industry and the FIRE (finance, insurance, real estate) industries and plot their employment growth relative to all other industries in Canada.  Their disproportionate contribution to employment gains is immediately evident:

Clear enough? The Canadian housing market is indeed vulnerable to a recession caused by economic weakness abroad, but the Canadian economy is far more at risk of a housing market correction.  Let's not put the cart before the horse.

-Ben