Canada's Housing Bubble

Jan 5, 2009 Matt Stiles examiner.com

With the kids returning to school and the regularity of holiday shortened weeks coming to a close, the investment community is back to a more normal schedule.  With them also comes a plethora of economist and pundit "prediction" pieces as well as look-backs on their past performance.

The usefulness of such pieces is debatable.  Some authors even acknowledge that the very nature of their predictions entail large margins of error.  It can typically be concluded that any "consensus estimates" are more likely to be wrong than is often admitted.  In other words, the range of estimates are fraught with "tail risk" - something that can't be calculated with mathematical models.

So many investors and money managers search along the periphery of established views.  They look for alternate interpretations of past and present, trying to gain an edge on low-probability events for the future.  It is a high-risk, high-reward game.

But for those who prefer not to try and predict the future - for whatever reason - it may be more useful to simply understand the major issues of the day and react to them as they evolve.  To this end, 5 issues are highlighted below that demand close attention for all participants in the Canadian economy.

1. Increased legislative and regulatory scrutiny toward potential asset bubbles

Record low interest rates, loose lending standards and federal directives to the CMHC (Canada Mortgage and Housing Corporation) have teamed up to send asset prices soaring in comparison with historical price-to-income and price-to-revenue metrics.  For this reason, Canada's top finance policymakers have been making noises about measures to hinder these excesses.  Should they intervene, home prices could take the first hit, especially in highly-speculative urban markets.  Watch out for potential downstream ramifications in areas dependent on continued residential expenditures.

2. Interest rates and the debt servicing burden

With plenty of excess capacity in the manufacturing sector and higher than average unemployment, most assume that inflation expectations among consumers, producers and central bankers will remain low enough to keep interest rates subdued for many years going forward.  But inflation expectations are not the only determinant of interest rates.  Default risk also has a large impact.  And with interest rates at their lowest level ever, but total debt at their highest level ever, small changes in rates have an increasingly large impact on the total debt servicing burden of the economy.  As the debt servicing burden rises, the ability to invest in new productive ventures is constrained, thus debilitating the economy's organic growth engine.  Watch for default risks around the world rising as a metric for fixed investment.

3. The Loonie as commodity currency, anti-US dollar hedge, or something else?

The recent performance of the Canadian dollar has many expecting a continuation of the trend and thus further pressure on Canadian exporters.  The perceived safety of Canada is also bringing increased foreign investment, resulting in job creation.  Factors commonly thought to affect the Loonie include commodity price direction, interest rates, economic growth and overall sentiment toward the US dollar.  Watch for one or more of these correlations to break, and many confused faces as a result.  "Hot money" foreign investors are a fickle bunch and global imbalances have a knack for invoking the law of unintended consequences.

4. Employment trends, consumption habits and the willingness to go into debt

With much of the economy's "vitality" not dependent on the production of goods or investment in productive capital, but rather on consumption, anything that effects people's consumption habits bears close attention.  Employment numbers will obviously have a large effect on this, but watch for the quality of that employment as a leading indicator.  How many hours are people working?  Are they being used for overtime hours or being given extra "holiday time"?  Are people still willing to go further into debt in order to bridge the gap between their lifestyles and their incomes?  Watch for the overall mood of Canadians in their willingness to conspicuously consume their way to happiness.  It is a deeply cyclical frame of mind.

5.  Fiscal stimulus and its aftermath

The logic behind fiscal stimulus is that government must step in to "fill the void" left by private sector deleveraging and the creative destruction process.  When this process winds down, so does the fiscal stimulus and the economy is able to grow into its higher debt burden.  In Japan, the fiscal stimulus was never followed up by a private sector expansion - the economy has not grown in 18 years.  So while Canada endures a large fiscal deficit in order to keep GDP elevated, watch for whether or not private investment takes the baton.  If it does not, and the stimulus begins to wear off, GDP will likely contract significantly - and leave a larger debt burden to boot.  Something Canadians are familiar with after similar problems in the 80's.