By Carl Gomez
Canada’s swift recovery from the Financial Crisis in 2008 and subsequent leading performance among advanced countries is certainly well-known by now. However, momentum in the Canadian economy began to fade over the last few years. The labour market has cooled to its weakest non-recessionary pace in nearly 20 years while the trend rate of real GDP growth has barely managed to exceed two percent. This year, growth is not likely to even reach that modest pace.
This slowdown should not be surprising given that Canada’s business cycle is somewhat longer in the tooth than most other advanced countries. But there are also a number of fundamental factors behind the loss of momentum. For example, after stretching to do much of the heavy lifting coming out of the recession, the domestic side of Canada’s economy is showing signs of restraint due to exhaustion. This is reflected in the more frugal pace of consumer discretionary spending as households cope with record high personal debt levels. Meanwhile, the federal government has also pulled back on spending to help bring balances back into surplus in time for an election later this year. Lastly, but perhaps most importantly, softer commodity prices, especially oil, has prompted Canadian businesses to simply become more cautious with hiring and investment, particularly in the energy-dependent province of Alberta. Where does Canada go from here?
While a technical recession (defined as two consecutive quarters of negative growth) may be a reality for the Canadian economy in 2015, it’s important to note that there is only one sector (albeit a very large one) that is in full-blown contraction mode right now – energy. With oil prices unlikely to break into the $70 range anytime soon (due largely to a global supply glut), most non-traditional oil producers in this country will find it “uneconomic” to continue investing in new developments. Given this new global environment of “abundant oil”, capital expenditure cuts in the Canadian energy sector will be quite deep and this will weigh most heavily on the energy-dependent provincial economies of Alberta, Saskatchewan and Newfoundland.
But there is room to be more optimistic in other non-commodity segments of the Canadian economy and by extension, other regions of the country. With the Canadian dollar sitting below its purchasing power parity level of 86 US cents, traditional export-oriented sectors such as manufacturing and tourism (which are largely concentrated in Central Canada and BC) are better supported. This is especially the case, considering that growth is becoming more firm south of the border – the key destination for most of what Canada exports and where most of its tourists come from. The expected “rotation” of growth drivers away from domestic demand and towards this external side of Canada’s economy, should ideally support moderately better overall growth prospects for Canada as it heads into the second half of the decade.
To be sure, this sanguine outlook remains more “forecast than fact” since we have yet to see much of a turnaround in manufacturing and exports as of yet. To help move the expected rotation along, the Bank of Canada (BoC) is likely to remain extremely dovish with monetary policy. While the US Federal Reserve has made overtures about normalizing monetary conditions in that country, the BoC appears to be leaning toward further monetary accommodation through rate cuts if necessary. The resulting difference in cross border interest rate expectations (along with the sustained weakness in oil prices) will likely have the “de-facto” effect of putting further downward pressure on the loonie, thereby enhancing the support for trade-sensitive sectors in Canada.
Notwithstanding the Fed’s intention to begin moderately hiking its policy rate, it’s important to note that most central banks in the advanced world, not just in Canada, remain focused on keeping monetary conditions very loose. While this is certainly due to the heightened risk of potential exogenous shocks (including the threat of a “Grexit” - Greek Exit), it is also fundamentally due to a lack of any meaningful inflationary pressure given the excess economic slack enveloping much of the developed world. As a result, interest rates in most advanced economies, including Canada, could remain at historically low levels for some time.
Where do these economic trends leave Canada’s housing market? Unlike many advanced countries, Canada never suffered a housing market meltdown during the Financial Crisis mainly because our mortgage markets continued to function well. So while other countries were working hard to “reflate” their housing markets over the post-Great Recession period, ours continued to grow thanks largely to the availability of inexpensive credit.
However, housing activity has recently begun to cool across much of the country. Home price growth has slowed to rates just ahead of inflation in many Canadian cities outside of Toronto and Vancouver while new residential construction has slowed as well. This softening trend is currently more amplified in the typically volatile Alberta market as its housing sector is now contending with the recent collapse in oil prices. But as long as interest rates remain low, credit markets remain healthy and unemployment doesn’t jump significantly, much of Canada’s housing market is likely to remain on the path of a “soft landing” as house price growth continues to slow.
This is good news since many commentators (mostly foreign) point to an increasing risk of a housing market crash in Canada largely due to excessive price valuations. For example, “The Economist” magazine, Deutsche Bank, Goldman & Sachs and the OECD (Organisation for Economic Co-operation and Development) (to name a few) suggest that Canadian house prices may be overvalued by anywhere between 30-60 percent. However, these overvaluations need to be put into context. First and most importantly, “overvaluation” does not necessarily equate to an “irrational price bubble”. Despite higher home prices, affordability remains at very favourable historical levels across Canada thanks to record low mortgage rates. As such, Canadian consumers may be simply acting rationally as they use cheap debt to purchase appreciating assets.
Second, these valuation estimates (which typically compare average home prices to average rents) tend to slap a single “average” number onto a very diverse Canadian market, both in terms of region and housing type. This effectively exaggerates the degree of overvaluation. For example, average Canadian house prices used in the numerator of most valuation estimates are skewed by two of Canada’s largest and fastest growing markets: Vancouver and Toronto. And within those two markets, price estimates are further skewed by expensive single detached homes, which are increasingly limited in supply relative to demand in these two cities. If these single detached homes are stripped out of average price estimates, home price growth in Vancouver and Toronto would actually be about as tame as the rest of the country. QUOTE BOX
There are also two key problems with the denominator (rents) used in housing valuation measures for Canada. First, average Canadian rental data is largely sourced from old, relatively worn out apartment buildings, not single detached homes. Second these older apartments are often subject to “rent controls” which limit the rate at which rents can actually grow. This qualitative issue with the rental data results in an “apples to oranges” comparison and significantly overstates the degree to which house prices in Canada have increased relative to underlying effective rents. QUOTE BOX
To be sure, this “measurement problem” doesn’t discount the risk of potential imbalances in other parts of Canada’s housing market. Condo development, particularly in the urban areas of Vancouver, Toronto and Montreal, continues to run at very high historical levels. Buyers of this product are increasingly unsophisticated “mom and pop” investors who are seeking speculative price gains rather than owner-occupiers who purchase units to live in. As such, the supply of new condos may be running well ahead of fundamental demand. In the long run, this imbalance could result in potential price declines within this segment of the market, especially if interest rates materially increase and cause speculators to suddenly “walk away”.
When interest rates do eventually normalize and Canada’s economy gains more momentum, the long run prospects for the country’s housing market will largely be dictated by demographics and land use/transportation policies. Real estate markets with the best prospects for future growth are those that can continue to attract people from both home and abroad. Generally speaking, Toronto, Vancouver and Calgary fit this criterion. But within these large growing urban areas, relative location will also increasingly matter. Well located properties with easy access to major transportation nodes, so that people can easily integrate “living working and playing” into their lives, will provide the main foundation for durable real estate values over the long term. Quote box
Carl Gomez is Senior Vice President & Chief Economist at Bentall Kennedy. With over fifteen years of business and academic experience, Carl provides management and clients with strategic insight into the impact of emerging macroeconomic and capital market forces on real estate investment markets in North America. He is also responsible for leading Bentall Kennedy’s Canadian research initiatives including portfolio and asset management strategy.