Just So We Are Perfectly Clear - Canada Has A Major Problem
Summary
- The Bank of Canada just raised the key interest rate by 25 basis points because of strong economic fundamentals.
- Investors should not be misled into thinking that there is anything but trouble on the horizon for Canada's economy.
- The Canadian consumer is leveraged beyond belief and house prices are ridiculously priced relative to income.
A decade ago I thought that Canada (EWC) was in the catbird seat.
First, it seemed all but certain that we were headed towards a future of steadily rising (if not spiking) oil prices.
Canada, which was sitting on mountains of barrels of oil in the tar sands seemed to be on the verge of a 50 year boom.
Second, while the U.S. banking sector was falling apart the Canadian banks stood tall thanks to their responsible lending practices.
Yes, the future looked bright. There was a long term economic catalyst and there was a rock solid banking system.
My how things have changed.
This week the Bank of Canada raised its key overnight lending rate by 25 basis points from 0.50 to 0.75. The reasoning for the decision was a quickly improving economic outlook and a stated primary desire to always keep inflation under control.
The Canadian dollar has responded to the Bank of Canada hinting at and then instituting this increase.
Source: XE.com
That is an eight percent swing in roughly a month which is a big move for a currency.
Don’t bet on it continuing. This country has a huge problem with respect to real estate and the debt that is directly tied to that. There is no way that the Bank of Canada is going to be moving rates higher in any meaningful way.
The Canadian housing and debt situation is going to be an anchor on this economy for a long time to come. If it isn’t it is only because the problem has disappeared in a shorter time period through a major housing crash.
Let me show you what Canada is facing through a series of charts.
The first chart makes very clear what has happened in the Canadian housing market. The chart plots Canadian housing prices versus the United States.
Source: Bloomberg
Follow the blue line that is Canada. The country has had housing market crashes previously, in the early 1980s and early 1990s. The Canadian and U.S. markets got to roughly the same point in 2007 when the U.S. housing bubble popped and prices crashed.
Canadian housing prices paused but didn’t crash, and then kept on accelerating higher. The percentage increase in just the past couple of years in Canada is absurd, especially considering how much prices had already risen before then.
The actual housing price changes aren’t what matter, it is the affordability of housing for Canadian residents. As you would expect, on this metric Canadian housing looks terribly expensive.
Source: The Economist
Relative to average income, Canadian housing is more than 50 percent more expensive than where it was in the year 2000 (which was a normal level). To come back down to that level is going to require a massive correction or years of stagnant home prices allowing income to catch up.
If you follow the Canadian housing market at all you will be aware that this housing bubble exists across the entire country. The vast majority of the bubble is in Vancouver and Toronto.
The graph below shows how Toronto’s average house price stacks up against average household income.
Source: Toronto Real Estate Board
Today the average house price is nearly 10 times average household income. The historic norm prior to our last decade of near zero interest rates was roughly 3.5 times.
That means Toronto house prices could be cut in half and still be expensive relative to historical norms. That is a frightening thought.
Vancouver, by the way, is worse with a price to average income closer to 12 times.
Canadian housing prices are very high - there is no disputing that. There is also no disputing how those prices got to where they are: Canadian have leveraged up in a massive way.
The chart below compares Canadian household debt as a percentage of disposable personal income against the same figures for the United States.
Source: Jerome Levy
How can you be bullish on the Canadian economy when you see how much Canadian people have already leveraged up to purchase their expensive homes?
The average Canadian is more than twice as leveraged as they were in the 1980s. The average Canadian is 60 percent more leveraged than the average American.
To make matters worse for Canada, consider how much more important housing is for the economy than it is in the United States.
Source: Deutsche Bank
Almost twice as many Canadians work in housing construction in Canada than in the U.S. That makes sense given the incredible boom that the country has had.
And The Bank of Canada Is Starting To Raise Rates?
Canadian housing prices probably should have popped like they did in the United States in 2008. They didn’t, and have soared significantly higher.
The Bank of Canada just raised rates by a quarter point and have hinted that there are more increases to come. Please look at the charts presented above and tell me: how they can possibly do that without crashing the housing market and the entire economy?
The implications for investors in my opinion would be as follows:
- Exposure to the Canadian dollar likely isn’t a great idea
- Exposure to companies with significant exposure to the Canadian economy also likely isn’t a great idea
- Exposure to the Canadian financial sector likely isn’t a great idea
- Exposure to Canadian housing prices or the Canadian housing industry likely isn’t a good idea
I realize that people have been talking about the Canadian housing bubble for a long time. That doesn’t mean that it isn’t a dangerous bubble; it just means that predicting when or how it ends isn’t easy.
Perhaps the Bank of Canada rate hike is the catalyst that pushes the panic button for Canadian real estate owners.
Head on down to the comment section and let’s discuss this further. Click “follow” up top if you’d like to get my future articles.
Thanks for reading.
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Comments (242)
ye, ye. they are in guessing mode......the rate hike was just window dressing, nothing more. their goal was to prop up the lenders with higher rates on the sell side. plus the market is quite fragmented and not efficient enough.
ye, ye. Canada is desperado for foreign investments (direct and portfolio). all fresh investments are welcome. the market is still underperforming, so the need for fresh capital injections is quite present.
One MJ company is buying a town in CA and going to turn it into a MJ destination.
ha ha. they go South/East for "procedure".... too cheap and better quality/speed.
ha ha. put the BC homeless folks there.........problem solved.
Maybe the crack shacks. That should work , they wreck everything anyways.
