Last week, I covered how certain areas in the U.S. are overvalued and likely to see prices decline when interest rates rise. I don't expect a meltdown on the scale of 2008 but recommended avoiding any banks, homebuilders, and mortgage companies with concentrated exposure to the California, Nevada, Washington, Oregon, and Florida markets. You can read the original analysis here.
Several commenters mentioned Canada, so I decided to look into the data on Canada's housing market. What I found could be disastrous. The issue also seems to be getting a fair deal of attention on both sides of the border as Canada's housing bubble has reached epic proportions. If this develops into a full-blown crisis, then Canadian stocks could dramatically underperform U.S. stocks over time.
Mortgages in Canada are typically adjustable rate
Homebuyers by the millions are piling into housing, with quickly rising prices and adjustable rate mortgages with low-interest rates. Unlike the United States, which heavily promotes homeownership through government policy, Canada has never set monetary or fiscal policy to explicitly favor homebuyers or encourage people to buy homes, and as such, the majority of mortgages in Canada carry a 5-year balloon and a 25-year amortization. Canada was spared from the housing crash the first time around in 2008 because there were never a significant amount of subprime loans made in Canada. I found a great article from the Cleveland Federal Reserve on this, which I highly recommend you read. However, this time around, adjustable rate mortgages and sky-high prices mean that Canadian consumers will feel the full force of interest rate hikes. On a million dollar mortgage, a 2 percent rise in mortgage rates will cause the payment to go from roughly $5,550 to $6,750, nearly a 22% increase. If this happens, which is likely given that the central bank in Canada hiked rates again in the last week, properties will flood the housing market in Toronto, Vancouver, and other major cities.
Historically low rates caused a surge in prices
With continued breakneck property appreciation and a looming surge in interest rates, Canada has set the stage for a housing crash that will rival the U.S. in 2008. The median Canadian household makes about what the average U.S. household makes after the exchange rate is factored in. However, they are more indebted and have higher home prices.
However, prices have risen past the ability of consumers to purchase. The cracks are already starting to show in the Canadian market. Toronto prices are in freefall now. Vancouver is also starting to see the first wave of price declines. This is only the beginning of the roller coaster ride for Canadian housing prices. As interest rates continue to rise, things will go from bad to worse. Buyers will not be able to buy at current prices even if they wanted to, and sellers will be hit with both larger payments to make as well as a difficult market to sell. Interest rates haven't gone up in decades in Canada, so we haven't been able to see the effects recently. Mortgages in Canada are set on a 5-year balloon, so it could take 24-36 months to see how just how much chaos rising interest rates will cause. The current vintage of homeowners in Canada due for interest rate resets is the buyers from 2013. Speculative buyers who bought in 2016 and 2017 won't see their rates change until 2021 and 2022, respectively. Just as the housing market didn't bottom until 2011 after the crash, Canada's housing market could have a long way to fall over the next 3-5 years.
Here's a graph that illustrates the fall in interest rates. Basically what this means is that when every vintage of homeowners in Canada reset their mortgages over the last 20 years, their payments were adjusted downward. Now, with interest rates at rock bottom and nowhere to go but up, consumers face the prospect of their payments going up, not down like in the past. You can some excellent and original analysis here from HuffPost Canada.
The days of low rates in Canada are numbered
After pushing through another round of interest rate hikes this week, Bank of Canada governor Stephen Poloz was asked about what the interest rate moves would do to housing affordability. His response? Move to a smaller house. The "let them eat cake" attitude of the Canadian central bankers illustrates a few possible points. They may be popping the housing bubble on purpose for the long-term good of the economy. In any case, they are not setting policy to protect homeowners in any way, shape or form. They also have a difficult choice. To keep interest rates much lower than the United States is likely to significantly devalue the Canadian dollar against the U.S. dollar, which is bad for Canada as it imports heavily. As such, interest rates in Canada tend to move closely with the U.S. The bottom line is that interest rates in Canada are going higher and prices are starting to drop with a lot of room below to fall to. This has the potential to cause a recession in Canada and a large drop in home prices, home equity, and stock values.
The United States will be fine
Canada has a population of roughly 36 million people, which compares to California at 39 million. The U.S. has over 325 million people and the world's largest economy. The Canadian housing market is not going to take down the U.S. economy. For one, Canada's regulatory policy is not friendly to securitizing mortgages and selling them off, so you aren't likely to find huge bets on Canadian real estate in Wall Street banks' balance sheets, although Wall Street always manages to surprise. Real estate prices in Canada have run up to unsustainable levels relative to income and will need to come down. The Bank of Canada seems to be setting its policy to make this happen. The U.S. also has some overvalued markets that are due to correct, but there are many positive factors influencing the U.S. economy right now. In all, I would recommend avoiding deliberately investing in Canadian real estate or stocks over the next 12-36 months, as it is likely to underperform the U.S. as the housing bubble deflates.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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