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The Great Canadian Deleveraging: A Growth and Housing Crisis
Jeremy Carrier, Global Capital Markets, Senior Associate
“Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one.” (Taleb, 2009)
The Canadian economy is heading for a rough point. We are starting to see real risks play out in response to quantitative tightening not seen in decades – following a post-GFC decade of artificial growth fuelled by leverage and excess cheap debt.
Throughout this rate hiking cycle, the Bank of Canada (BoC) has been deliberately one step ahead of the Fed in combating historic inflationary pressures – hiking rates in March 2022 and pausing hikes in July 2023 – to hold the policy rate steady at 5%, less than 18 months and 475 bps of tightening later, from a pandemic low of 0.25%. The central bank has expressed that the end may be in sight, yet pricing pressures continue to raise rates expectations, with the probability of one more hike by year-end moving towards 100%.
Compounded by rising interest rates, the divergence in risks and embedded leverage between the US and Canadian systems is being understood – with the emergence of a growth and housing crisis, idiosyncratic to the Great White North.
The Indebtedness of Canadian Households
Unfortunately, Canada’s high levels of household debt, one of the highest in the G7, makes the economy vulnerable. The balance sheet of Canadians weighs heavily on overvalued real-estate assets and ever-growing mortgage liabilities.
Housing valuations have masked the pain felt by most Canadians, having been spared the housing crash south of the border. Net worth benefited as housing prices doubled in the last decade, whereas income, having not kept pace, rose only 25%. Canadians have made-up the difference between income and house prices with debt – prices outpaced savings and homebuyers borrowed the difference.
With over $1.80 of debt for every $1 of income, and 75% of this debt tied to mortgages – Canadians rank top 3 globally in Household Debt to Income and Household Debt to GDP, highlighting the key risk of debt serviceability going forward. Mortgages now result in the highest borrowing costs seen since 2007. For the 2/3 fixed rate mortgages, bank lending rates, derived from rising bond yields, are resetting at the highest rates seen recently. For the 1/3 variable rate mortgages, amortizations are increasingly being extended as trigger rates are hit and fixed payments no longer pay down principal. Where is the uptick in mortgage delinquency?
Given higher borrowing costs, there has been a dip into pandemic savings and a drop in demand broadly, slowing consumer spending throughout 2023. Monetary policy is pushing our consumption into the future.
Bank of Canada Policy Reaction Function
Stress from higher rates have started to form cracks, providing paths to a potential hard landing and recession. What will change the policy reaction function of the Bank of Canada?
Like a stool with 3 legs, the BoC monetary policy currently stands by the 3 legs of economic growth, labour, and housing – as long as these legs hold, the monetary regime will stand. We have seen the leg of growth slow considerably, while the 2 legs of labour and housing start to teeter yet have not fallen and continue to surprise.
Stagflation Rears its Head
With renewed inflation concerns, Canada is undergoing a challenging period of stagflation – defined as period of rising prices, rising unemployment, and slowing growth. On both a real and per capita basis, the Canadian economy is effectively in a recession. As GDP has contracted or remained flat for the first 2 quarters of 2023, the population has grown at a record pace, double that of the other G7 countries due strong immigration. Consequently, growth measured by GDP per capita has steadily fallen, driven by a larger denominator. Q3 GDP is expected to be no different at near 0 growth. In fact, Canada’s real GDP per Capita is forecasted to be the worst out of all OECD countries going forward to 2030 – a staggering outlook for investment in Canada. Where is growth to be found if its sectors face troubles (real estate, banking) or are divested from (energy, materials, and manufacturing)?
Resilient Canadians at Work
The labour market in Canada, with rising unemployment over 2023 (another definition of recession), has remained resilient in the face of economic troubles. After reaching a high back in May 2020 of 14.1% to a low in July 2022 of 4.9%, the unemployment rate has again been steadily rising over this aggressive hiking cycle – now at 5.5% and forecasted to grow to over 7% by 2024. Nonetheless, positive data releases and employment changes continue to surprise. Yet, they paint a misleading picture, as it can be said to represent population and labour force growth and not a better economic situation.
While the cost of debt has risen, it has been offset by rising disposable income of Canadians. The central bank fears rising wages and wage demands to help deal with rising costs will lead to a “Wage Price Spiral”, resulting in further inflationary pressure – and it will be hesitant to shift policy while this scenario exists.
As a lagging indicator, the labour market will need to see a material weakening before the BoC is likely to act to cut rates – and before any wide-spread consequences are seen to spread to the housing market.
The Fantasy and Safe Haven of Real Estate
Real estate is top of mind for most Canadians, representing >20% of national wealth, over 1mm jobs, and the largest sector in the economy. However, this housing dream has slowly become a fantasy as housing affordability has fallen over the past decade and out of the pandemic – the worst it has been since the 1980s. A fundamental driver in housing valuations bordering bubble territory has been inadequate supply. The Canadian Mortgage and Housing Corporation (CMHC) indicates over 3.5mm more housing units over and above what is being built is needed by 2030.
Housing is driving the accelerating and sticky inflation problem in Canada, as it persists through the shelter component of the CPI, with a 6% annual change reported in Aug 2023. Now with house prices starting to cool down (and expected to continue into 2024) since the high at the end of 2022 and start of rate tightening cycle, it is both a welcome sight and a prominent risk.
Uncertainty Ahead
A great deleveraging is occurring, reminiscent of the 1980s, after a similar period of high inflation and high interest rates that resulted in a housing recession. It is a pivotal time as the BoC must balance policy to prevent what may break next and to navigate out of this rates regime, still held up by the legs of labour and housing in the economy.
In the year ahead – the diverging and recessionary risks underpin Canada and there is uncertainty how it will develop. Although previously mirroring the US inflation path, expect relative real rates to be driven lower, CAD weakness to get worse before it gets better, and potential volatility to emerge.