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April 2018 | Michael Medeiros, CFA, Global Bond Analyst

Slowing Canadian housing market prompts cautious view on current cycle

The structural and cyclical outlook for the housing market is a key factor in our overall view on the health of Canada’s economy.

Key points

  • The structural and cyclical outlook for the housing market is a key factor in our overall view on the health of Canada’s economy.
  • We see signs of structural vulnerabilities amid elevated house price valuations and high household leverage.
  • Macro prudential tightening measures combined with higher mortgage rates have worked recently to slow housing market activity and house price gains.
  • Over the near term, we are cautious on the overall economic cycle given the potential spillover effects of the housing slowdown.
  • For global bond investors, we see opportunities for the front end and intermediate points of the Canadian curve to outperform the US.

Falling house prices and growing household leverage create structural vulnerabilities

OVER THE PAST DECADE, A SIGNIFICANT APPRECIATION IN HOUSE PRICES HAS LED TO OVERVALUATION ON A NUMBER OF METRICS. House prices are well above historical and short-term averages relative to incomes, rents, and overall inflation. Until recently the housing market has been supported by a number of important fundamental factors — accommodative monetary policy, strong levels of net migration, and strong foreign investment into select cities and regions. These positives are countered by evidence of a growing supply and demand imbalance with the number of units in the pipeline ahead of demographic demand.

In addition, household leverage has increased rapidly to concerning levels — 162% of disposable income, largely due to increased residential mortgage credit (which amounts to 72% of total). 1 By comparison, US household leverage peaked around 125% in 2006. On a cross-country basis, Canada ranks highly relative to the rest of the developed world (Figure 1). While many countries went through a painful deleveraging process since 2008, increasing household leverage in Canada has been an important support for overall consumption and recovery.

Figure 1

Canadian household debt ranks highly versus other OECD countries/></p>
<h2>Policy efforts to slow housing market activity now showing signs of success</h2>
<p>Historically, Canadian policy makers have deployed macro prudential tightening measures rather than the more blunt instrument of interest-rate increases to slow overall housing market activity. Since 2008, macro prudential tightening has been deployed six times, with limited efficacy. On average, these measures have slowed overall sales by 10% (peak to trough), but have only lasted for two months before the fundamental factors of low rates and strong migration have dominated. <sup>2</sup> There has also been only a negligible and temporary impact on house prices. </p>
<p>More recently, a new round of macro prudential tightening took effect in January, with the Office of the Superintendent of Financial Institutions setting new stress tests for uninsured mortgages, requiring lenders to enhance loan-to-value measurements and limits, and placing additional restrictions on lending activity designed to circumvent previously established loan-to-value limits. While it has only been two months, the negative impacts on housing have been more pronounced than previous iterations, with existing home sales down 19.4% since December 2017 and house prices falling by 3.5% year over year (<strong>Figure 2</strong>; dark blue line) — the weakest pace of house price growth since 2009. </p>
<p>In addition to tighter macro prudential conditions, mortgage rates are 75 basis points higher compared to nine months ago, as the Bank of Canada has responded to a closed output gap by increasing interest rates starting in July 2017. <sup>3</sup> Higher rates are a key difference from previous efforts to slow housing market activity. While incomes are growing 4.7%, the household debt-service ratio has crept higher, approaching levels last seen in 2008.<sup>4</sup> Thus, we are watching these developments closely as the latest round of slowing in the housing market may have a higher probability of longevity compared with previous iterations, given the added headwind of higher mortgage rates on households’ ability to service debts. </p>
<h4>Figure 2</h4>
<p><img class=

What could a slowing housing market mean for the overall cycle?

Overall, the cyclical outlook for Canada is supported by loose financial conditions led by improving terms of trade and the tailwind from elevated domestic demand in the United States, which should support export growth. However, our analysis suggests housing market activity can have important spillover impacts and tends to be more of a leading, rather than lagging, indicator. With a lag, slower house prices have previously led to a slowdown in mortgage credit, in addition to weaker consumer confidence and retail sales. So far, there are signs that household credit growth is slowing, with the credit impulse negative (Figure 2; light blue line). Should this bleed into weaker consumer confidence, we would become more worried about a spillover into consumption activity, and potentially the labor market, with a lag, should growth slow below trend. Furthermore, shelter costs represent roughly 26% of the overall CPI basket, and currently contribute 0.4 percentage points to annual inflation. The weakness in house prices suggests shelter costs could swing to a negative contribution later this year — a potentially important development for the Bank of Canada, with overall core inflation close to its 2.0% target.

Implications for global bond investors

The combination of higher debt-servicing costs, elevated household debt to income, and the recent cyclical weakness in the housing market leaves us cautious. While a strong US cycle should benefit Canada with a lag, we see opportunities for the front end and intermediate points of the Canadian curve to outperform the US.

1Source: Bank of Canada as of 31 December 2017 | 2Source: Wellington Management based on data from the Canadian Real Estate Association as of 28 February 2018 | 3Source: Bank of Canada as of 28 February 2018 | 4Source: Bank of International Settlements

Views expressed are those of the author. Views are as of April 2018, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This piece contains estimates and forward-looking statements. Actual results may differ, perhaps significantly. Certain data provided is that of a third party. While data is believed to be reliable, no assurance is being provided as to its accuracy or completeness. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.

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