The Bank of Canada (BoC) raised short-term interest rates by 25 basis points to 5% earlier this week, the 10th hike since March 2022, which was on expected lines going by what the bond yields indicated. It is crucial to note here that this is the highest interest rate level since 2001. This will have several implications for the real estate sector and the general economy in Canada.
Canada’s real estate market has been quite stable and a preferred pick for investors over the last two decades. The real estate market in Canada sailed through the 2008 crisis and avoided any banking collapse. However, since 2008, the policies of ultra-low interest rates have led to massive debt accumulation in the entire economy. Canada today has the highest Private sector debt-servicing ratio and the highest household debt-to-GDP ratio among the G7 countries.
Household Debt to GDP
Canada’s household debt is greater than the country’s GDP (107% of GDP). Why is it significant? Because these are highly unsustainable debt figures, it is in bubble territory. US Household debt to GDP was close to 100% when the real estate bubble burst in 2008 in the USA. Canada’s real estate market did not suffer in the 2008 crisis because it was not significantly leveraged (Canada’s Household Debt to GDP was ~78%). Increasing interest rates at a rapid pace in a highly leveraged economy causes things to break.
The below chart is a good representation of economies that carry significant risks in the real estate market.
Source: BCA Research 2023
Rising interest rates matter, especially for economies that are already heavily indebted and consumers locked into variable-rate mortgages. Canada checks both boxes. Not long ago, the interest rate in Canada was 0.5% (March 2022). The magnitude of rate hikes from 0.5% to 5% is massive, as is the speed at which this has happened. The impact has yet to trickle down into the real economy.
Variable Mortgage Rates and Negative Amortization
The variable mortgage owners bear the brunt of the rate hikes. More than 50% of the mortgages issued over the last few years in Canada were variable-rate mortgages.
The Bank of Canada has frequently mentioned that interest rates will remain low for a long period post-Covid. This has not played out well due to inflation getting out of control. But that dovish commentary has led to massive inflows into the real estate sector, with loan rates being aggressively low just a year ago. Those consumers who have had variable mortgages are feeling the most heat from the interest rate hikes. If you had a variable interest rate mortgage in 2021 at 2%, the rates are currently running at 6-7%. Effectively, your EMIs have gone up by over 300%. The Banks, however, do not always increase the EMI; instead, the loan amortization period is extended, keeping the EMI constant. But because of the magnitude of rate hikes, the loan amortization period has gone up in some cases to 70–80 years! If rates keep increasing, at a certain point (trigger rate), your fixed EMI will not cover even the interest cost. So, even if you continue your EMI payments, your loan balance will keep increasing! That is ‘negative amortization—generational wealth damage. More than 3/4 of the people with variable-rate mortgages have already hit their trigger rates from last year.
The below chart is a better illustration of what we are discussing:
Source: Macrodesiac
A ‘mortgage term’ is the length of your current contract, at the end of which you'll need to renew. The amortization period is the total life of your mortgage. Most mortgages in Canada have a 5-year fixed interest rate term with a 25-year amortization period. So, even the ones with fixed rate terms will be up for renewal at 2-3x higher rates in the coming 2-3 years. This will put significant pressure on disposable income.
Look at the below chart. The yellow line indicates the new 5-year interest rates charged, and the purple line is the average outstanding mortgage rate (5-year fixed). The data in the chart is slightly dated. The yellow line is closer to 6.5% now. As renewals kick in, pressure on consumers’ disposable income will be significant.
Source: Bank of Canada
Affordability Issue
Real estate is the biggest driver of the Canadian economy today, which is why the focus is on this segment of the economy. It is not only the highly leveraged households in Canada that are concerning; it is also the affordability. Affordability is a key factor for a sustained bull run in real estate.
The Canadian GDP is growing; however, the per capita GDP (even in nominal terms) has been stagnant over the last decade while house prices have more than doubled (in real terms). Since 2005, no other G7 country has seen the gap between home prices and incomes widen this much. It is not even close.
The below two charts tell a compelling story: (Do note that the first chart is in real terms i.e. adjusted for inflation), while the per capita GDP chart is in nominal terms)
Source: Corpay
Canada Per-capita GDP (Nominal Terms)
Source: Trading Economics
Another indicator of how bad the affordability situation is is to see the eligibility criteria for new loans. Under the stress test requirements for a mortgage in Canada, a person earning $100K per year, would qualify for a 5x mortgage amount when interest rates were at the 0.25% mark. Today, at the same income level, it is difficult to pass for a mortgage loan of 3x income at most banks or they will get the loan, but at fixed rates which are the highest in 20 years in Canada. The average home price in Canada is over $750K and only about 11% of Canadians currently earn more than $100K. Add these all up and the picture is far from ideal.
Immigration: It’s Different this time?
A key factor that has been touted as the difference in this case from the previous real estate bubble in Canada (1990s)- is the massive immigration targets by the Canadian Government.
Well, immigration in the short run is inflationary – you need a roof over your head first and this adds to the demand pressure for Canadian real estate. However, the supply side will take time to catch up. Here is an interesting chart that shows how the supply of real estate (Measured in Housing starts – new construction) has been on a decline in Canada.
Source: The Economic Longwave
This is where I feel there is a slight disconnect between the expectations that interest rate hikes will cool down prices because the demand gets hurt, but what about the supply? This is not just for Canada but seems to be the case across most developed markets today.
High interest rates mostly lead to higher corporate defaults and lower capex as the cost of capital shoots up, resulting in reduced competition, which ultimately leads to higher prices. Effectively speaking, as interest rates keep going up, it could lead to structurally higher inflation!
It does seem counterintuitive, but I think there is a caveat to this, which is the public debt in the economy. When government debt levels are low in the economy (the 1970s), interest rate hikes are an effective tool to control inflation, but if the economy is overleveraged (1940s and 2020s), their effectiveness could diminish. It is something that I have been trying to wrap my head around.
In my opinion, interest rates and inflation do not always have a strong correlation; otherwise, it would have been fairly easy to assess the impact of rate hikes or cuts. Public debt levels, in my opinion, impact the dynamics of interest rates and inflation.
The money supply is a key factor that drives inflation. Although difficult to classify, the source of the inflation can be differentiated to some extent. Most of the broad creation of money happens through a combination of fiscal deficits (government spending) and bank lending (credit creation). In the 1940s, high inflation was led more by fiscal deficits (caused by wars) and less by credit creation (bank lending was slow in the 1940s). The public debt-to-GDP ratio was at record levels. In the 1970s, the inflationary period was led by credit creation and less by fiscal expansion (public debt to GDP was low). Central bank action (taking the US as a proxy) was different but still led to inflation getting under control in both situations. The below charts indicate the same:
Source: BLS, Fred Database, Lyn Alden
The current environment has more similarities with the 1940s (huge fiscal deficits led by the pandemic and the Russia-Ukraine crisis). Some of the developed economies are running deficits at par or higher than some of the emerging markets today. At first, raising interest rates in the face of high deficit-driven inflation (the current situation) can slow inflation down, which makes it seem like it is working. This is because the Central Banks can potentially slow down bank lending and thus slow the economy down, even as those fiscal deficits keep pouring in. As a lender of last resort, the Central banks keep funding all those deficits by absorbing the bond supply and expanding their balance sheets. This continues to add to inflationary pressures.
So, in a nutshell, while we are seeing inflation cool off from the high base of last year, expect another round of high inflation in the coming years (higher volatility in inflation). Coming Back to Canada and what it Means for my asset allocation in Canada.
Given that we expect inflation to continue to cool off in the short term, primarily with energy costs down significantly over last year, fixed-income bonds could be a decent short-term trade if the BoC pauses on interest rate hikes. The yield curve is significantly inverted and for taking positions if any, I would look at the shorter duration of the yield curve. Overall, given the longer-term view, I’m not very bullish on the Canadian debt and the CAD currency. I think there are better alternatives on the fixed-income side, more so in some of the emerging markets.
Real estate as an asset class in Canada still looks expensive, even as prices are down 12–15% from their peak in February 2022 in most provinces. We have seen some recovery in real estate prices in 2023. This has been led by the assumption that we are at the peak of the interest rate cycle and rates should start correcting from here. I still believe this could be short-lived, and we might see a price correction again. With 30% of the real estate market owned by investors rather than homeowners, the risk is high that it will create a downward spiral if prices continue to correct. The biggest reason it would be truly unusual for the housing market to begin a new bull phase is that affordability remains quite poor. I would avoid real estate as an investment in Canada currently.
As far as equity markets are concerned, they seem relatively better placed. Valuations have cooled off significantly, and the broad index $TSX has just been in a sideways market for the last two years. The price-to-book valuation seems reasonable, close to 1.6x. However, the Canadian economy and the index are asset-heavy and dominated by highly cyclical industries—banks, industrials, mining, and energy—all of which are high-risk bets in an economic downturn. Would remain underweight, especially in banking, which has just started to see signs of stress with increasing delinquencies in non-mortgage loans. Given the points discussed earlier on the mortgage side, they could soon follow suit and add pressure to the bottom line of the Canadian Banks. At an aggregated level, I would remain cautious or underweight and wait on the sidelines for better entry points in Canadian equity markets. Would keep higher allocations for precious metals like Gold and cash.
On a closing note, New Zealand and Australia have a very similar setup in their housing market. The risks seem more pronounced there. Watch out for those markets as well. That’s a wrap on this week’s asset allocation series. More will follow in the coming weeks. Thank you for reading, and have a great day!
Regards,
Shivam Jain
Disclosure: I’m not a SEBI Registered Investment Advisor. All content on this website is purely for educational purposes. Please consult your financial advisor before making any investment decision.
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