Will rising interest rates be the pin that bursts the housing bubble?
The COVID-19 pandemic sparked higher demand for Canadian housing, even as the market was arguably already overpriced and undersupplied. In our view, the elevated housing market has been an ongoing tail risk for the Canadian economy. Now, increased consumer leverage and rapidly rising interest rates could be the catalyst that pushes the housing market, and possibly the economy, into a slower growth or even recessionary phase.
Canada has been one of the few global markets benefiting from inflation in commodity prices because it is a significant producer of oil and gas, which has helped the TSX Index outperform most international equity markets this year. However, in our view, this outperformance remains vulnerable in the months ahead, given the potential for softening commodity prices, as well as a cooling Canadian housing sector. In this backdrop, the Canadian financial sector, as well as the energy and materials sectors, are at risk of underperformance.
Growing household debt and rapidly rising prices
During the pandemic, household debt, in relation to disposable income, has risen to new record highs, reaching above 180%, as housing prices have outstripped wage growth. From 2020 to 2022, the new home price index rose almost 20%, while wages grew at a mere 7.3% over the same time frame. This rapid rise in debt has led to increased monthly payments and shrinking discretionary income.
Comparatively, we've seen debt levels internationally in the U.S. on a long-term downward trend since the 2008 financial crisis. Although the average price for a house in the U.S. has risen sharply, many consumers used the federal pandemic stimulus to pay down mortgages, and debt to disposable income has remained steadily low.
Source: Statistics Canada
This chart shows the rapid rise in housing prices and debt levels, especially around the start of the pandemic in 2020
Higher interest rates lead to higher monthly payments
The Bank of Canada (BoC) has been raising its key interest rate aggressively to combat high inflationary pressures by resetting the supply-demand dynamic in the marketplace. However, higher BoC interest rates almost immediately impact the housing market through higher monthly housing payments. As the five-year-fixed mortgage period ends for consumers in Canada, households will have to start higher monthly payments.
Using data from the BoC and Statistics Canada, we can do a rough calculation of how much monthly mortgage payments would increase for the average household. Monthly payments will rise by about C$315 on average for every one-percentage-point increase in mortgage rates. With many market participants forecasting a 3% BoC interest rate in January of 2023, that is roughly a C$900 increase in the average household mortgage payment.
Although only 10% of households are forecast to hit the five-year mark in their mortgages this year, this can significantly impact economic growth, as consumers have less money to spend on goods and services. We expect discretionary spending in Canada to soften this year, while the impact of higher rates will be felt more significantly in 2023 and over the next several years.
Source: Bank of Canada. Past performance does not guarantee future results.
This chart shows that interests today are much higher than 5-years ago.
Lack of diversification in the TSX and Canadian banks
In the Canadian TSX Index, the top two sectors are financials, with a 32% weighting, and energy, with 19%. This compares with a 10% weight to financials and 4% weight to energy in the S&P 500 Index. The TSX would be more negatively affected than the U.S. equity markets by any slowdown or contraction in housing or energy.
Also, banks in Canada keep a far higher proportion of their balance sheets in mortgages (about 80%) than banks in other developed countries (in the U.S. this number is around 20%, for example). We are keeping an eye on how much capital banks reserve for bad debt, and these reserves could cause Canadian banks to revise their earnings lower if delinquencies rise. But so far, delinquency rates have remained low.
Source: FactSet. Past performance does not guarantee future results. Market indexes are unmanaged and cannot be invested into directly.
This chart visualizes the differences in the two index weightings, with the TSX having a greater financial sector weighting .
It's Not All Bad News
Although the housing sector poses a risk to economic growth, keep in mind that the Canadian economy started from a position of a strength. Household incomes are well-supported by a strong labour market and healthy corporate financial positions, which should provide some cushion in a softening economic backdrop.
Overall, after a period of outperformance, the Canadian equity market may now be at risk for underperforming the U.S. and broader global equity markets, driven by softer financial- and energy-sector performance. In terms of how to position client portfolios, we recommend a neutral allocation to Canadian large-cap equities for now, but we are closely monitoring how the domestic housing market and consumers respond to the BoC rate hikes. With the S&P 500's larger weighting to technology and growth-style investments, U.S. equities have already dipped into bear-market territory (down over 20%), perhaps already pricing in much of the economic weakness ahead. We slightly favour U.S. large-cap equities over small-caps and Canadian equities, as U.S. consumers are relatively more capable of absorbing higher interest rates due to their lower household debt than Canadian consumers.
While we may continue to see volatility in the months ahead, for long-term investors this may provide an opportunity to diversify, rebalance, and ultimately add quality investments, in both the U.S. and Canada, at better prices.
Sloane Marshall, CFA
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