July 2023 Outlook: What can we read into housing market resilience

Housing IS the Business Cycle – September 2007 NBER Working Paper

Central banks are beginning to restart and accelerate their monetary tightening cycles. The Bank of Canada (BoC) surprised markets by increasing interest rates by another 25 basis points (bps) in June. In the BoC’s Summary of Deliberations, there was a robust debate on the reasons behind the unusually resilient consumer spending. The Governing Council discussed the role of excess savings, strong job and population growth and even statistical factors such as seasonal adjustments.

It is worth noting that a 2007 paper from the National Bureau of Economic Research (NBER) suggests that residential investment is the best early indicator of an impending recession. If this still holds true, then it would appear that we are currently in a recovery phase rather than experiencing stagnation. Home resales saw a consistent increase for four consecutive months to May, with home sales transactions up 1.4% from a year ago. This marks the first time since mid-2021 that home sales have shown positive annual growth. The increase is observed across various regions in Canada, with more than 75% of local markets experiencing growth compared to last year.

One of the contributing factors to this trend is the limited housing supply. New listings have declined by 13.6% over the past year and remain around 16% below the pre-COVID average. As a result, current market conditions favour sellers (see Chart 1). Many households seem hesitant to list their homes due to concerns about potential price decreases since their purchase, the inability to port a low-rate mortgage or the availability of rental properties in a strong rental market. Overall, this is a remarkable outcome, especially considering the nearly 4 percentage point increase in the posted 5-year mortgage rate. It seems housing, like the economy, is unusually resilient.

Chart 1: Low number of listings imply a return to sellers market

Source: CREA, Macrobond

In this respect, Canada is not unique. House prices in other global developed markets such as Australia, the US and South Korea, are also seeing a stabilization in house prices. This can be attributed to strong household finances and a structural preference for more living space as many continue to work from home. Thus, central banks are engaged in crucial debates surrounding the all-important question.

Are interest rates sufficiently high?

Canada’s economy has a particularly high proportion of sectors sensitive to interest rates, about 25% versus 21% in the US (see Chart 2), primarily due to the housing sector’s importance in Canada (see Chart 3). In addition to the global factors noted above, Canada has a number of unique factors that further bolster housing activity.

Chart 2: Canada has higher share of rate sensitive sectors vs. the US…

Source: NBF Economics and Strategy

Chart 3: …and relative to other countries

Source: OECD, Macrobond

Firstly, population growth has been consistently strong for the past three years, supported by immigration and an increase in non-permanent residents attending school or working on visas. Moreover, borrowers have been extending mortgage amortizations to delay the impact of higher interest payments that accompany rate increases. Even so, interest servicing costs have risen to historic highs, accounting for 15% of personal disposable income (see Chart 4). In its latest Financial System Review, the BoC noted that over a third of mortgages had already been reset or affected by higher interest rates as of May this year. Looking ahead, its modeling shows that this figure will rise to 47% by the end of this year. Furthermore, due to the influx of homebuyers during the pandemic, this will apply to nearly everyone between 2025 and 2027 (see Chart 5).

Chart 4: Canadian debt servicing costs are back at their highs

Source: StatCan, Federal Reserve, Macrobond

Chart 5: Nearly all mortgage payments will increase over the next 3 years

Source: BoC

Consequently, debt service costs are almost certain to rise for the 35% of households that own their home and have mortgages.

While the adjustments will undoubtedly be challenging, we believe the worst outcomes are likely to be avoided. Homeowners will have built some equity and household net worth has surged to $15.7 trillion, a 27% increase since the end of 2019 (see Chart 6). As a result, debt levels as a proportion of assets remain manageable (see Chart 7). Indeed, new mortgages were stress-tested to ensure affordability with mortgage rates near current levels of 5%. The excess savings that emerged from limited spending and extensive fiscal support during the pandemic were substantial. Although diminishing, excess savings are estimated to be around $25 billion, with a significant portion redirected into term deposits and other assets like equities. Perhaps most fundamentally, both employment and real household incomes have grown materially, by about 5% since 2020.

Chart 6: Household net worth has surged

Source: StatCan, Macrobond

Chart 7: Debt levels are high, but asset values have also grown

Source: StatCan, Macrobond

However, the Canadian household sector diverges starkly from the US. While high housing demand has led to a similar increase in housing starts, household balance sheets differ. Effective mortgage rates paid by US households have remained relatively flat due to the prevalence of 30-year fixed-term mortgages, leading to lower debt and debt servicing costs (see Chart 4 again). Nevertheless, a short-term risk arises from the recent Supreme Court decision to reverse student loan forgiveness, implying that this cohort of consumers will face resumed loan repayments. A recent survey indicated that 40% of respondents were unaware of this ruling and unprepared to resume payments. Estimates suggest that interest on student loans amounts to between $64 billion and $96 billion annually, which would reduce total after-tax incomes by approximately half a percent.

The stability of housing markets has been remarkable, defying the conventional wisdom that a more indebted country like Canada would be more vulnerable to higher interest rates. While savings, employment, asset values and immigration demand have all supported the real estate market to date, they will not fully offset the impact of rising debt servicing costs as excess savings dwindle. We still believe a recession still lies ahead, with the potential silver lining that the BoC may have less work to do going forward.

Capital markets

Following a strong and volatile first quarter in asset markets, the second quarter was calmer. Market enthusiasm seen in the first half of the year reflects the view that economic activity will be sustained as inflation eases. Resilient economic data played a role in supporting corporate earnings. Notably, asset value gains became more narrowly-driven by specific themes, particularly the growing enthusiasm in artificial intelligence (see June Outlook). This resulted in market leadership being centred on large-cap technology stocks, which significantly outperformed the broader equity market. Thus, while the S&P 500 Index rose by 8.7% in Q2, the tech sector accounted for the majority of this gain, surging by 17.2%. On the other hand, the Canadian equity market lagged its global counterparts due to its relatively limited exposure to technology companies. Still, cyclical stocks, such as consumer discretionary, industrials and financials outperformed defensive sectors. Indeed, the breadth of the equity rally has been better in Canada this year, as the S&P/TSX outperformed the S&P 500 in six of the eleven major GICS sectors year-to-date. Commodities were largely flat, but oil prices were down for the second consecutive quarter.

Global fixed-income markets were caught off guard as central banks resumed or accelerated rate hikes in response to resilient economic activity and persistently high inflation. The BoC raised its target overnight rate by 25 bps to 4.75%, and both the BoC and the Federal Reserve indicated that rate hikes were not yet over. Bond yields increased significantly in the second quarter, led by shorter-term yields, resulting in yield curve inversions reaching levels not seen since 1990. Even with tighter credit spreads that were helped by low supply and strong demand, the FTSE Canada Universe Bond Index fell -0.69% in the second quarter.

Portfolio strategy

While the cyclicality of housing lends itself well to predicting economic cycles, various financial flows and consumer preferences have prevented housing markets from experiencing the full effects of higher interest rates, which has posed a challenge for central banks. Indeed, Canada’s economic resilience is particularly noteworthy considering high household debt levels. However, the link between higher rates and an economic slowdown, although delayed, is unlikely to be eliminated. Historical trends show that unemployment rates tend to remain low until the onset of a recession and even a 0.5 percentage point increase can trigger a recession. The renewed efforts by central banks to further raise rates at this stage of the tightening cycle, while suggesting the need for sustained high rates, increase the risk of a hard landing. 

As a result, we anticipate declining profit margins as wages continue to add pressure and pricing power diminishes. Consequently, we maintain a cautious outlook for equities and expect weaker earnings in the upcoming quarters. In Canadian equity portfolios, we favour companies that are likely to consistently deliver earnings in a low-growth environment. At the same time, we continue to search for companies whose valuations reflect the anticipated slowdown or align with our secular themes, such as rising business capital expenditure. The latter includes companies involved in rebuilding supply chains and advancing the transition to green energy sources.

In fixed income portfolios, we have started to position for a broader steepening of the yield curve while maintaining an underweight exposure to credit. Both of these positions should benefit portfolios as we approach a recession. Our balanced portfolios remain underweight equities and fixed income, with a preference for cash. While the economic stability has been welcomed, market optimism suggests that it will continue. In our view, the downside risks are gathering pace.