Monthly Economic Letter

June 2022
Feature article

A real estate crash on the horizon?

Spring is usually the busiest time of the year for the real estate market, but a slowdown this year could make it a bitter season for both recent buyers and hopeful sellers.

With a decline in sales in March and April, inventories are up and, more importantly, prices are down. There is no doubt that with inflation and the accompanying rise in interest rates, the market has slowed down, but just how far will the pullback go? Are these the first signs of a real estate collapse in Canada?

The infamous bubble that may go pop...

Fear of a real estate bubble in Canada has been a favourite topic of discussion for several years. In fact, warnings about this threat have resurfaced regularly since the crisis in the U.S. housing market in 2008. Will 2022, be the year the bubble finally pops?

If there is one sector that has benefitted from the pandemic, it’s residential real estate, which has broken record after record over the last two years. Despite the recent declines, the average price of a home remains 40% higher than before the COVID crisis began. Lockdowns and telecommuting combined with favourable economic conditions explain the housing frenzy during the pandemic.

If one thing was certain in the spring of 2022, the torrid pace of activity in the Canadian housing market was unsustainable. As Canadians slowly begin to acclimatize to a world where COVID is endemic and economic conditions more difficult, new market dynamics are emerging.

Demand is cooling

A key factor driving the market slowdown is inflation. It remains at 30-year highs and is not expected to abate anytime soon in Canada. The rising cost of goods saps consumer confidence, leaving people less inclined to make major purchases like a house.

But the dominant factor hurting demand is the cost of financing. While rate hikes take several months to work their way through the general economy, the real estate market reacts more quickly. With the affordability problem that many Canadian housing markets are currently experiencing, the impact of rate hikes is already being felt.

The Bank of Canada’s policy rate jumped from 0.25% in March to 1.5% at the time of writing. And interest rates in the bond market—the benchmark for mortgage rates—were rising even before the central bank began its tightening cycle.

In April, the five-year mortgage rate hit 4.19%, the highest level since July 2019 and it’s expected to continue increasing in the coming months. In fact, the rate could reach the 5% mark before the end of the year.

The last time the Canadian real estate market faced rates that high was in 2010 when the market was still reeling from the effects of the financial crisis.

A slow down but not a crash

While a slowdown in demand is underway and affordability issues are hurting many Canadian markets, these factors are counter-balanced by a growing population and a large number of first-time buyers in the market.

First-time buyers still account for about half of all home buyers and the growth prospects for this group remain strong. Thanks to immigration, the number of millennial and Z generation Canadians is growing strongly. In fact, millennials will soon (within the next seven years or so) outnumber baby boomers to become the dominant demographic group in the country.

Generation Z, born between 1996 and 2012, is beginning to enter the job market and therefore the real estate market. The investment habits of this generation make them more likely to be financially ready to buy homes at age 30 than millennials were at the same age.

So which will carry more weight? Population growth or interest rates

In the end, we expect price declines across the country, but not a crash like the one that hit the U.S. market 15 years ago. Even though a huge portion of Canadians’ debt is linked to real estate, it’s unlikely that defaults will increase significantly. Credit standards are tighter than they used to be and the overall credit quality of buyers has improved during the pandemic.

Ultimately, higher-price markets in the country’s largest cities will be more impacted by interest rate increases and could experience price corrections of up to 10% over the next year. However, these declines should prove temporary as buyer, sellers and their agents get used to the new reality of higher interest rates. This could happen sooner than you think.

From a national perspective, we expect a small decline in prices followed by a plateau before growth resumes at a more moderate pace. In the first-time home market, things could remain hot because inventory is low and demand remains strong.

In short, do not underestimate the resilience of the Canadian real estate market despite the jolts that will come in the next few months.

Canadian economy at a glance

The Canadian economy remains strong

Unlike many other major economies, notably the United States, Canada made it through the first quarter of 2022 without much difficulty.

Although weaker international trade weighed on growth, increased spending by households and businesses offset this decline. Overall, the Canadian economy grew at an annualized rate of 3.1% during the quarter, a strong performance even though many analysts had expected better.

Demand is robust

Businesses are likely to have plenty to keep them busy as domestic demand remains strong. Household spending rose at an annualized rate of 3.4% in the first quarter.

While demand for services continues to recover, consumption of goods still leads the way. Inflationary pressures on goods, supply issues and easing of pandemic-related health measures should begin to benefit services in the coming months. Retail sales net of inflation grew by an anemic 0.2% in the first quarter, according to Statistics Canada.

How far will the Bank of Canada’s tightening go?

As expected, the Bank of Canada made a second 50-basis-point rate increase on June 1. Central bank’s officials emphasized that the bank’s goal is to bring inflation back to its 1% to 3% target range at all costs. This suggests another aggressive rate hike at the bank’s next scheduled announcement on July 13 in the face of inflation that remains at levels not seen in decades.

The policy rate, which sets the trend for the nation’s interest rates, is now at 1.5% and is expected to reach 2.5% by the fall. Recall that the policy rate started the year at 0.25%, so we are witnessing a historically rapid tightening cycle.

The risk that the central bank could provoke a recession by choking off demand is increasing, but there is still plenty of room for a smooth transition.

Housing starts pick up despite rising rates

We had expected to see another decline in housing starts in April in a continuation of the trend of the past few months. However, homebuilders actually began building more new units during the month. New housing starts remained below the record levels set in 2021, but are still high compared to their historical average.

The new home craze is likely still benefitting from changing needs and preferences related to the pandemic with many Canadian companies just finalizing their telecommuting policies. A lingering lack of inventory and home buying incentives announced by the federal government are also likely helping to keep housing starts up.

The current pace of construction is addressing the housing inventory deficit, but interest rate increases should soon begin to impact the new home market. For now, however, the number of building permits being issued indicates that a solid pace of activity will continue in the near term.

Finally! The tourism industry is taking off again

Strong tourism spending during the March school break bodes well for a busy summer for the industries hardest hit by the pandemic. The arts, entertainment and recreation sector and the accommodation and food services sector both experienced strong monthly growth in March (+13.5% and +10.9% respectively). These sectors are rapidly approaching their pre-pandemic levels, a milestone reached by the Canadian economy as a whole six months ago.

Health restrictions were still weighing heavily on the tourism industry at the start of the year. Significant gains are expected in the coming months as international tourism picks up.

In March alone, air travel activity was up 57.2% over February, a clear sign that COVID-related requirements for international travellers was a drag on the sector's recovery.

The impact on your business

  • The Canadian economy is still on solid footing with strong domestic demand supported by a strong labour market. Therefore, households spending should hold up. We should begin to see a greater rebalancing of household budgets towards services from goods.
  • Tourism-related sectors will be relieved to see activity approaching pre-pandemic levels. At least the demand will be there; now it's up to companies to be ready to meet it!
  • Housing starts are regaining some of the ground lost in recent months, despite interest rate hikes. The number of construction sites should fall in the next few months, but the industries that are closely linked to the residential sector will be busy this summer.
U.S. economy at a glance

U.S. growth is expected to make up for lost ground

The most recent U.S. GDP data suggest the first quarter was worse than last month's initial estimate. The revised figures indicate that GDP declined at an annualized rate of 1.5% from the last quarter of 2021.

Despite an upward revision on consumer spending, inventory declines and a slowdown in residential investment ate away a larger portion of growth than estimated last month.

However, several factors point to a recovery in economic activity in the second quarter. Transitory factors related to COVID and the outbreak of war in Ukraine in the first quarter snarled supply chains and slowed the ability of U.S. companies to meet demand.

Momentum has picked up in the U.S. as the labour market continues to expand and consumption holds up, despite inflation and interest rate hikes.

The job market is still hot

In May, the U.S. economy added nearly 400,000 new jobs, bringing the total year-over-year gain to more than 6.5 million.

In addition to the historically low unemployment rate of 3.6%, there are other signs the labour market is tightening and the economy is performing well. The number of job openings remains far greater than the number of unemployed in the country. Despite this, wage growth is showing signs of moderation against the backdrop of a growing labour force.

The number of long-term unemployed is steadily declining with discouraged workers (those marginally in the labour force) beginning to return to the jobs market. At this point in the cycle, slower wage growth would offer welcome relief for the Fed's efforts to control inflation.

Americans are still in spending mode

Consumer confidence remains low and this usually signals a slowdown in consumption. However, despite the pessimism, inflation still does not seem to be slowing consumer spending. It increased by 0.7% in real terms in April compared to March. Our neighbours to the south are still spending 18% more than before the pandemic, while inflation is over 8%.

However, households are beginning to dip into their savings to maintain this pace. An expected slowdown in employment and incomes  in the coming months could lead to a rapid reduction in demand.

Quantitative tightening and aggressive rate normalization

Despite the first quarter slowdown, the U.S. economy is doing well as consumption remains strong and employment is thriving.

Consumer and investor inflation expectations suggest Americans remain confident in the Federal Reserve's ability to contain inflation. For now, the Fed is signalling more significant rate hikes ahead to calm inflation. More 50-basis-point hikes are expected this summer and through the end of the year.

The Fed will also begin a quantitative tightening cycle in June, meaning it will begin to reduce its impressive holdings of bonds and other securities with the goal of reducing liquidity in the economy.

The impact on your business

  • Employment continues to perform well and will support consumption for several more months.
  • Rising interest rates and the start of quantitative tightening in the U.S. will keep the Canadian dollar low against the greenback, which should benefit Canadian exports.
  • However, households are beginning to dip into their savings and wage increases will continue to slow. If you deal with U.S. customers, you may feel a pullback in orders in the coming months.
Oil market update

Little hope for lower oil prices anytime soon

Don't hold your breath for a drop in oil prices this summer. Crude oil prices for August delivery are over US$120 per barrel and refinery margins remain too high for the price at the pump to come down.

The current price of crude is supported by both supply and demand factors. On both sides of the market, there is no indication that prices will come down anytime soon.

A rebound in Chinese demand

After two months of intense lockdowns due to the COVID-19 pandemic, Beijing is finally easing health restrictions. Shanghai, China's largest city and commercial capital, is quietly returning to normal. The Chinese economy, the world's largest importer of oil, is expected to gradually recover, leading to an important increase in global oil demand.

Chinese manufacturing had already started to rebound in May and the easing of health restrictions has increased since then. However, Shanghai remains far behind North America and Europe in terms of reopening. As Chinese restrictions are lifted, energy demand will increase.

New embargo on Russian oil

It's done. The European Union has declared an embargo on Russian oil. The phased embargo means that 90% of Russian crude exports to the EU will cease by the end of the year. This is specifically a restriction on imports by ship, although Germany and Poland had already given up imports by pipeline.

Markets did not react strongly to the announcement because they expect discounted Russian oil to find its way to Asia. At the same time, Middle Eastern and West African oil normally destined for the Asian market would be diverted to the European market.

The impact of the embargo on supply is therefore expected to be limited and should not contribute to major price changes in the coming months.

A step in the right direction for OPEC, but...

After months of pressure from the West to increase production, the Organization of the Petroleum Exporting Countries and its allies (OPEC+) has finally agreed to increase crude production more quickly.

Members of the group pledged to supply an additional 648,000 barrels per day starting in July, or less than 1% of global demand. This will not be nearly enough to rebalance the market.

For one thing, the increase is spread proportionately among the participating nations, including Russia. It would be surprising if Russia managed to increase its production in the current context.

Additionally, OPEC+ has failed to meet its production targets for months. With the exception of the United Arab Emirates and Saudi Arabia, the majority of producers are already at maximum production capacity.

Bottom line…

Already strong oil demand will likely rebound further in the coming weeks as Beijing eases lockdowns and economic activity and mobility picks up in China.

The European Union is triggering a phased embargo on oil imports from Russia that will likely create little stir in prices, but the risk of exacerbating supply issues is increasing.

Finally, additional production hikes announced by OPEC+ will not provide relief to the market. The increases are too small and production in several countries is already at full capacity. The result? High pump prices through the summer.

Other economic indicators

Controlling inflation at all costs

The Bank of Canada raised its key interest rate by another 50 basis points on June 1, bringing the rate to 1.5%. The economy is still in excess demand and the Canadian labour market is tightening a little more each month. Wages are starting to rise faster, and inflation continues to be on a wild ride. The Bank of Canada is expected to keep the ball rolling and announce another half-percentage point increase in July or even 0.75%. At the current pace, the policy rate could reach 3.0% before the end of the year.

The dollar is regaining ground, but it won't last

Despite a slight decline in May, the loonie is generally weathering the uncertainty better than other currencies at the moment, likely supported by good economic growth in the first quarter. In May, the dollar traded at an average of US$0.78, a slight decline from the previous month. However, the loonie began a strong rally in early June as the Bank of Canada became more aggressive in addressing inflation. The Canadian dollar could move closer to US$0.81-0.83 in the next few weeks but should then fall back to the US$0.77-0.80 range as the Fed also accelerates rate hikes.

Entrepreneurs' optimism backed down

While demand remains strong across the country, the economic risks and challenges facing businesses continue to increase. This was finally reflected in the confidence of business leaders last month. In May, the Canadian Federation of Independent Business (CFIB) Business Barometer's long-term index fell by more than three points. Despite this decline, the results indicate that the majority of business leaders are still optimistic about the future.

The end of low interest rates in Canada

Notwithstanding the fact that the Bank of Canada's policy rate is still slightly below the level that prevailed in February 2020, effective household and business rates are now at levels that last prevailed in the fall of 2009—almost 13 years ago!

Since last March, the Bank of Canada's policy rate has increased by 1.25 percentage points to 1.5%. Effective interest rates charged to households and businesses are adjusting rapidly.  They reached 4.2% and 3.9% respectively at the beginning of June. Further increases in policy rates are expected in the coming months, so that effective rates charged to households and businesses could reach decades-old levels quickly.

Key indicators—Canada