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Monthly Economic Letter

May 2018
Feature article

Where are house prices going? And why it matters

The market is cooling and that could put pressure on indebted consumers

Falling house prices have been generating a lot of headlines lately. That’s understandable, given the fact that over two-thirds of Canadian households own their own home, and 36% of their wealth is wrapped up in that single asset.

Higher real estate prices have created a lot of wealth for Canadians, and the economy in general, in recent years. The rising value of homes, even if only on paper, makes homeowners feel richer, encouraging them to borrow and spend.

Now that house prices are increasing more slowly or falling in some areas, typically this consumption pattern would reverse with homeowners turning cautious on spending. That, in turn, would slow the economy at least in the short-term. However, over the longer term, the fundamentals behind continuing demand for housing in Canada, especially in urban centres, remains positive.

Three key reasons why housing price increases are slowing

1. New regulations in B.C. and Ontario

To curb rising prices, the governments of British Columbia and Ontario imposed taxes on non-resident buyers, among other measures, in an attempt to limit possible speculation driving up prices.

In August 2016, the B.C. government imposed a 15% tax on foreign buyers in the Greater Vancouver area. In April 2017, the Ontario government copied the measure, covering Toronto and the Greater Golden Horseshoe area. Then, in February, the B.C. government increased the foreign buyer’s tax to 20%, and expanded it to cover areas outside Greater Vancouver.

2. New bank lending rules

The Office of the Superintendent of Financial Institutions (OFSI) announced last autumn new restrictive lending rules for banks, beginning on January 1. Banks must now ensure that uninsured mortgage borrowers can afford to pay interest that is either 2% above the contracted rate or the five-year benchmark rate published by the Bank of Canada, whichever is greater.

This measure affects new homebuyers seeking a mortgage and homeowners renewing their mortgage with a different bank. This year, there is a higher than usual number of renewals coming due—47% instead of the typical 25-35%, according to CIBC.

3. Higher interest rates

The Bank of Canada began raising the overnight lending rate in July, moving it from 0.5% to 1.25% where it currently stands. Commercial banks have raised their borrowing rates as well, with the effective interest rate for households up about half a percentage point.

What’s the impact?

Recently, average prices have fallen in the previously hot markets of Vancouver and Toronto. The average price in the Greater Toronto Area peaked last April at about $920,000. As of March this year, it was about $785,000. While less dramatic in the Greater Vancouver Area, the peak price was $1.1 million in May last year, and average prices have been hovering just above $1 million for the last few months.

This is a result of a lower number of transactions. Between March 2017 and March 2018, the number of sales of existing homes has fallen by about 30% in Greater Vancouver and 40% in Greater Toronto, whereas sales in some other major markets declined by about 14% based on data from the Canadian Real Estate Association.

Canada’s economic growth is likely to slow down

One important outcome of these developments is that homeowners will have less equity to borrow against if the value of their home falls.

Some homeowners use the equity they have built up as collateral to access credit, using it to pay for everything from home renovations to cars to restaurant meals.

As well, the pick-up in interest rates means it’s more expensive to service a mortgage, leaving less disposable income. Last spring, Manulife found that 72% of mortgaged homeowners would have difficulty paying their monthly mortgage payment if it were to increase by 10%, equal to mortgage interest rates rising by one percentage point. Mortgage rates are up half a percentage point since July 2017.

Already, Canadians are feeling the pinch of rising interest rates. Interest and debt payments rose 9.2% and 6.7% respectively in the fourth quarter of 2017 compared to the prior year (see chart).

Because of the high debt load of Canadian households—$2.1 trillion in mortgage and non-mortgage debt at the end of 2017—the Governor of the Bank of Canada estimates the economy is 50% more sensitive to rate hikes than in the past.

As a result, the Bank of Canada needs to raise interest rates sufficiently to manage inflationary pressures, but not so much that it risks putting households into a cash crunch, sending loans into default. This would hit bank balance sheets, restraining their lending capacity with negative effects through the whole economy.

Foundation for a balanced housing market

The good news is that rising disposable income and population growth are providing support to the housing market.

The pace of wage growth is strengthening in Canada, leading to more disposable income in the pockets of consumers. (For more details on wage growth, see the feature article in our February Economic Letter.)

Meanwhile, Canada’s population will continue growing at a pace of about 1.2% over the next few years, with immigration responsible for two-thirds, according to Statistics Canada. While this is modest, there are two aspects to our population growth, which are positive for housing demand.

  • First, the aging of the population won’t necessarily reduce demand for housing. Researchers at the Bank for International Settlements argue that in wealthier countries, such as Canada, the elderly will stay in their homes, given they generally own them outright and it is stressful to move. This will help underpin demand for new housing stock.
  • Second, non-permanent residents coming to Canada are today more likely to be workers and students rather than refugees as they were 20 years ago, which means they are more likely to form households. According to research by Canada Mortgage and Housing Corporation, non-permanent residents were more likely to buy either more expensive homes than, or homes of the same value as, permanent residents. This will also be supportive of continuing housing demand.

What does this mean for entrepreneurs?

  1. Businesses may see consumer spending slow as interest rates continue to rise, limiting households’ disposable income.
  2. If your business is exposed to the housing sector, a slowdown is occurring which is likely moving the market to a more sustainable pace of expansion.
  3. The housing market is cooling, but a crash is not anticipated.
Canadian economy at a glance

Canada's economy grows modestly

Canada’s economy is maintaining a sustainable rhythm. After a small contraction in January, Canada’s gross domestic product rebounded in February with growth of 0.4%. The Bank of Canada expects 1.3% annualized growth for the full quarter, so further firming of growth should continue.

The best performing sectors so far this year were manufacturing and construction.

Construction remains strong, especially in British Columbia

The construction sector continues to show strength—with residential construction up 5.8% on an annualized basis for the first two months of the year—and no slowdown in sight.

Nationally, developers received $8.4 billion in building permits from municipalities in March—up 3.1% from February—mainly to build apartment buildings in Quebec and British Columbia, and commercial buildings in British Columbia, Alberta, Quebec and New Brunswick.

Resources sector picks up steam

The mining and oil-and-gas sector picked up some of the ground it lost in January and remains at an elevated level on an annualized basis, very close to last year’s high output level.

While coal mining continues to track lower, potash mining picked up significantly in February recovering from five months of negative growth.

Exports of energy products picked up again in March after slowing down last fall, but minerals and mineral products exports remain lower, as did forestry exports.

Manufacturing production helps to drive exports

Merchandise exports rose 3% on a real basis in March, though year to date, the level is below last year’s strong result. Exports of manufactured goods including industrial machinery and equipment, electrical and electronic equipment and aircraft reflect the solid manufacturing production in February.

Automotive exports have not returned to their high level of 2015, in part because U.S. consumers are demanding auto models manufactured domestically or in Mexico.

Trade in autos, specifically the rules of origin, is up for discussion at this month’s round of NAFTA negotiations. President Donald Trump has signalled he wants a new NAFTA deal to be in place before the July 1 Mexican presidential election and U.S. congressional elections in the autumn.

Diversification of export markets will be critical to increasing Canada’s exports

Canada’s trade is dominated by the United States with about 75% of our goods exports and 55% of our services exports going south of the border. Canadian exporters could profit by increasing the number of markets to which they sell.

For example, Canada’s trade with China over the past two decades has largely been in primary materials. However, as the world’s second largest economy transitions from an export-led economy to one that is domestically driven, with the share of middle-income households rising, Canadian exporters will be able to sell more value-added products. These include manufactured foods, autos and various services demanded by Chinese citizens. The Conference Board of Canada forecasts that Canada’s exports to China will rise by 4.4% for merchandise and 5.4% for services over the period 2018 to 2022.

In Europe, the coming into force of the Canada-European Union Comprehensive Economic Trade Agreement (CETA) last autumn gave Canada privileged access to a market of more than 510 million people, accounting for 22% of global GDP. The E.U. buys 4.5% of our exports, and the U.K. another 3.5%. This new trade deal eliminates or significantly reduces tariffs on the vast majority of goods and services. The agreement is broad in scope covering investment, government procurement, labour mobility and regulatory standards.

Meanwhile, the Comprehensive and Progressive Agreement for Trans Pacific Partnership—an agreement between Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, Vietnam—was signed in March. The agreement opens up a market of 495 million people with a combined annual economic output of US$10 trillion or 13% of global GDP. Once ratified by all the countries, the agreement will eliminate or reduce tariffs on the vast majority of products.

Exports should grow more strongly this quarter

The Bank of Canada anticipates that exports will rebound this quarter, stimulated by strong global demand as well as improvements in transportation.

With a rebound in production and exports, inflation should continue to rise

Inflation continues to tick up, with the consumer price index rising 2.3% in March. Some forecasters expect the Bank of Canada will raise its key policy rate this summer by a quarter of a percentage point. If it does not, the widening interest rate differential with the U.S. key policy rate will put further downward pressure on the loonie.

What does it mean for entrepreneurs?

  1. While the economy maintains a comfortable rhythm, unless capacity is enhanced, inflation is likely to rise, pushing up interest rates.
  2. With interest rates currently relatively low, it makes sense to invest to increase capacity in your business to serve more clients and new markets.
  3. Consider new export markets by learning about the advantages of new trade agreements with Europe and a number of Asian economies. The Canada Tariff Finder provides detailed information on tariffs by product type and destination country.
U.S. economy at a glance

The U.S. economy continues steady growth

U.S. economic growth slowed to an annualized pace of 2.3% in the first quarter, down from 2.9% in the fourth quarter of last year, even as massive tax cuts began to kick in.

Consumer spending, residential investment, exports and government spending all slowed compared to the prior quarter, while inventories increased, largely driven by the wholesale sector. Imports decelerated from their strong pace in the fourth quarter, allowing trade to be a net contributor to growth.

Because the fourth quarter included significant rebuilding after the hurricanes of last fall, the first quarter’s result may appear somewhat lacklustre in comparison. As well, very cold weather in early January likely kept some shoppers at home.

Indeed, households chose to save more of their money even though personal disposable income rose at a brisk annualized pace of 3.4% compared to 1.1% in the fourth quarter, largely due to the tax cuts that went into effect in January.

While investment in capacity rose, it was less than the increase in the fourth quarter

Some companies chose to increase share buybacks rather than invest the money they’re saving in taxes. Already in February, buybacks were double last year’s value at the same time, according to Birinyi Associates.

Other businesses may have put investment plans on hold waiting for more clarity on the tough trade talk emanating from Washington. We will need to wait for more data to see whether investment will pick up more strongly and contribute to a virtuous cycle of expanding capacity, wage growth and higher spending.

Inflation is rising and financial conditions are beginning to tighten

Although spending slowed, price increases did not. Inflation, as measured by the consumer price index, hit 2.4% in March. The Federal Reserve’s preferred measure—core personal consumption expenditures index—was a little lower at 1.9%. The Fed kept its policy interest rate at 1.75% earlier this month, but most analysts expect a quarter percentage point increase in mid-June. Yields on government bonds are also picking up, with the 10-year yield hovering around 3% recently.

The unemployment rate hit an 18-year low of 3.9% in April, down from 4.1%. While employers created a net 164,000 new jobs, the lower unemployment rate was largely driven by more than 230,000 people leaving the labour force. Some of those people are most likely retiring baby-boomers.

A shrinking labour force should put upward pressure on pay. Wages did continue to rise in April, growing 2.6% compared to a year earlier, but it’s still not quite at the pace most analysts would expect given the low unemployment rate.

Consumer confidence fell in April, compared to March, but remains elevated compared to the historical average. According to the University of Michigan, the tax plan and import tariffs had offsetting effects, and consumers seem to sense the economy "is as good as it gets."

Overall, the U.S. economy is showing steady growth, and a surge could materialize if companies invest their tax windfall, increasing capacity and raising wages, which would translate into higher household consumption.

What does it mean for entrepreneurs?

  1. While consumption slowed last quarter, the tax cuts should begin to show up in higher investment, which will be positive for Canadian firms selling into the U.S. market.
  2. U.S. government bond yields are rising, spurring greater demand for U.S. dollars. That’s making the loonie weaker, relative to the greenback, another positive for Canadian exporters.
  3. As interest rates continue to rise in the U.S., the wholesale borrowing costs of Canadian banks will rise, putting pressure on them to raise their rates, as well. If you have investment plans, it may make sense to lock in a rate sooner rather than later.
Oil market update—April 2018

Global oil benchmarks averaged US$66/barrel (WTI) and US$71/barrel (Brent) in April as oil stocks continue to draw down and tension in the Middle East rises.

Oil stocks are close to their five-year average (see chart) as colder than expected weather over the past few months in the U.S. and Europe increased demand for heating oil and propane and kept refiners busy.

Lower production, except in the U.S., has drawn down oil stocks

In March, OPEC and non-OPEC producers cut supply even more than agreed, that is, the supply agreement calls for cutting 1.8 mb/d but producers cut supply by 2.4 mb/d. Mexico produced about 300 kb/d less than it promised because its oil fields are maturing and becoming less productive, while Venezuela’s chronic economic mismanagement forced it to produce 600 kb/d less than agreed.

Even Canada has cut supply because of the low price for Western Canadian Select

Canada also produced 235 kb/d less in March as the discount for Western Canadian Select (WCS) compared to West Texas Intermediate (WTI) was nearly double the usual discount. There is always some discount for WCS compared to WTI because of the different quality of WCS (it is heavier and has more sulphur content) and it costs more to transport it to the Gulf Coast. Given the low price, Canadian producers advanced maintenance plans to allow stockpiles to draw down.

The main factor keeping the discount wide has been the limited availability of pipeline capacity

Producers have been using rail and even trucks to bring their product to the thirsty U.S. market. Trucking oil is very expensive. According to the Financial Post, a truck can only carry 200 barrels of oil, compared with 60,000 barrels in one unit train, or nearly 600,000 per day on the Keystone Pipeline—the equivalent of 3,000 trucks. The discount of WCS to WTI began to narrow in late March as stocks drew down and there was less supply on the market. There has also been some positive news on the Trans Mountain pipeline with the Federal Court of Appeal on March 23 dismissing the B.C. government's bid to challenge a National Energy Board ruling that allows Kinder Morgan Canada to bypass local bylaws during construction of the pipeline expansion.

Still, there are a number of other legal decisions pending which could affect the pipeline’s construction. Despite these pending decisions, Prime Minister Trudeau stated on April 9 that the Trans Mountain pipeline is in Canada’s national interest and the Federal government is considering a broad range of options, which could include direct investment or some kind of financial backstop to the project.

Given lower oil inventories in western Canada and the willingness to get product to the U.S. by whatever transport mode available, the price differential between WTI and WCS should remain relatively steady, around US$15-20/b. Once Kinder Morgan makes its decision on the Trans Mountain pipeline at the end of May, the price of WCS will stabilize at its current level if the decision is to continue the project. If Kinder Morgan were to cancel the project, we anticipate markets would react negatively initially and then prices would return to fundamentals within a few months.

While others pump less, the U.S. ramps up production

The U.S. continues to pump more oil and is hitting new highs each month.

However, the International Energy Agency sees constraints mounting. Wages are rising, materials are becoming more expensive and the pipelines from the Permian Basin to Houston’s export terminal are approaching capacity. The pipeline capacity will remain an issue until the middle of 2019 when new infrastructure is expected to be complete. A sign that transportation costs have become so expensive is that the U.S. Atlantic Coast is buying Nigerian crude oil because it is cheaper (including transportation costs) than Bakken crude shipped by rail from North Dakota.

Geopolitical risk is affecting prices

As inventories have fallen and the oil market’s supply and demand have become closer, geopolitical risk is making oil prices more volatile.

With U.S. President Trump’s decision to quit the 2015 nuclear deal with Iran, oil prices have risen, trading around US$70-77/b in the days following. Iran produces close to 4 mb/d of oil, and exports about 2.7 mb/d. While prices rose on concerns of a supply shortage, such a situation is unlikely to occur given the ample production capacity in Russia and Saudi Arabia, which have been holding back supply into the global market to drive prices higher.

Longer term, the issue will be whether the development of Iranian oil and gas fields continues given the renewed U.S. sanctions on Iran. The scope of the sanctions includes foreign firms that do business with the Central Bank of Iran, which effectively locks out firms from the U.S. banking system.

Bottom line

Oil prices have hit new highs recently as global oil stocks have fallen close to their five-year average on continued lower production. Due to the drop in inventories, geopolitical risks are making the price of oil more volatile. Prices will stay elevated temporarily. Strong fundamentals will be supportive to prices in the range of US$55-65/barrel.

Other economic indicators

Key lending rate unlikely to change

The next decision on the key rate for the Bank of Canada will be announced on May 30. Many forecasters do not anticipate a rise in interest rates before July’s meeting. We can expect the Bank of Canada to keep a close eye on Canadians' debt levels since that appears to be a key reason the Bank is moving slower than its American counterpart. The U.S. Federal Reserve kept its key rate unchanged at its meeting on May 2nd.

Interest rate differentials dominated the loonie’s slide in April

The Canadian dollar appreciated against the greenback in the first half of April reaching 79.7 by mid-month. However, it lost the ground it gained afterward, closing at 77.9 on the 30th, close to where it started the month. While oil prices have hit new highs since the 2014 price crash and the Fed maintained its key rate at 1.75%, the gap between American and Canadian rates remains and kept the loonie under 80 cents.

SME confidence fell again in April

Canadian SME confidence, as shown by the Business Barometer Index compiled by the Canadian Federation of Independent Business, fell 4.1 points in April to 56.6—its third consecutive monthly decline. While optimism declined from coast to coast, the Index reading is still greater than 50 points in every province, meaning business owners expecting stronger performance in the next year outweigh those expecting weaker performance. The proportion of business owners expecting weaker firm performance rose by 5 percentage points hitting 22.8%, the highest proportion in 2 years. Similarly, the number of firms recording below normal unfilled orders and accounts receivable increased last month, which may indicate a slowdown in the economy.

Access to Credit Remains Relatively Easy for SMEs

Most businesses continue to have easy access to credit. According to the Bank of Canada’s Senior Loan Officer Survey, the credit conditions facing small businesses eased slightly during the first quarter of the year. The business effective interest rate is continuing to rise, unsurprisingly, as financial institutions gradually transfer the hikes of the key rate to their clients. The Bank of Canada recorded a business effective interest rate of 3.42% at the end of April, an increase of 55 basis points since the Bank started to raise its rates last July. Business credit growth slowed in recent months, although remains positive.

Key indicators–Canada