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Monthly Economic Letter

April 2019
Feature article

Are these the first signs of a housing crash?

Some housing markets have slowed amid rising interest rates and new mortgage rules

Since 2000, home prices increased 240% across Canada—with the price of homes in Vancouver and Toronto leading the pack.

After this long period of huge gains, house prices have started to cool. At 2.9%, the annual increase in prices in 2018 was way below the 13.3% increase in 2017. Factors such as rising interest rates and new mortgage rules are having an impact.

Are these the first signs of a housing crash? What will happen in 2019? This article looks into the reasons behind the surge in home prices and provides insights into the future direction of housing prices.

What drove the boom in house prices?

Immigration and housing demand—Canada’s population is currently growing at a faster pace than it did in the last decade. Since the 1990s immigration has accounted for about two-thirds of population growth. The recent trend has been even stronger, with net migration accounting for 80% of population growth this decade.

Research by Statistics Canada and the Canada Mortgage and Housing Corporation also indicates that immigrants may have a stronger preference for investments in housing than Canadian-born citizens. The average value of single-detached houses owned by immigrants in Vancouver is 17% higher than that of comparable houses owned by people born in Canada.

Low interest rates—In the aftermath of the last financial crisis, the Bank of Canada reduced its trend-setting interest rate to 0.25%—the lowest ever seen in Canada. Low interest rates enabled home buyers to purchase more expensive properties.

More condos are being built than single-family homes—The construction of multi-dwelling units has outpaced single-family housing nationally since 2006. The trend began much earlier in the major cities—since the early 1990s in Vancouver and the early 2000s in Toronto. This has created a shortage in available single-family homes, resulting in strong upward price movement for these homes.

In some cities, other issues, such as zoning by-laws (density requirements, green belts) and geography, have limited the supply of housing and helped drive prices up.

The market cooled in 2018

The run-up in prices took a break in 2018, when nominal house prices grew by only 2.9% and real prices rose by just 0.7%. Changes in mortgage rules and higher interest rates were behind the slowdown.

In the 1990s, mortgage guidelines were loosened to spur housing investment. They were relaxed further in 2006 when mortgage amortization periods increased from 25 to 40 years and loan-to-value (LTV) ratios increased from 95 to 100, meaning no down payment was required.

Following the financial crisis and recession of 2008-09, lending conditions tightened. Ultimately, the amortization period was cut back to 25 years and the LTV ratio for all houses was lowered back to 95 or more restrictive in some cases. Provincial policy measures targeting foreign buyers also hit the market. British Columbia has implemented a foreign buyers’ tax of 20% on homes in the Greater Vancouver area. Ontario followed suit and adopted a similar tax of 15% for homes in the Greater Toronto area.

The latest change came last year from the Office of the Superintendent of Financial Institutions. Its Rule B-20 requires regulated lenders to put potential borrowers through stress tests. This new mortgage rule reduces the amount Canadians can afford to borrow by around 20%, disqualifying about one in five potential buyers and shutting many young buyers out of the market, according to a Mortgage Professionals Canada survey. The new rule had an immediate tempering effect on the market.

Higher interest rates have put a further damper on the housing market. The Bank of Canada raised its rate by 0.75% in 2018, and by 1.25% since 2017.

Research shows it takes between three and five years for changes in central bank interest rates to fully work their way through the economy. When they do, a one percentage point change in interest rates can have a three-to-five percentage point impact on home prices. This means we can expect the increases in the bank’s policy rate in 2017 and 2018 to continue to dent housing prices in coming years.

The biggest risk to the housing market is high household debt

As housing prices have increased, banks have extended more credit to households, the majority of which has been mortgages (72%). As a result, the total household debt-to-income ratio has been on a relentless upward trend, reaching a record 174% in 2018.

Another worrisome trend is that household income growth has slowed down, even as interest payments have risen. This is showing up in a higher share of disposable income going to service debt—almost 15% as of the fourth quarter of 2018.

The vulnerability of households to a rising interest rate environment has become an increasing concern. Indeed, the Governor of the Bank of Canada estimates that the economy is 50% more sensitive to rate hikes than in the past. This could potentially force a significant number of households into a difficult financial position, triggering a broader slowdown in both the housing sector and the broader economy.

Is a crash coming?

We don’t think so. The economy is doing well. Job growth is strong, with the economy creating over 390,000 new jobs between December 2017 and 2018 and GDP regained lost ground in January (see our Canada article for more information).

As long as people continue to work, they will likely to be able to meet their debt repayments. Also, there were a number of measures announced in the federal budget designed to assist first-time home buyers.

The Bank of Canada’s pause in its hiking cycle for 2019 will also help.

What does it mean for entrepreneurs

  1. If your business operates in the housing or construction sectors, expect a mild slowdown. However, you probably don’t need to worry about a housing crash.
  2. For homeowners planning to sell, prepare for lower price gains than in the past, especially if you are located in Vancouver and Toronto.
Canadian economy at a glance

GDP regains lost ground

A rebound in Canadian economic growth in January calmed recession worries after a slowdown in the last two months of 2018. Real GDP rose by 0.3% in January, regaining ground lost at the end of 2018 when it declined by 0.1% in both November and December.

The January upturn was widespread, with gains across 18 of the 20 industries. Production rebounded in industries that had suffered a slump in December, although the mining and oil-and-gas extraction sector continued to struggle. A decline in the oil-and-gas sector was expected because the industry is still fighting headwinds. An oil production cut by the Alberta government, a lack of pipeline infrastructure and low prices continue to hold it back.

Strong gains in the construction and manufacturing

Construction and manufacturing together account for about one-fifth of the economy. In January, a 1.5% increase in manufacturing and 1.9% in construction were responsible for 83% of the total GDP growth. Notwithstanding the construction sector’s strong gains to start the year, it’s unlikely the industry performed as well in February due to a slowdown in housing starts and a low level of existing home sales during the month.

Despite the housing sector’s poor performance in February, the Canadian economy is on track to grow by 0.8% in the first quarter, according to a Bank of Canada forecast.

Poor retail sales point to a consumer-led slowdown

Positive GDP in January is encouraging, but low consumption is hindering Canada’s economic growth. Healthy household spending is of paramount importance to the Canadian economy because these expenditures represent about 60% of GDP.

The drop in consumer spending can be traced to interest rate hikes. The Bank of Canada began its rate hiking cycle in July 2017. Since then, the Bank raised rates five times from 0.50% to 1.75%.

The result has been subdued retail sales as consumers continue to adjust to higher interest costs. In the 18 months following the first hike, retail sales grew by an anemic 0.4%, compared to 9.4% in the 18 months preceding the first hike. The Bank of Canada forecasts that household spending will continue to ease throughout 2019-2020.

Labour market strength and low inflation help offset consumer spending slowdown

Canada’s labour market remains solid with 116,000 new jobs created in 2019 to date. Employment flattened in March, but increased by 332,000 in the last 12 months. The unemployment rate remains low and steady at 5.8% again this month.

Meanwhile, inflation remains well under control—below the central bank’s target of 2.0%. The all-items inflation rate increased slightly to 1.5% in February from 1.4% in January.

The solid job market will help consumers deal with higher interest payments, while low inflation will reduce the likelihood of more rate hikes in the near future. A pause in the Bank of Canada's interest rate hikes should provide some relief for indebted consumers.

What does it mean for entrepreneurs?

  1. If your business is operating in the retail sector, your sales may be under pressure. Consider where you can trim costs and take advantage of technology to improve efficiency.
  2. If your business is exposed to interest-sensitive sectors, such as housing, construction and retail, be aware that a slowdown is occurring.
  3. Interest rates should not increase any further in 2019. Given the pause in hikes, it’s a good time to move ahead on investment projects to get ahead of your competitors.
U.S. economy at a glance

Slower growth ahead, but no recession in sight

The U.S. economy slowed more than anticipated in the fourth quarter with GDP revised down to 2.2% from 2.6%.

Lower consumption and business investments mainly explain the fourth-quarter downward revision. Still, the underlying trend points to a moderation in growth this year, not a recession. Most recent economic indicators show slowing consumer spending and a weaker housing sector, but manufacturing continues to expand and the trade deficit has shrunk.

In the context of low inflation and slowing economic activity, the Federal Reserve has sent strong signals that interest rates should not increase this year. However, U.S. real GDP is still expected to grow by a very respectable 2.4% in 2019, according to consensus forecasts.

Consumer confidence falls

Consumer confidence deteriorated in March compared to February. The Conference Board Consumer Confidence Index was 124.1 in March, down from 131.4 in February. Consumers’ assessment of current business and labour market conditions, as well as their short-term outlook, weakened. Financial market volatility, a partial government shutdown and a weak February jobs report may have caused this more pessimistic stance.

It’s too soon to say whether weaker consumer confidence has had an impact on consumption because data collection and processing were delayed by the government shutdown. However, February figures on retail sales showed only a slight 0.2% drop.

Housing is cooling

After posting a strong increase in the previous month, much of the gain in housing starts was clawed back in February. Starts fell by 8.7% to a two-month low of 1.2 million units in February. This unexpected drop was the largest in eight months.

The decline may partially reflect unseasonably cool weather. It may also have been caused by capacity constraints faced by builders, including higher labour and material costs, which limited their ability to ramp up the supply of new homes, especially in lower-priced market segments. Building permits dropped to 1.3 million units, reaching a four-month low.

Manufacturing expansion continues

Activity in the manufacturing sector expanded in March for the 31st consecutive month. New orders, production and employment grew. Prices also rose, following a decrease in February. All manufacturing industries reported growth with the exception of paper products and apparel, leather and allied products.

Average employment growth slowed in first quarter

Employment increased by 196,000 in March. The job creation estimate for February was also revised up from 20,000 to 33,000. Employment growth averaged 180,000 per month in the first quarter of 2019, compared with 223,000 per month in 2018. The unemployment rate is unchanged at 3.8%. Salaries continue to grow, reflecting tight labour markets.

Trade deficit shrinks

As exports increased and imports decreased, the U.S. international trade deficit in goods and services contracted by 15% in January to reach $51.1 billion. The deficit with China fell by the same percentage to $33.3 billion.

Is the contraction attributable to the trade war between the two countries? That’s hard to say. Despite placing tariffs on billions of dollars of goods from China over the past year, the U.S. trade deficit with China increased to $419 billion in 2018 from $376 billion in 2017. Indeed, Chinese imports helped fuel America’s booming economy last year.

The recent trade deficit contraction is more likely the result of cooling economic activity than successful tariff policy. According to the National Bureau of Economic Research, the protectionism measures had a negative effect of $7.8 billion on the U.S. economy in 2018, equivalent to 0.04% of GDP.

Federal Reserve unlikely to raise rates

The U.S. fed funds rate increased from 1.5% to 2.5% in 2018. On March 20, the Federal Open Market Committee left the rate unchanged at 2.5%. The committee cited low inflation and a strong labour market, but slower growth in household spending and business fixed investment in the first quarter, as justifications for its decision. Projections released by the committee indicate rate hikes this year are unlikely.

What does it mean for entrepreneurs?

  1. Stable interest rates in the U.S. mean that Canadian banks' funding costs are based in part on the yield of five-year U.S. Treasury notes. This means entrepreneurs can take advantage of stable interest rates in Canada.
  2. Despite a moderation in growth, the U.S economy is still vibrant and will continue to offer great opportunities for Canadian exporters.
Oil market update

Global oil demand on track for slow growth this year

Despite dropping in the last quarter of 2018, global oil demand is expected to increase marginally in 2019, according to the latest estimate from the International Energy Agency (IEA).

The agency’s March global demand estimate for 2019 was unchanged at an average 100.6 million barrels a day (mb/d), 1.4% higher than 2018. However, a slowdown in economic activity in China, where GDP growth is expected to slow to 6.3% in 2019, according to the IAMF from 6.6%, introduces a downward risk to this forecast.

Production falls, but reserves could mitigate supply disruptions

Global oil production fell during the first months of 2019 as production cuts by OPEC and non-OPEC countries deepened. OPEC production dropped on losses in Venezuela and lower output from Saudi Arabia and Iraq. An electricity crisis in Venezuela is a cause for concern. The power outages could present a serious supply constraint if they lead to a collapse in that country’s production.

In December, OPEC countries and some non-OPEC countries agreed to implement output cuts of 1.2 mb/d. Overall compliance from the OPEC members reached 94% in February, with Saudi Arabia cutting back by about 170,000 barrels a day (b/d) more than required. The non-OPEC countries—Russia, Kazakhstan, Mexico and six other countries—are complying more slowly, with a rate of just 51%. Russia is reducing its output very gradually.

Due to the cuts, OPEC members are sitting on about 2.8 mb/d of spare capacity. Those reserves are composed of crude of similar quality to Venezuela’s exports. In the event of a collapse in Venezuelan production, these reserves could mitigate supply disruptions.

U.S. production continues to grow

Growth in U.S. crude oil production has been driven by the development of shale oil resources, primarily in the Permian Basin in western Texas and eastern New Mexico. The boom in U.S. shale oil production shows no signs of relenting, as the industry continues to improve drilling efficiencies and reduce costs.

Total U.S. oil production reached 11.8 mb/d in January 2019, up from just over 4 mb/day in September 2008. The IEA anticipates the U.S. will become a net oil exporter in 2021. This is an incredible turnaround in just a decade.

Although rising U.S. production will enhance the security of supply and provide some protection against geopolitical concerns (in places like Libya, Venezuela and Nigeria), in the long run, the extra supply will keep prices tame.

The WCS discount narrows, although export constraints persist

At the time of writing, the Western Canadian Select (WCS) price discount to West Texas Intermediate (WTI) had narrowed to US$9.40/barrel (it started the year at US$15.65/barrel), as a result of Alberta’s output cuts implemented in January.

On March 2, Enbridge announced a one-year delay in the start-up of its Line 3 pipeline replacement project. The project, which is expected to boost Line 3’s capacity from 370kb/d to 760kb/d, is not expected to be in service now until mid-2020.

In the meantime, the Alberta government is making more rail transport available, but moving volumes by train can cost between US$10 and US$15 a barrel. For rail transport to make economic sense, the WCS discount would need to exceed that cost. Since the WCS discount narrowed in late 2018, rail exports are less viable and rail export volumes have fallen.

Bottom line

World oil demand is likely to stay the same or increase slightly this year. Although U.S. crude production is growing, that increase is expected to be offset in the short term by declining OPEC and non-OPEC production.

Demand may outstrip supply in the second quarter of 2019 by about 0.5 mb/d, according to the IEA. This may have an upward effect on oil prices in the near term, or at least prevent any significant decrease.

Other economic indicators

Rate hikes are off the table for a while

The Bank of Canada will most likely leave its policy rate unchanged at 1.75% at its next meeting, scheduled for April 24. The Bank’s Governing Council stated on more than one occasion during the month of March, that its outlook continues to warrant a policy rate below the neutral rate (the level at which the policy rate neither constrains or stimulates the economy). Contrary to rumours of a possible interest rate cut, the Bank of Canada seemed confident that the slowdown is temporary—which would not warrant a decrease of the policy rate. The Bank of Canada is instead more likely to be patient during the year, in line with the U.S. Federal Reserve, which annouced that there will be no further hikes this year.

The loonie remains stable

The Canadian dollar slightly depreciated against the U.S. dollar in March and closed under US$0.75. The loonie has been quite stable since the beginning of the year, oscillating between US$0.74 and US$0.76. The differential between Canadian and U.S. interest rates will continue to put downward pressure on the Canadian dollar during the year while a slight increase in oil prices should partly off-set that pressure.

SMEs’ confidence dipped in March

The Canadian Federation of Independent Business’ Barometer Index losts the ground it gained at the start of 2019. SME confidence decreased by more than 3 points between February and March to 55.9. CFIB estimates that a healthy index level should be 65 or above. Entrepreneurs in the natural resources sector have been the most pessimistic every month since the beginning of the year. Confidence levels in that sector took a major hit in March and fell by almost 6 points to 38.8. Nova Scotia and Quebec are the most optimistic provinces this month. Confidence remains low in the Prairies and Newfoundland, in line with challenges in the oil industry and difficult agricultural conditions amid the U.S.-China trade war.

Business credit conditions soften again this month

The effective household interest rate has been stable at around 4%, since the Bank of Canada’s last rate hike at the end of October. Interestingly, the effective business interest rate has been easing over that period. It fell to 3.54% at the end of March, the same rate companies faced in July 2018. To date, the effective household interest rate has risen by 95 basis points and the business interest rate by 80 basis points. These increases are lower than the 125 bps increase in the policy rate over the same period.

Key indicators—Canada