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The Canadian Housing Dilemma - Views from the North

FICC Podcasts March 24, 2022
FICC Podcasts March 24, 2022

 

In this episode, Robert Kavcic, a Senior Economist from the BMO Economics team, joins me to share his insights on what’s next for the Canadian housing market as the Bank of Canada potentially gets more aggressive on rate hikes, and his views on the provincial budget season thus far.


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About Views from the North

BMO’s Canadian Rates Strategist, Ben Reitzes hosts roundtable discussions offering perspectives from strategy, sales and trading on the Canadian rates market and the macroeconomy. 

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Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week, I'm joined by Robert Kavcic a senior economist from the BMO Economics team. This week is titled the Canadian housing dilemma.

Ben Reitzes:

I'm Ben Reitzes, and welcome to Views from the North. Each episode, I will be joined by members of BMO's FICC sales and trading desk to bring you perspective on the Canadian rates market and the macro economy. We strive to keep the show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback, so please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg or via email at benjamin.reitzes@bmo.com. That's benjamin.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Ben Reitzes:

Rob, welcome back to the show, it's been a while. You are the resident housing expert, at least in my mind. And so I'm bringing you back on to talk about the permanent favorite topic or seemingly permanent favorite topic for most Canadians. Again, welcome back to the show.

Robert Kavcic:

Thanks for having me on, Ben.

Ben Reitzes:

Excellent. So let's get right to it. About a year ago, I think I had you on, I must have been almost exactly a year ago. We put out a piece in which I pretty much piggybacked on you, giving a rundown on measures the government, the bank, any policy maker could really to take to slow down what at the time was a very hot housing market. And you warned very loudly that if measures were not taken, things would get worse. And here we are one year later and things are worse.

Robert Kavcic:

Very much so. Yes.

Ben Reitzes:

So I guess, can you give us a lay of the land, maybe lay out, I guess what you think are the key drivers as to what's been persistently propelling housing here, and then I'll chime in and you'll shoot down all the other things that I bring in, all the counterarguments as we go.

Robert Kavcic:

Sounds good. So there's a lot going on as you know, right. So the simplest way to characterize it overall would be that we just have a fundamentally very strong housing market driven by demand side demographic fundamentals and some supply side constraints. And so for the last 10 or 15 years, we've seen this prolonged bull market in Canadian housing. And remember for the last 10 years or so, a lot of people were saying, "Oh, there's a bubble in Canada and house prices are collapsing." For that entire period, you and I have been arguing, no, it's not, right. It's very well rooted in fundamentals. So the pandemic, I think then early on magnified a lot of those fundamentals, pulled forward some of the demographic demand that we were going to get. Obviously created very, very sudden demand for space and opened up an affordability valve into some of the smaller markets outside the big cities, because we're able to work from home now on a more hybrid basis, right?

Robert Kavcic:

So all of that is fundamentally driven, but where it got concerning for, I know for you and I a year ago, was when we started to see the market move beyond that, where it was starting to feed its itself. The price growth was starting to feed on itself. So prices were accelerating just simply because expectations of further price growth, right? And we saw that in survey data, we saw that in the share of investors coming into the market, which is a good 10 or 15% points above what's historically been normal. And then obviously you see it in the ramp up in the pace of price growth, which now is running again at like 40 or 50% annualized on a seasonally adjusted basis, obviously that's just not sustainable. That's an overview of just very fundamentally strong market that start to feed on its self and pull in more speculation and more investment activity.

Ben Reitzes:

Okay. So what we read a lot of, and I'm just playing devil's advocate here, because I don't agree, but I'm going to say it anyways. And this is an argument made by many of our competitors is supply is the problem. There are not enough of houses to satiate the demand that strong, underlying demand that you're talking about. We need more houses, Canada go and build me more houses. Why is that dead wrong?

Robert Kavcic:

Well, so what I do sympathize with is the composition of the supply that we do have. So if you look at the raw number of units, we're building a lot, there are 300,000 under construction in Canada right now, for example, right. Which is a record high, in raw terms it's a record high if you adjust for the size of the population, which is to be fair growing very quickly. But we have a big bulge in the population that is moving into the low 30s and you and I both know that when you have your second and third kid, you need space, right? The problem is for the last 15 years or so by rule, we've not been building single detached housing. We've been building condos in towns and intensifying and that's fine, it brings us the number of units that we have, but maybe the composition is a little bit wrong for where we are in the demographic curve right now.

Robert Kavcic:

So that's fine. But in terms of these arguments that Canada just has the lowest housing stock in the G7, well, we're consistent with what we see in the U.S. and Australia, and when you adjust for things like household size and the available land that we have and things like that, we actually don't look out of whack at all. So some of those statistics, I think are a little bit manipulated to make a point that might not totally be valid. And then when you hear things like the panel that advised Ontario to build a million homes over the next 10 years. First of all, we're just physically never going to be able to do that, right, because we're already pushing full employment today, and we already have a severe lack of skilled trades in the building industry, so we're already running at capacity. There's no way we can do an extra million over the next decade. And then do we really need it? That's debatable as well, just given how much is already under construction today.

Robert Kavcic:

And what usually happens is that when demand starts to slow down and it will, when rates rise, because that's really where the excess is right now, then you got to get left with this big overhang of inventory that in some cases takes, three, five years, if not longer to absorb. And unfortunately that's the nature of housing, right, where demand can disappear very, very quickly, but supply takes a number of years to come to completion and then saturates the market for a long time. And we've seen that in markets like Alberta very recently, Regina, some others, if you go back through history, it's how that usually plays out. So contrary to the argument that we don't have enough houses, I think if you look at what is really different today versus pre COVID norms, it's just excess demand. And simplest way to look at it is just look how many sales are transacting. We're running 30 or 40% above what was normal pre COVID in terms of sales volumes, and that's demand, right? It's not supply.

Ben Reitzes:

Yep. Just demand and that's pushing prices up 30-ish percent year over year. Some cities more, even the Western cities are starting to, or guess the Prairie cities are starting to catch a bit here, as people realize that they're relatively cheap. But if you look at the home price charts and a lot of the Ontario cities that are smaller centers to put it nicely, the prices have gone parabolic and that's just not good. Any line that goes parabolic probably comes back down to earth at some point. That's probably the risk here. It's pretty clear that the Bank of Canada is going to be pushing rates consistently higher here, whether they do it in 25 basis point increments or 50 basis point increments. They're getting rates back to neutral in relatively short order. So what will that mean for housing? It's just cool demand and then things slow in an orderly fashion and sales come back down to trend, or maybe is there something a little bit scarier that's going to be coming down the road for housing?

Robert Kavcic:

My sense is that the asset price itself is going to get tested and we're probably going to see some pockets of the country correct, right. And that could be 10 to 20%, I don't think that's totally unreasonable. We saw cases back in 2016, 2017 where certain pockets of the market that were extremely heated after a little bit of a policy response actually did come off 10% or more. You didn't notice it because they were pretty isolated within the country and they were in the context of a broader economic expansion, right. But it did happen. Here's the thing, the market through 2021 and early this year at its peak was priced at around one to one and a half percent in terms of the underlying mortgage rate, right? First it was five year fixed that were down around one and a half percent or slightly lower.

Robert Kavcic:

Those rates backed up, I think we're above 3% on five year fix now, if I'm not mistaken, obviously going up almost probably by the day, at this point. And then what did Canadians do? They rotated into variable because they were still getting 1% of variable. When we look a year from now, if the Bank of Canada does raise rates another five, six, seven times, whatever it ends up being, our call is right in the middle of that, but 1% mortgage rates are going to be gone and the housing market's going to have to price itself at something more in the two and a half percent range at minimum, maybe up somewhere above 3%, depending how far the Bank of Canada goes. For a market that has stretched valuations in terms of affordability, even adjusting for incomes and interest rates, it's going to be a pretty stern test. And so at minimum, I think you're going to see prices level off and maybe some of the hotter markets actually do correct a little bit.

Ben Reitzes:

I think I'm more or less with you there. I think mortgage rates, if the bank gets to 175-ish, prime gets close to 4%. Most mortgages are prime minus something somewhere between 50 and a 100 for the most part. So you're looking at three and a half area to reprice and that's where we are the fixed. And the one thing I'd say before listeners get too bearish is all Canadian households get stress tested. And so as much as there is downside risk on housing, on prices, one, prices have gone up so much that even a 10 to 20% correction really probably only puts the most recent buyers under underwater, much very recent within the past six months or so.

Ben Reitzes:

The fact that everyone's been tested at five, five and a quarter percent, so Canadian home buyers need to be able to prove they can afford mortgage payments, if rates rise to five, five and a quarter percent somewhere in that neighborhood. And so even higher rates shouldn't put too much pressure on the housing market. You're not going to have a U.S. style crisis on the housing market just because rates are going higher at this point. So we're nowhere near that point, it's more like there is so much froth, we just need some correction. Am I off on any of that, Rob? Or that sound reasonable?

Robert Kavcic:

No, no, that's exactly how I think about it too. This is really an issue of just cleaning some froth out of the asset price that got probably too far ahead of itself. It's not a financial stability issue because as you said, we are stress testing and really it's not a major negative equity issue because if we get a 20% correction, you're really going back only six months or so, right? And at the end of the day, as well, as we talked about off the top, there is still real underlying demographic strength that is not going to go away at least for a couple more years. So there is going to be a support in there as well.

Ben Reitzes:

And immigration, don't forget that. There's four, 500,000 people a year coming into Canada, I don't see that changing anytime soon. And so that underlying support, that underlying demand is going to stay there. And one thing I forgot to mention on the supply side, you're dead on there just aren't enough trades people to build all those houses. My hot tub came last week, I'm still waiting for it to get hooked up because the electrician needs, I don't even know what he needs a piece. Johnson rod who God knows, wire through my house, I have no idea what's taking so long, but we're waiting and we're going to keep waiting apparently because he's got plenty of other stuff to do also. And I suspect I'm not first on the list given by the tiny size of my job.

Ben Reitzes:

Trades are definitely challenging to come by and that's just my story, but I've heard dozens of other people just trying to get little things done and there isn't anyone to take those jobs anymore. Given where the unemployment rate is and all that, it is a very tight labor market and the strength in housing and home construction, generally with all those houses still under construction. It's hard to believe that we can build even more than what's underway at the moment. I think it’s time to wrap up, I think from all this, or maybe the bigger takeaway. The fact that rates fell to the bottom during the pandemic and drove a change in housing preferences really did push home prices higher.

Ben Reitzes:

And some of that, of course, fundamentally driven, but the latest call it six to, I don't know, 12, maybe a little bit longer months of price appreciation, probably a little bit overboard at this point. So there room for some healthy correction to get us back closer to where fundamentals are. And longer run you still have those underlying factors that should support housing demand. So as much as prices probably pull back a little bit from here or once rates get up a little bit more, the longer term outlook is still decent. I think people expecting 10, 20, 15, whatever percent annual gains in their home price are probably delusional, they shouldn't be thinking that way, but prices should continue to rise, but surely over time, maybe low, mid-single digits sounds about right over a long run period of time.

Ben Reitzes:

Let's wrap up housing there. It is also as the Bank of Canada begins their rate hike cycle world. We're also in spring and that means provincial budget season. We have about half of the provinces already in hand, we'll get Saskatchewan later today. The biggies that we have so far are BC, Alberta, and Quebec. We had Quebec yesterday and maybe they might be one of the bigger stories of the three, just given what they've done here and how they've chosen to spend their money. Rob, can you give us a bit of an outline as to what you've seen in budget season so far, and if there have been any meaningful surprises?

Robert Kavcic:

Sure. So nothing overly surprising. I think the big surprise was over the course of 2021. Not so much a surprise for us or maybe even for the market, but for finance ministers and for relative to budget forecast, 2021 just came in so much stronger than they had initially thought, if you go back one year ago to the spring of 2021. At the end of the day, the economies and the job market just came back so much faster than finance ministers across this country could have predicted. And the increase in revenues relative to those initial forecasts through 2021 was just unprecedented, we've never really seen that kind of upside before. That deficit last year actually came in quite a bit smaller than expected at the start of the season.

Robert Kavcic:

This year, I think what we're starting to see is that the momentum has leveled off. So if you're in an oil producing province and you have access to royalties off of a $100 WTI, then yeah, you still have some pretty terrific budget momentum. But for the other names like the BC's, Ontario's and Quebec's, what we're starting to see now is that growth is settling down. Budget forecasts are starting to get more in line with reality rather than being massively surprised to the upside. And so that year over year momentum is starting to fade. So combined at the provincial level, that deficit is probably going to be pretty steady year over year, if not, maybe a touch wider, depending on what Ontario does, obviously they're a big driver of this and borrowing as well looks to stay pretty chunky again this year.

Robert Kavcic:

All that to say, the big takeaway through this is that the provinces got through this exceptionally well, even if momentum is leveling off right now. Combined we're looking at a deficit, that's probably only around 1% of GDP or so. The big story through COVID was that Ottawa stepped in and funded the vast majority of the spending that was necessary for Canada and actually transferred a good 30 or $40 billion down to the provincial level, which really helped support the bottom line. So the provinces are actually in great shape considering where we've been.

Ben Reitzes:

Okay. Good news story for Canada. Looking forward the drivers for provincial revenue, our nominal GDP growth, and given that inflation's probably going to stay pretty high through most of this year that should drive more solid revenue growth, am I correct in that assumption?

Robert Kavcic:

Oh yeah, for sure. So underlying revenue growth just from the income tax side is still going to run at a pretty strong clip. I think most this year are assuming three, four, 5% growth obviously depends on the province, but that seems to be utter slightly above what is trend like, or potential. Honestly, if inflation continues to run and real growth holds up, there probably will be a little bit of upside through this year as well, based on what we're expecting versus what some of the early provinces to post budgets have put down on paper. So that slide is pretty solid. The slide that's going to trail off a little bit is on Federal transfers and there was obviously some pretty outsized one off transfers through 2021 related to COVID. We're starting to see those come back down and normalize, so that's a little bit of a drag in some cases as well.

Ben Reitzes:

Okay. So the Federal transfer drag probably offset. We have inflation at five for CPI, at least at 5% this year. So I doubt any of the provinces are looking at it that high. So generally conservative as they always are revenue forecasts, maybe that gets offset by the drop in Federal transfers and still things look pretty good with borrowing coming down generally. We'll see what the Federal budget looks like, probably at some point in the next month, I would hope, now that we have a new agreement at the Federal level to get the budget passed. I suspect the liberals will unveil something in short order. We'll see what that brings, maybe I'll have you on again in a few weeks to discuss that since that should be interesting, see we'll get at the time.

Ben Reitzes:

Staying on the provincial theme, Rob, I guess, which province was the most disappointing? And I say that with an eye on Quebec's budget yesterday, where they, I think could have come in a little bit better. They announced notable new spending plans for next year, and they announced a cash handout for this year and spreads did widen on the back about, they widened about half a basis point. Quebec spreads on the back of the budget release. So the market was clearly a little bit disappointed looking for something better. Does Quebec stand out for you? How do they look and was there someone else that also maybe didn't look quite as good as you had hoped?

Robert Kavcic:

Yeah. So Quebec still looks pretty good. I guess maybe the disappointment was that we've been conditioned to see these much bigger upside surprises and there was underlying strength there in revenues. Through the forecast horizon, there was a pretty good chunk of revenue upside four or five billion dollars or something like that. What they did though, is they turned around and just pushed out $500 per person cash payment that ended up costing them almost three and a half billion dollars. So that took a chunk of the upside out of the bottom line. They're still are on a $3 billion deficit this year, so they still had, I think explicitly two and a half billion dollars’ worth of contingencies. And I'm talking on a public account basis now, not the number they report for legislative purposes.

Robert Kavcic:

This is the number that affects borrowing. So they could very well still have a balanced budget this fiscal year, even though they haven't posted it yet. And then next year, and through the forecast, the rising, they actually are posting public accounts budgets that are balanced. So they look quite good and that ratio is falling as well relative to GDP. And again, if anything, there probably is maybe a little bit of upside on the economic side there. So I wouldn't write them off yet. They still look quite good from a fiscal perspective. You mentioned who was maybe the disappointment, I would say probably British Columbia to be honest. So they went back into deficit probably by more than we're going to see anybody else do this year at five and a half billion dollars.

Robert Kavcic:

And they're borrowing a lot, so not just to fund that bigger deficit, but they have a pretty big capital spending program going on as well. Part of it's related to flood rebuilding and stuff like that. But I think they're borrowing about $19 billion this year, so that's up like $10 billion year over year. And that's pretty chunky for them. And with a lot of spending priorities in the pipeline, they're looking at deficits in the five billion, four billion, $3 billion range, still over the next two or three years. So on a relative basis, we're used to seeing persistent surpluses and low and stable debt to GDP ratios in BC. We're seeing a bit of the opposite now where we're seeing persistent deficits and that debt ratio rising. So that's one area I would say was a little bit disappointing. Now to be fair, they always do run with very conservative budget assumptions.

Robert Kavcic:

And as long as I've been doing this, unless there's some crisis out there, British Columbia will come in above the bar that they set by the time the year is up. It's just that message we're getting from them of persistent deficits and rising debt is not the best one, especially relative to some of the others out there.

Ben Reitzes:

Rising debt that was going to be my question, I guess. That's picking up clearly, that's not credit friendly. This is a bit of an unfair question, but I'm going to ask it anyways, halfway, or at least halfway through budget season, who are your favorite provinces at this point? And it's not fair to ask because we don't have Ontario yet. So I guess you could still pick them, expecting them to beat, but who knows, in this day and age you never know what the government's going to come up with from a spending or revenue perspective for that matter. Pecking order, maybe top three provinces, why don't you do it that way at this point, given where spreads are, how they've behaved and what our macro forecast is for the Canadian economy, for the provinces, for oil prices, all that stuff.

Robert Kavcic:

Yeah. Well, the easy one is Alberta. The question is what's priced in already, and probably a lot has already been priced in, but that province very quickly went from one of the tougher fiscal situations in Canada to now probably again the best. And I know their credit rating was under pressure early last year, and it was just way too premature because look at where we are now, right? Back in surplus and already the budget that they just least now with a small surplus is already probably five, $6 billion too light, or underestimating what they're actually going to see, if not more this year. So they're in a great spot again and obviously a $100 oil is behind that. And it can come and go quickly, but right now it's coming. That's the easy one. You mentioned Ontario, Ontario's been a mystery through this whole pandemic because they've been publishing numbers that look just so exceptionally weak to what we think the reality is and what some of the others are doing.

Robert Kavcic:

I still can't fully wrap around why they're looking at last check at $18 billion deficit this year. I think they already cut that in half, but I suspect if they want to, they can chop that in half again. So I think there's upside here. Of course, we do have an election in June, so the budget that we do get from Ontario, whenever we get it, is probably going to be loaded with some measures, either on the tax side or some other combination of spending that pushes a lot of the fiscal upside back out to voters and tax payers. But from a medium term perspective, I think there's still quite a bit of room to go here as this economy recovers. And then you asked for three, who else do we like?

Ben Reitzes:

If you only have two, that's fine.

Robert Kavcic:

We talked about Quebec. I think Quebec is still pretty solid as well. I guess the only question here is at a $100 oil, if it persists, this is typically where Central Canada starts to weaken relative to the others from an economic perspective. I don't think it's going to look quite as dramatic as we saw earlier in the decade where Alberta was growing at six or 7% and a lot of labor in central Canada was just off for Alberta. I don't think it's going to be that dramatic. I think Ontario and Quebec can continue to grow pretty solidly even if they do get hit a little bit harder by oil prices.

Ben Reitzes:

Yeah. So I totally agree there on Ontario, Quebec and on oil and then the relative growth dynamics in Canada, an important aspect of that 10 years ago or so, and really Pre global financial crisis and post global financial crisis. Canadian dollar, as oil prices went up Canadian dollar strengthened that hurt Central Canada exports, that weighs on that part of the economy. And we're not seeing that now, you're not seeing that strengthen the Canadian dollar. And so the export hit isn't there, the way that it was before. It also means we bear the full brunt of higher prices, but I think that probably is a tradeoff that's okay. Especially as the intensity of oil usage declines over time, that should mean that Central Canada comes out of this okay.

Ben Reitzes:

And there's no way you're to going to get that labor exodus that you had. There just isn't the demand for labor, the way that there once was. There's no monster new construction sites in Alberta for the new oil science projects or anything like that because there really aren't any new projects. So part's pretty key. That being said, I like Alberta, just like you. Longer term I'm pretty upbeat on oil still. I think there's a pretty high floor under oil at this point. It's pretty clear that higher prices don't really drive higher production right now. That's important, it tells you that you're probably unlikely to get a big time drop in prices. And it's hard for me to think that the sanctions on Russia are going to go away anytime soon, that feels like a long term thing as well.

Ben Reitzes:

So ongoing sanctions there, ongoing pressure there, move a global or Western shift away from Russian energy generally, all that suggests that oil stays at least at 80 bucks, probably I'd argue probably 90 might be the floor somewhere in that neighborhood until something really fundamentally changes. And that's bullish Alberta, I think the question for them will be how disciplined they can remain over the next few years. And if next year's budget looks good, like this year, then spreads probably keep going, there is room for them to tighten a little bit further.

Robert Kavcic:

Yeah. Totally. If you look back to when they were running surpluses, mid 2010s, I think where was Alberta like 20, 25 basis points through Ontario?

Ben Reitzes:

Yep.

Robert Kavcic:

So we probably don't go all the way back to that extreme, but we have more room to go from where we are today I would say.

Ben Reitzes:

Yeah. At the time they had no debt, so that's different rules they have, they have net debt now, but that'll get paid down over time. That's why I think the government needs a little bit of credibility and a bit of a track record here and then there's room to keep going on this. That's about time, so let's wrap things up here, Rob. Thanks for coming on the show this week, and I will have you on again, maybe for the Federal budget sooner than you think.

Robert Kavcic:

All right. Let's do it, sounds good to me.

Ben Reitzes:

All right. Thank you.

Ben Reitzes:

Thanks for listening to Views from the North, a Canadian rates and macro podcast. I hope you'll join me again for another episode.

Speaker 2:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated, and BMO Capital Markets Corporation. Together BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts. Notwithstanding the foregoing, this podcast should not be construed as an offer or the solicitation an offer to sell or to buy or subscribe for any particular product or services, including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or a suggestion that any investment or strategy referenced herein may be suitable for you.

Speaker 2:

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Speaker 2:

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Benjamin Reitzes Managing Director, Canadian Rates & Macro Strategist
Robert Kavcic Director and Senior Economist

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