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How Do You Solve a Problem Like Hot Housing? - Views from the North

FICC Podcasts March 31, 2021
FICC Podcasts March 31, 2021

 

This week Robert Kavcic, a Senior Economist from the BMO Economics team, joins me to share his insights on the raging Canadian housing market, potential policy actions, and his views on the latest provincial budgets.


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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 the 13th episode of 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's episode is titled, How Do You Solve a Problem Like Hot Housing?

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 perspectives 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.Reitzes@BMO.com. Your input is valued and greatly appreciated.

Speaker 1:

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

Ben Reitzes:

Before we start, here's some background on Rob. Rob's been with BMO for 15 years, and we've worked together closely throughout that entire period. When I have questions on housing or the provinces, he's my first call or email. Or back in pre-COVID days, I'd just shout over. Welcome to the show, Rob.

Robert Kavcic:

Hey Ben, thanks for having me on.

Ben Reitzes:

So we put out a piece on Tuesday this week, outlining potential policy actions the government could take to cool the housing market. In case any of our listeners missed it out there, reach out to me. I'm happy to send that along or send you a link. Rob, I guess, why the sudden urgency to push policy makers to act? The housing has been strong for a while now, what's changed in the past, call it, a couple of months or so, or maybe it's just more of the same and then it's time to act?

Robert Kavcic:

Well, so the short story is I think the market, it's almost gone parabolic the last six months or so. As we see them now, prices are detaching from fundamentals and that's really the concern. I say this as somebody, and as you know very well, you've been in my camp on this too, probably for the last 10 years or so, that we're not housing bears at all. We've very much been of the belief that supply and demand fundamentals have been explaining a lot of the strength in housing and home prices have been rising because they should have been rising.

Robert Kavcic:

But when you see prices going almost 20% year over year, and then on a three or a six or a one month annualized basis, 30, 40, 50%, I've seen some comps that are up, no joke, 40% just since the fall, not annualized. We have a bit of a situation brewing where the price strength is starting to feed on itself. And if that starts to bring in more speculation and prices detach even further from fundamentals, then we're going to have to obviously pay back for this over a long period of time once this is done.

Ben Reitzes:

So home prices shouldn't go up 100% per year? Is that what you're saying?

Robert Kavcic:

Doesn't seem healthy to me.

Ben Reitzes:

That's fair. Bubble. The bubble talk started a while ago. And I think at the time it was more like, well, we're clearly headed in that direction potentially, but why don't we wait to get there before calling it that? Is that how you would characterize where we are at the moment? And I guess, is it the whole market? Parts of the market? How would you characterize it?

Robert Kavcic:

So I hate the word bubble because we've been arguing against this for, as I said, for 10 years. So I don't want to just jump in and call it that. Because I think at the root of this, there are real supply and demand fundamentals that are driving prices. The problem is pandemic has magnified everything. So you have supply side constraints, you have a lot of demand coming down the pipeline for millennials or people looking to trade up for single detached homes. And the pandemic pulled a lot of that demand forward and threw record low interest rates on it, threw very aggressive fiscal policy on it. So it's almost like, not a bubble, because there are underlying fundamentals underpinning this market, but it's more like a perfect storm of factors that have compressed all this strength into a very short window.

Robert Kavcic:

So at its root, I don't think there's anything wrong with it. It's just it's starting to run too hot and it's starting to possibly feed on itself. And that's where policymakers maybe have to start looking at this and saying, yes, we have supply fundamentals. We have demand fundamentals that are legitimate, but if this price strength starts to pull in speculation, then it becomes a problem. And then it starts to look more like that classic bubble where prices are rising faster simply because prices are expected to rise faster. And if you want to call it that, that's pretty much where we are right now. We have some survey data that suggests as much. And just speak to people on the ground, it suggests as much too, that there's nothing to stop the housing market at this point. So yeah. I hate the term, but let's be honest, it's looking more like that, I guess.

Ben Reitzes:

Fair enough. You talked about fundamental factors, and I love demographics, something I'm always interested in. Can you outline, because you do it better than I do, the demographic factors that are impacting the housing market at the moment? And what kind of durability do those have? How long is that going to last? And so, even with we put in new measures to slow things down, those factors are still going to be there. And so they'll still be that underlying support for housing. Outline them please for the listeners. I think, like for me, that's number one. That's the most important thing. And then everything else is kind of secondary after that.

Robert Kavcic:

Yeah. I agree. The factors are not going to go away. So policy isn't, in that piece we put out, policy is not attempting to eliminate this fundamental support, it's attempting just to cool down the froth that's built on top of it. So on the demographic side, it's really, I would say two main pieces. One is the one that everybody knows about and that's international immigration. And since 2015, 2016, when the government changed over and immigration targets were increased, we've seen a dramatic increase in international immigration flows. With respect to the age distribution of those flows, they're typically younger to middle age, and that's a prime segment of the demographic that requires housing, or looks to buy housing.

Robert Kavcic:

Right now, obviously those flows are on pause, just given the pandemic. A lot of the decline we've seen in the immigration flows over the last year has been in non-permanent residents. So the bigger impact there has really been on the rental market. Things like students and temporary foreign workers. Permanent residents still seem to be flowing, but obviously down a little bit. But I think the key here is that Ottawa is making it pretty obvious that, once we get through this pandemic, not only are we going to return to very strong permanent immigration targets but we actually might see those targets increase to make up for lost time.

Robert Kavcic:

And so initially what happens is those inflows tend to get scattered pretty evenly across the country. And then, so the second piece of that demographic story is inter-provincial migration. So a lot of those flows over time typically gravitate to where the strongest job markets are. And that's, at the end of the day, it's Toronto, Vancouver, Montreal, Ottawa, and that's not, coincidentally, where the vast majority of the housing market strength has been. You do have periods where Alberta draws provincial migration when oil prices are strong and that economy is strong, but that's just not the case right now. So it's really those four major cities.

Robert Kavcic:

And then the biggest piece of this that nobody seems to appreciate for some reason, or maybe they're starting to wake up to this now, but I know you and I have been talking about this for the last 10 years, is that the millennial group in Canada is huge. And if you look at a population pyramid in Canada, there's a huge bulge in the population pyramid. The leading edge of that is about 38 to 40 years old right now.

Robert Kavcic:

And what those households are doing is they're moving up the population pyramid. And as you get into your thirties, you start having kids and you start looking for single attached houses. So the problem is that we have that demand curve for single detached housing shifting out consistently year after year. But because of policy on the supply side going back 15 years, the supply curve for single detached housing is getting steeper and steeper and steeper. So this is not going to go away. This is something that's going to be with us probably still for another decade, and once we get through this pandemic. I think it's here to stay.

Ben Reitzes:

That's a good point. And then you can add to that, the fact that baby boomers are staying in their homes for even longer. And there's just not ... The rush to get out of that home is not maybe what people thought it was going to be, I don't know, 10, 15, 20 years ago. People like their houses. I don't blame them. I like staying in my house also. My parents are still in their house, and until they can't walk up and downstairs, they're still going to be there and they're in their seventies. So probably still a few years to go before they even exit theirs. And I think that seems to be the general sentiment. And demographics for me, that part's key. Millennials want to have houses pretty simple as that, like anybody else, and a lot of focus in Canada tends to be on the supply side and what we can do on that side.

Ben Reitzes:

But realistically, it takes time to build houses. It takes time to change that supply side of things. And so calling on policy makers to build more houses. Yeah, that's fine and dandy for the next five to 10 years, but that's not going to stop the train that's running right now. So that's a long-term solution, not a short-term one. And that's something we need to, I guess, think about, but it's the short-term stuff right now that really matters.

Ben Reitzes:

If the government does nothing, what's the risk here? I've seen some hyperbole in the media and in a recently global mail article printed with our names on it, not our hyperbole luckily, but what's the worst case scenario here if things just keep running, the government does nothing?

Robert Kavcic:

Well, it becomes an asset price bubble. And we have to pay the consequences of that on the other side. Go back to the late eighties in Canada where we had a pretty obvious ramp in housing bubble in Southwestern Ontario, prices took probably almost 10 years to come back. So the risk is, it's probably more of an economic one and a household one, where, if you're getting pulled into the market today because you're scared of missing out. And then the market cracks a little bit, and say we do get a 20% decline or something like that, just as an example, you could have a situation where households are stuck with negative equity for a number of years. And the longer this runs, the bigger and longer that risk becomes.

Robert Kavcic:

So that impacts mobility and all that kind of stuff and consumer confidence and spending. Where I don't think that ... where the hyperbole has gone a little too far is some people are saying that this is a systemic risk to the financial system. I don't think that's the case because we've been tightening mortgage lending standards in this country for about 15 years almost now. So this isn't the case where we're probably going to see a massive increase in delinquencies or a big impact filtering through the financial system like we saw in the US. This is more of an asset price bubble and the consequences that come with prices falling off.

Ben Reitzes:

Excellent point. The US built way too many houses. It was a supply issue there as much as anything else. They gave money to people who probably didn't qualify or should not have gotten the money and they built too many houses. We don't do either of those.

Robert Kavcic:

No, you're totally right. We walk into a bank today, and if you're paying one seven on a five-year fixed, you're qualifying at 479. So it's almost the opposite of the US, it's extremely conservative here.

Ben Reitzes:

Exactly. And home building, because of regulatory reasons, home building has been too low for too long, especially in the single family part. Couple more things on housing before we move on. I guess this is a pretty hard question. God, I'm not even sure how to answer this, but how far do you think prices are overdone at the moment? Because there are fundamental factors driving this, and there's also more speculative factors, I guess, how much have the speculative factors layered on in your opinion? And that doesn't mean prices need to fall by that amount, it just means that we could go probably go sideways for a little while, more likely than not given those strong underlying factors. But how much of the move in prices is too much?

Robert Kavcic:

It's tricky to untangle everything. Basic thing we do is we have a model that we keep in here that looks at prices relative to incomes and interest rates. So it takes all those fundamentals into account. And it's a pretty decent track record of telling us when things are going off the rails a bit. Like 2016, for the first time it started to say, well, hang on, prices are running a bit too hot here. And then of course, remember what happened then. We saw the foreign buyer tax come in BC and Ontario, and then the bank tightened policy and the hottest markets like single detached in Toronto and Vancouver corrected about 10 or 15%. And it took four or five years to get those declines back.

Robert Kavcic:

I would say that's where we are today, at minimum. We've probably gone past that. We've also probably seen strength that's a lot broader than we saw back then. But when I run that same model today, I think we've gone about 10 to 15% too far right now. And that is giving some credit to the fact that some of this is real fundamental demand that was pulled forward. So some of the relative shift in pricing that we've seen, say out of Toronto and into the smaller markets around Southern Ontario is going to stick with us. Some of that's permanent, but I'd say about 10 to 15% of it is gone ... reflects just excess. The concern is that next month it might be 20. And then a month after that, it might be 25. So that's why we've been calling on policymakers here to step in.

Ben Reitzes:

So the next logical question is, what should policymakers do? But you know what, I'm going to let my listeners go to our website. They can go to the BMO economics website and check out our list of potential measures, fraught with too many landmines when we go through them. Because almost no matter what you choose, no matter what the government does, they're going to make somebody angry. And so us voicing our preferences, not the best idea.

Ben Reitzes:

I'm going to wrap up housing on this note. From a market perspective, I think the way .... a financial market perspective, I think probably the single most or largest impact of a potential, I guess, measure on slowing housing down from the government, likely from the government because the Bank of Canada moving on rates is pretty much zero at this point, or the likelihood is pretty much zero, would probably come with the swap market.

Ben Reitzes:

What we've seen for a number of months now is consistent paying out of bank treasuries in that three to five-year sector. And you've seen swap spreads widen out notably and get pretty rich here. We're at really historically rich levels for looking back quite some ways. And so, if there is some kind of measure coming up in the budget, which is out on April ... the federal budget, which is out on April 19th, I think that's where probably the market opportunity is. And there's a chance that the measures should come sooner than that. The volume on this topic is only rising by the day. I can tell you that Rob and I, after we put this article out, multiple radio interviews, multiple media news outlets coming to discuss things. Rob had a good interview on BNN that was 10, 12 minutes long, which is exceptionally long for that station.

Ben Reitzes:

And there's just huge interest at this point. So as the volume grows, and we'll get the March numbers in the coming days, the first few days of April, if those are insanely strong again, the volume is only going to go up another notch. And so it's going to be tough for the government to resist doing something at this point. The calls, it's questioning what they do, I guess, more than anything else, and how impactful whatever they choose to do ends up being.

Ben Reitzes:

Let's change gears a bit here. So Rob's main specialty beyond housing is the provinces. And we've had a few provincial budgets over the past couple of weeks. And 2020 was particularly challenging for all levels of government. No doubt there, but despite the rise of [inaudible 00:16:37], provincial finance has actually made it through the year in pretty decent shape. If you look at the depth of the downturn, the federal government really shouldered the bulk of the pandemic spending burden. And they really still are at this point with spending still going. We've seen Ontario, Quebec, Alberta, Nova Scotia budgets so far. Why don't we start with Ontario? They're the biggest. Did anything stand out there? Or was it just status quo and steady as she goes for now, as we slowly make our way back to normal?

Robert Kavcic:

Ontario, I would say there wasn't much in there to be honest, and that's not a criticism. It's a very uncertain spot right now. So they really just held the line and said, we're going to spend more in 2021, 2022 to support the economy and the healthcare system through COVID. But beyond that, there wasn't much from a policy perspective. I think the biggest thing is, so two things. The deficit this year, it's still very wide considering that we're coming out of the pandemic in theory. So 3.7% of GDP on the deficit versus four and a half last year. It's not a huge improvement, and they didn't put any timeline to balance the budget on the books. And they actually still, two or three years out, it still had deficits that were around two or 3% of GDP. So not a lot of improvement there going forward.

Robert Kavcic:

I think the takeaway here though, is that they're setting the bar as low as they possibly can. And that we are going to see, as this fiscal year unfolds, we're going to see these numbers come in quite a bit better than they have on paper right now. So I think last year, last year deficit was 38 and a half billion. That's going to be the low. This year at 33 is, again, setting the bar low. And just as an example, on their growth forecast, I think they're very well below consensus and very well below we are right now. And I think that they're actually two percentage points below where we are on a real GDP call for 2021.

Robert Kavcic:

And we just saw another monthly come in way stronger than expected. You know as well as anybody, we're probably pushing the Canadian growth forecast up, not down. So the takeaway here is that they've set a very conservative bar. And I think some of the numbers that came out of that budget might've had a few heads shaking. I think those numbers will pretty easily be beaten.

Ben Reitzes:

Yeah. Their growth forecasts are definitely ... We've been on the more optimistic side of things, and we're not at the top of the pack anymore, which is a little disappointing to me. But after the January GDP number, again, beating above the flash, most of the country was in lockdown in January and the economy still grew 0.7%, which is pretty strong to say the least. And then February, it looks like it's going to be solid. Their flash estimate was plus 0.5. And there's no reason for March to be any worse. If anything, things were more open in March. So another solid month there. And even if we see another lockdown, which is looking increasingly probable in April at some point, even if it lasts a month or two, January suggests that the economy is able to cope pretty well at this point.

Ben Reitzes:

We've figured out how to live to some extent, as soul crushing as it is for some of us, through these lockdowns for extended periods of time, and the economy's done okay. So it looks as though growth forecasts are going to be ... whatever was put on the books a month or two ago, which is when these budgets were put together, are going to be super conservative. So there's huge upside there. So I'm pretty hopeful that, even our current forecast is maybe on the conservative side, there's probably, maybe not conservative, but there's probably upside. I think the risk is probably a little more skewed to the upside, but that's been my bias for a long time. And we'll see how that plays out over the next couple months or so.

Ben Reitzes:

I'm guessing all the other provinces are similarly positioned. They've created this low bar where they can easily surpass it and look good whenever their elections end up coming?

Robert Kavcic:

Seems that way. Quebec was similarly conservative. Their deficit numbers look better though, but they came into this in a stronger position anyway. So they're going to see, at this point, quicker fiscal consolidation. And on the policy front, it was pretty similar with Quebec in that they've released some more funding for pandemic related spending, but not much else beyond that.

Robert Kavcic:

Alberta is the other one. Obviously they have the energy sector to deal with as well in that province, in addition to COVID, and they, on their oil price forecast, they came in pretty conservative too. So we've seen WTI trading around $60 over the course of the last month, and I believe their budget penciled in about 46. Yeah. $46 for WTI. And just the rule of thumb is all else equal, they're already about $5 billion ahead for the fiscal year if these prices stick. So that's a pretty common theme. Bar's being set pretty low for this budget season.

Ben Reitzes:

Upside galore then. So I guess, from an issuance perspective, which is what the investor community tends to focus on, what kind of improvement are we looking for relative to last year? And I guess, if you look at what they're telling us versus maybe what's more realistic, or maybe in line with BMO's forecast, let me put it that way, assuming we're right on our better growth outlook, how does the issuance forecast change relative to last year? And maybe look at it also relative to 2019.

Robert Kavcic:

So 2020 we obviously saw a huge increase in issuance. So I think we were tracking about 165 billion at last check. This year, I would say ... so for '21, '22, I would say we would probably come down from, 165 to, I would say 145 to 150 is what we're looking at right now, on total provincial issuance, 145, 150 billion dollars.

Robert Kavcic:

And part of the downside reflects deficits have come down a little bit. Some of the provinces have pre borrowed too. So Ontario and Quebec were pre borrowing right through the first three months of this year to get ahead of fiscal '21. It turned out to be a pretty good call because we saw longer-term interest rates back up as well. So there's that aspect. And I think even then, 145, 150 billion is probably the high bar. And if you want to make an estimate based on how much room there is for improvement given our economic forecast and stuff like that. And the fact that I think these initial budget numbers are very conservative. Maybe you take another $10 billion off of that or so, so maybe you look something more around 140 billion or a little bit below by the time we're all done with this.

Ben Reitzes:

All right. So I'd say that's good news for spreads and provincial bond owners, generally. It is probably going to be a tough environment for duration generally. If we're right on the growth forecast and it's looking more and more like Canada actually, as bleak as the next month or two looks, we're going to have 44 million doses of vaccine by the end of June. So that should be one, at least for every adult 16 or 18 and over in the whole country. So we should be well on our way to be through this, hopefully by early in the summertime. And that points to a really strong rebounding growth, which what goes with it is higher rates generally as well.

Ben Reitzes:

So duration might come under renewed pressure as we see the full reopenings, and assuming my optimistic view is right here. So better credit definitely helps on that front offset a little bit of the backup in rates. And then just I think for those who live in Ontario and other Canadians, other provinces, good to hear that at least the provincial budgets are headed in the right direction at least. And the big numbers that we've seen are definitely on the conservative side.

Ben Reitzes:

All right. I guess that wraps things up for this week. Rob, thanks for coming out. We'll see what the, or if the federal government does anything on housing in the coming weeks, and I guess target date is that April 19th budget. But again, we could see something before that. And thanks for coming on.

Robert Kavcic:

All right, man. Thanks for having me.

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 1:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO, Nesbitt Burns, Inc, 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 of 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 suggestion that any investment or strategy referenced here may be suitable for you.

Speaker 1:

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Speaker 1:

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Benjamin Reitzes Director, Canadian Rates & Macro Strategist

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