One of the favourite pastimes of those who acknowledge the existence of a credit bubble in Canada (self included) is predicting what will cause its demise and what might give us an early indicator of debt fatigue.
What will cause the credit bubble to pop?
Contrary to popular opinion, I don’t believe that higher interest rates are necessary to deflate a credit bubble. One need to only look at the extreme Japanese example to see this is true. Even our neighbours to the south have experienced a household deleveraging amid a period of historically low interest rates.
While a rapid rise in interest rates would certainly kill the bubble in a hurry, I’ve always maintained that it’s not necessary to force a consumer deleveraging.
Bubble are strange. They are the product of mass psychology and are often accompanied by some form of government elixir to intoxicate the masses. In the case of the US and Canada, the sweet elixir was the loosening of mortgage requirements which dragged demand forward by luring dewy-eyed property virgins and those previously priced out into the market. This led to the massive propagation of mortgage debt and a spike in home prices…..followed by the ‘my house is an ATM’ mentality and rampant HELOC growth…..which goosed consumer spending, lowered unemployment, raised consumer perceptions of the strength of the economy, and the process repeated itself.
The ‘elixir’ may have had a different flavour and was undoubtedly served in a more potent form in the US, but make no mistake….we’re drinking the same stuff. It’s just taken us a bit longer to get tipsy.
But now the room’s starting to spin and consumers are starting to dry heave. Consumer debt is at a record percentage of personal disposable income. It currently sits above the level of debt racked up by those ‘imprudent’ American consumers whose ‘foolish’ ways brought about their own fiscal ruin. Gone are the days when the media held up our prudent banks and conservative consumers as a stark contrast to the irrational behaviour seen south of our border.
While our debt to PDI ratio could conceivably follow the experience of the UK consumer and hit a peak in the 160% range, let’s not lose sight of the ultimate end of a credit bubble. My great concern is that this whole process I described above is set to work in reverse as it is in the US, leading to anemic growth over which the government and central bank have little control amid a wholesale repudiation of debt.
Mean reversions and monetary deflation
In economics, marked variance from a long-term mean tends to do two things: 1) Create the illusion of a new paradigm in which people believe that their current experience constitutes a new and stable norm; 2) Greatly disappoint those who stake their financial future on an illusory trend, as they are overwhelmingly often followed by a mean reversal.
In this case, I believe several great mean reversals are set to occur at some point in the near future:
1) Consumer spending will return to its long-term mean somewhere closer to 55% GDP, though certainly under 60%. It currently accounts for ~65%.
2) Consumer debt levels will revert back to a more stable level. I have no idea exactly how far it will fall from the current level of 150% PDI, but I would suggest that we’ll see it push 120% PDI over the next decade, with a significant chance of it pushing double digits.
3) Savings rates will rise to their long-term means. The realization that too much debt and no cash cushion is a recipe for financial hardship will dawn on many Canadians far too late. I’d expect savings rates to double over the next 5 years to at least the 8-9% range.
Anyone who sees these trends coming will also recognize that the combined impact will exert strong monetary deflation on the Canadian economy. Demand for debt will dwindle, existing debt will be retired, and the velocity of money will fall significantly. Deflation will pull strongest on leveraged assets priced in local currency…..namely real estate. As I’ve explained before, commodities could move higher in such an environment as they are priced on international markets. This is the worst case scenario as deflation would likely pull at wage growth making debt loads more burdensome while at the same time rising commodity prices would eat into remaining incomes. For the time being, I’m not entirely convinced the recent boom in commodity prices is anything more than rampant speculation, fear of future inflation, and a China growth story that is missing some key chapters. Nevertheless, it’s worth acknowledging the increasing possibility that this dynamic of debt deflation in Canada could occur simultaneously with a global commodity boom.
A debt/credit bubble or a housing bubble: The chicken or the egg?
It’s extremely difficult to determine where our Canadian debt/credit bubble ends and our real estate bubble begins. They are joined at the hip. Mortgage credit alone accounts for 70% of the outstanding debt in Canada.
In addition, real estate is responsible for indirect credit creation via HELOC grow, the rate of which has dwarfed even the brisk pace of mortgage growth.
In total, HELOCs and mortgages account for 80% of the total outstanding consumer debt. This is not unusual, but again the pace at which this debt has been accumulated that is problematic as it has greatly outpaced income growth and inflation, particularly in the past 5 years.
The question then becomes, which comes first: A retrenching consumer which causes weakness in the economy and a house price decline by extension, or house price declines which cause a retrenching consumer and a weaker economy?
I looked at this exact question back in October. The bottom line is that it is really an academic argument as either one exerts significant pressure on the other. It’s the Great Connection in reverse.
Looking for signs
Let me suggest a few things that might precede either a retrenching in consumer spending or a declining real estate market:
1) Falling home sales. As prices overshoot the ability of buyers to access adequate mortgage financing, sales fall. There are two things that could certainly exasperate this: 1) Rising 5 year government of Canada bond yields, upon which all mortgages (even variable) much be approved. Bloomberg tracks bond yields here. Keep an eye on this. 2) Upcoming mortgage rule changes which may or may not affect maximum amortization and minimum downpayment.
As an aside, the most recent realtor board stats showed significant cooling in home sales across the country, particularly in Vancouver and Toronto.
2) Falling housing starts. Developers typically have a pretty good sense for current and future demand. When housing starts drop off significantly, it’s often an early indication of dwindling demand for new homes. While the month-to-month numbers can be notoriously volatile, watch for a general trend lower. With housing starts having averaged nearly 200K over the past few years (outpacing net household formation by 25K per annum), I’d be very surprised to see housing starts much above 150-160K this year. October and November housing start data has told two VERY different stories. Watch these numbers closely.
3) Falling consumer confidence. Consumers whose view sours on the economy and their own prospects tend to hold their dollars a bit tighter. Consumer confidence readings are also notoriously volatile but have shown a clear downward trend over the past few months.
4) Rising defaults on unsecured debt. As debt burdens become increasingly onerous, consumers will begin to default on unsecured debt first. Watch for an increase in credit card delinquencies (check out this story!) and rising delinquencies in unsecured lines of credit.
Keep your ear to the ground and your eyes wide open. I believe we’re in the early stages of a period of recognition and enlightenment where consumers will begin to grasp the sad and dangerous state of their household finances. The media is certainly trumpeting this story. I think the great Canadian debt/credit/real estate bubble will be THE story of the next half decade.
Happy bubble watching!