Capital Economics back at it again
Just a few weeks after releasing a controversial report suggesting that Canadian real estate was heading for a significant correction, Capital Economics is once again back at it, this time suggesting that this same downturn is set to hit the economy hard.
The report can be read in its entirety here…(publication removed at the request of Capital Economics -Ed.)
Interestingly, I share many of the same general concerns as the authors of the report. In particular, I see a correction in real estate as being of far more serious concern to the broader economy than most economists do. I’ve outlined my concerns in the past in posts like ‘The Great Connection’ and ‘My Canadian Economic Forecast‘.
On house prices:
“Because Canada emerged from the global financial crisis largely unaffected, many Canadians now appear to believe that the economy is somehow invincible. This level of hubris is disconcerting when housing valuations have lost all touch with the fundamentals, driven up by a massive surge in household debt. We’ve seen this story played out in countless other countries and it never has a happy ending.”
It’s one point that I have raised over and over again: Canadians have refused to learn lessons from other countries. Granted our excesses never paralleled those of the US, Ireland, Spain, etc. but by no means should that suggest that we are entirely out of the woods. I have often said that by the time the US real estate correction is over, it may well represent the greatest destruction of wealth in human history. Now imagine the ignorance of gazing at that smoldering pile and saying, “we weren’t as bad as them, therefore we have nothing to be worried about”. A large portion of the blame goes to the media for this, as they have been willing (or clueless) accomplices in perpetuating certain myths, as these ridiculous articles shows.
“Relative to incomes, our calculations suggest that Canadian housing is now just under 40% over-valued, which is about the same level of excess that the US market reached before it collapsed. We have pencilled in a 25% cumulative decline in house prices over three years, mirroring what happened south of the border.”
40% strikes across the board strikes me as a bit much. A 25% peak-to-trough decline centred in a few particularly bubbly locales would be in line with my predictions, though I would argue that by the time the US has bottomed (and there is mounting evidence that the second leg down is intensifying) we’ll see a substantial difference in the total peak-to-trough movements between both markets.
Remember that the price/income and price/rent ratios are the most important measures of fundamental value. The price/income ratio can see a sustained expansion well beyond norms only if it is a period of declining interest rates (meaning incomes can support more debt) and/or if lending standards are being loosened. We have come through exactly this period over the past decade, particularly since 2005. Going forward there is little doubt that rising interest rates (the rate at which they rise is debatable, the direction is not) and tightening lending standards will put downward pressure on this ratio.
On the impact of a housing correction on the Canadian economy:
“The now inevitable downturn in the housing sector will severely constrain economic growth over the next couple of years, as consumption expands at a more muted pace and housing investment shrinks”
“Canada’s economy has grown overly-reliant on the housing sector in recent years, so any drop back in prices could lead to a sizeable contraction in housing investment, which is currently well above its historical average. In the aftermath of previous housing booms, housing investment has fallen by roughly 2.5% of GDP.”
You’ll also note that Canadians are more in debt relative to their assets than at any point in at least the past two decades. This strikes me as odd given the run-up in real estate prices and recent run up in stock markets. If calculated correctly, it certainly suggests that consumers will retrench hard in order to rebuild their balance sheets as they will quickly discover that assets fall quickly in a bust (particularly when leveraged 20:1)…..but debt remains.
On consumer deleveraging and the impact on employment:
“Canadian household debt is now up to 150% of disposable income, well in excess of what we saw in the US. Admittedly, low interest rates mean the servicing costs on that debt are not currently excessive.”
“Rebuilding that saving rate will require a marked slowdown in consumption growth.”
“…The housing sector has become tremendously bloated during the boom. Construction now accounts for 7% of overall employment. Even without big declines in house prices, we would expect that share to shrink back to its long-term average of about 5.5%, which would involve the loss of 250,000 jobs.”
“Housing investment will shrink as a share of GDP too, with the expected contraction in home renovation alone reducing GDP by 1%.”
There’s much more. Obviously they are particularly bearish on real estate, but not all of the report is as dark. They weigh in on export growth, inflation, interest rates (like me they think they will likely stay low once the housing market starts falling apart), etc.
Certainly an interesting report, though as commenters pointed out the last time I highlighted a Capital Economics report, their business model is selling research. Arguably, boring and bland research doesn’t sell, creating a sort of bias towards sensationalism. Nevertheless, their predictions are very much in line with what I have written on this blog before……..and you get this for free.