Capital Economics on the Canadian economy: Housing downturn to hit hard

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.



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9 Responses to Capital Economics on the Canadian economy: Housing downturn to hit hard

  1. ph says:

    An Irish economist once said “Real estate bubble never end with soft landing. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market and the market will crash. It was the nature of real estate boom to end with crashes.”

    People still think it is different in Canada. Until , the fear factor (interest rate rises or adverse economic condition around the world) forces Canadian to change their perception.

  2. Shortest Strawman says:

    It’s been at least 3 years that I have been frequenting bear dens in hope for the “It’s finally here” sign. Nothing happens. Ben, as much as I enjoy your posts, I guess that you and Pope and Mohican are preaching to the choir. Whoever knows that the situation is utterly perverse, knows. Whoever makes a couple dozen thousand dollars in a quick flip would not visit these sites. I am afraid that as long as the government supports the bloc of the absurd with full legal might, prudence and sanity stand no chance.

    • jesse says:

      “Whoever makes a couple dozen thousand dollars in a quick flip would not visit these sites”

      Actually, my guess is more than a few do, if only to convince themselves that since “bear bloggers” been “wrong” for so long, it irrefutably verifies that said blogs’ arguments are wrong too. I can honestly state I can’t argue ad nauseum with logic like that!

      The Capital Econ report is wrong too of course, because, well, they don’t understand what’s really going on out there and focus too heavily on the data and drawing parallels to the experiences of other countries that, by definition, are different from Canada’s. History will show their concentration on the numbers, and not looking for evidence justifying the new “permanently high plateau”, to be their penultimate mistake.

      Buy now or be priced out forever.

  3. jesse says:

    Looks like Capital Economics is reading this blog! Hi guys! 🙂

  4. mfx says:

    Thank you for sharing the analysis.

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  6. Pingback: Capital Economics Report – “Canadians now believe the economy is invincible. This level of hubris is disconcerting. Housing valuations have lost all touch with fundamentals, driven up by a massive surge in household debt.” | Vancouver Re

  7. Pingback: Capital Economics Report – “Canadians now believe the economy is invincible. This level of hubris is disconcerting. Housing valuations have lost all touch with fundamentals, driven up by a massive surge in household debt.” | Vancouver Re

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