The ‘tapped out’ consumer
Scotia economics has reiterated a call that I’ve been sticking to all year: The Bank of Canada will be highly hesitant to raise rates later this year…..if at all. But for the housing bulls who frequent this blog, let’s recognize that while the speed at which interest rates will rise will likely be slow, their ultimate direction is unquestionable.
Further to that point, the only way that interest rates can stay exceptionally low is in the event of persistent weak inflation or outright deflation and/or a significant reduction in domestic credit demand. Neither of these outcomes bode well for real estate.
Scotia adds more insight into the interest rate debate, but what I really want to focus on is the section of the report dealing with the Canadian consumer. The Canadian economic miracle has been the envy of the world as nations have been quick to heap praise on our ‘strong economy’ and ‘prudent banks’. What they gloss over, however, is the rapid and unprecedented expansion in consumer debt by Canadian households who, for the first time in history, continued to add debt during a recession. From Scotia:
“The Canadian consumer is tapped-out. Exhausted one might say, as inflation adjusted retail sales have dropped a cumulative 1% through two successive monthly declines.
Why such weakness? One reason could well be to return to one of our themes that,
unlike elsewhere, there is no pent-up demand in Canada. Real consumer spending
indexed to the start of 2007 for Canada compared to other major economies shows
Canada as being unique in having moved to record highs through the crisis and
following, while every other major economy was flat to down”
You’ve often heard me say that the cumulative effect of loosening mortgage standards and record low interest rates is to pull housing demand forward. By enabling increasingly marginal buyers to become home owners, the effect is to juice current sales at the expense of future sales. It’s these marginal buyers who helped goose the housing market from its 2009 lows, and it’s the remaining marginal buyers in the buyer pool who are now under pressure from tightening mortgage requirements. This wasn’t lost on Scotia:
“…Mortgage innovation starting in 2007 at an already strong point in the housing cycle pulled forward future housing demand into the environment of the past few years. The country cannot have its cake and eat it too by way of sustained expectations that the household sector can outperform other countries through the crisis period, and expect to continue doing so in the years ahead”
It’s a virtual given that the next 10 years for Canadian real estate will look nothing like the last 15. Exactly how it will look is the million dollar question, though I continue to believe that a widespread mean reversion in such elements as the price/income ratio, the price/rent ratio, and most importantly in consumer perceptions of real estate as an investment are all in the cards.
TD on Ontario’s debt problems
Ontario remains the California of the north, though our per capita debt burden is far worse. TD released a great report today highlighting the risks of carrying such debt burdens. I’ve noted some of these before, most notably the idea that as our deficit funding is increasingly reliant on bond issuance, we run the risk of getting an ultimatum from nervous bond investors who have the power to drive up borrowing costs by demanding an increased risk premium. Ironically, the likelihood increases with the debt burden meaning that when the funding is needed the most is also when it is likely to be more expensive. From TD:
“With the growing debt burden comes increasing costs to service the debt. As these costs grow faster than overall revenues, they crowd out the available funding for public services. For example, in FY 10-11, ten cents out of every dollar earned goes towards these interest payments. This leaves only ninety cents to pay for programs like health care and education.
Over the past few years, the degree of crowding out has been mitigated by extremely low interest rates. However, it is important to note that borrowing rates will not remain at these low levels forever. Higher rates on the horizon will feed through to increased debt servicing costs. In turn, under this scenario, fewer funds would be available for a whole slew of other government priorities”
As TD notes, while the deficit has been eye-popping in the past few years, what has been lost is the total debt burden relative to our GDP:
So much attention has been placed on the province’s budgetary position. This
is understandable given the $88 billion cumulative deficit tally projected over the
next seven years. However, the growing debt burden has gotten lost in the shuffle.It is this latter measure that acts as a constraint on future activities and choices.
Indeed, net debt to GDP has already more than doubled in the past 20 years from 15% of GDP in 1991 to over 35% today.
On the risk of a smackdown by the bond market, TD had this to say:
Another risk…is the potential for a sudden shift in international investor sentiment. To recall, this is what took place in the early 1990s. During this time, the large and growing string of deficits at both the federal and provincial levels drove up borrowing requirements sharply. What resulted was an increasing reliance on foreign investors to fund the gap.
As markets and investors grew concerned about ability to pay down these deficits, government credit ratings were downgraded. The lack of confidence from foreign investors led many to bail out, which resulted in even higher market interest rates….Ultimately, severe cuts to programs and services and higher taxes were required to restore confidence to markets.”
The bottom line is that as we’ve engaged on an unsustainable spending binge under several of our most recent premiers, most notably McGuinty, we’ve also significantly increased the risks that this spending will have to be repaid at substantially higher interest rates if the bond market becomes concerned about our deteriorating balance sheet. This ‘gift’ of social spending may turn out to have massive strings attached unless a more fiscally responsible government is elected to right the ship and correct the blatant disregard for public finance shown by the McGuinty government.