Scotia on the ‘Tapped out’ consumer; TD on Ontario’s debt problems

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”


Scotia notes that the consumer spending also spilled over into the housing market as home ownership rates continued to move up, largely against the global trend:

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.

Cheers,

Ben

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17 Responses to Scotia on the ‘Tapped out’ consumer; TD on Ontario’s debt problems

  1. John in Ottawa says:

    I believe there is a very large gap between what we like to spend and what we need to spend. Somewhere in there, for many, there is quite a bit of inefficient spending.

    The very nature of all the gadgets and services we can buy today compared with 40 years ago guarantees that consumers can cut back without suffering much degradation of quality of life. I think we suffer from “gadget creep” and given cause and a few moments to reflect, it isn’t hard to shave several hundred dollars from the monthly expense bill.

    A few examples:

    Telephone features. How many telephone features do you have and how many do you actually use or need. I have caller id. I won’t answer the phone if I don’t know who is calling. But I cut out voice mail because I never check it, the long distance plan because I stopped calling long distance a few years ago but never did anything about the plan, and a few other bits and pieces.

    Cell phones. Lots of room there. A friend just told me that his wife is keeping her plan because she gets 600 minutes/month for $25. The only problem is, she never, ever uses her cell phone. I cancelled my cell phone because I don’t use it and my wife just went over to a pre-paid card because she only wants the phone for emergencies. My son, of course, has to have an IPhone 4, but, really, if your company isn’t picking up the tab, smart phones are an indulgence.

    Television. I have satellite, a PVR, and the movie channels. I like to watch movies. I looked just last week to see if I might want to add in some more packages. Nice offer for something like 12 packages for $50/month. There were a couple of channels I would watch occasionally, but not enough to add even one package. How many consumers have all the packages in order to get “the most savings?”

    Internet. I live out in the country and have to use a mobile stick for internet access. I was paying about $130/month for barely adequate service. Finally, I looked into the situation and found out I could get far better service, from the same provider, for $50/month. I was just on the wrong plan. I feel a little foolish that it took me as long as it did to look into the matter, but I was just used to paying the bill and grumbling a bit.

    Wine! I’m no expert, and I don’t have to have the latest trendy wine that all the in crowd is drinking, but I have found over time that $15 bottles of wine are pretty reliable for every day consumption. I got used to paying around $15 and never checked to see if there were any better alternatives. One day a friend pointed me to an $8 bottle of wine that turned out to be every bit as good as the $15 wines I was used to. We drink, on average, about 24 bottles of wine/month. We’ve been drinking the $8 wine for about a year now and we have saved $2,000. That’s not chump change.

    Food. About two years ago I discovered, again thanks to a friend, that I can buy a whole rib eye from Costco and cut it up myself. With BBQ season about to start again we did that just this past weekend. I cut 20 1″ rib eye steaks from an $82 piece of meat. Those same steaks, which would not be as nice or uniform, from the local market would have cost more than twice as much. I like the savings and I like getting exactly the cut I want.

    These are just a few examples, but they are meant to illustrate that many consumers have the ability to cut back on expenses without significantly impacting their quality of life just by getting rid of “gadget creep.”

    It isn’t particularly good for the economy, but it can make debt service a a little easier. Maybe even pay some off.

    • UnagiDon says:

      Thanks for your examples. I’m also a careful spender, so let me give a few examples of what I’ve done:

      – Television. I don’t pay for cable TV. I watch movies via iTunes (cost ~$5 per movie, which adds up to about ~$20/month for our weekly movie). I can get HDTV channels via antenna.
      – Internet & Home phone. I use Teksavvy and pay $36 per month for unlimited internet, and $20 per month for the phone. Long distance rates are dirt cheap, comparable to Skype.
      – Cell phone. Unfortunately with Rogers now, soon planning to switch over to a prepaid. If you have any suggestions about this, I’d be happy to hear them!
      – Wine. I decided I’d rather drink higher quality wines less frequently than low quality wines often. An Amarone once a month costs the same as a Yellowtail once a week. I’d rather have the Amarone.

      It’s important to know where your monthly expenses go. I wrote software that automatically downloads all my credit card and bank account statements, categorizes expenses, and can generate monthly reports. I send these reports to my wife too so that we both know where all the money goes. Microsoft Money and Mint.com provide similar functionality.

      Thanks to this, I know that alcohol and movies are both less than 1% of my monthly expenses, whereas groceries are about 15%. So it makes more sense to optimize the groceries than the wine. (This is Amdahl’s Law.)

      • data junkie says:

        If you live in one of the big cities, I’d suggest Wind Mobile. My plan is $40 a month for unlimited everything (data, calling, text, LD to Canada and the U.S.), and they have a similar unlimited plan for $25 a month minus the U.S. LD and the data. No 911 fee, no SAF, just straight up $25/40 a month.

      • jesse says:

        “switch over to a prepaid”

        I think you can get a $100 prepaid with 1 year expiry. Just check their sneaky voicemail and incoming SMS charges. $100 for a year is enough for most casual users.

        I don’t have a cell phone and almost bought a pager. If the pager could be 2 way with unlimited SMS that would be a winner for me.

        I don’t know if people are old enough to remember that we used to arrange beforehand where and when to meet up. These days it’s a mess. Save money: plan ahead.

      • Joe Q. says:

        Cell phone rates are opaque. Sadly, the best deals are obtained by calling your provider, threatening to quit, and seeing what they offer you. (This technique does work!)

    • Financial Newbie says:

      “It isn’t particularly good for the economy…”

      As I was reading your post (and I do enjoy them John – they’re always well written), I couldn’t help but think about what you said (quoted above). Stop buying all those gadgets/services and what does that mean to Bell, Rogers, wine companies, grocery stores, etc.?

      I’m sure you’ll quickly see where I’m going with this oversimplified example, but…

      If we stop spending frivolously I think we’ll cut into the profit margins of corporations. If we cut into the profit margins of corporations, they probably lay people off (or at least pay them less). If we have too many layoffs in the private sector, we usually see a “have vs. have nots” issue between the private and public sectors. If we have an issue between sectors, we usually see politicians stopping the “gravy train” and pushing for public sector layoffs (despite an arguable need for MORE public employees when there are more unemployed Canadians requiring help to get back on their feet). If we lay off public sector employees, they can’t afford to buy gadgets/services and we cut into the profits of corporations…

      Rinse, wash, repeat.

      Anyways, while I agree with your observations and think everyone should be mindful of their expenditures, I also can’t help but be an incredible pessimistic for a “soft landing” future simply brought about by cutting back.

      I almost feel like we’re a person who has been chain smoking for the past 40 years and now wants to “cut back” as we’re concerned about our health, when in reality we probably need a brand new lung just to survive.

      • ATP says:

        The problem is that the modern economy increasingly relies on ‘waste’ to achieve ‘growth’.

      • Dmitri says:

        The goal should be “redirecting energy and money into sustainable future trends”. For example robotics, automation etc. Such that we would not have to slave away from 9 to 5 any longer.

  2. Alex says:

    John, excellent post. Being cheap (thrify, frugal, SMART) with your after-tax dollars is incredibly important. I’ve been doing just that for so long now that it actually hurts when I’m forced to pay the regular, non-sale price for ANYTHING. 🙂

  3. Sams Mango says:

    I am not sure how old everyone is here, but my kids would dwarf your savings with spending..not no need to worry about it impacting the economy.

    • TS says:

      That current account balance on the Stats Can chart page 18 says it all.
      2004 was a very good year. Downhill from there.

      • John in Ottawa says:

        Don’t forget that 2004 was the year our Loonie started strengthening. We went from about 65 cents to over $1. That has a huge impact on the current account.

  4. Pingback: CIBC on the housing and the Canadian Consumer; Bank of Canada speech; Other noteworthy news stories | Financial Insights

  5. RonB says:

    Hi Ben – I know this is completely off topic, but would it be possible for you to comment on the Can$ /US exchange rate and in particular do you see that the Canadian Dollar has risen above its true value. Also to what extent does the Canadian Dollar move in tandem with the price of oil.

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