In a previous series we examined house prices relative to GDP growth across Canada. That data seems to suggest that a significant level of overvaluation exists in many provinces from Ontario west (Quebec data was absent in that series). Hopefully next week I’ll be able to post about the growth in house prices relative to incomes across the provinces. From the preliminary work I’ve done with this data, it certainly seems to support the notion that house prices have outpaced fundamentals across much of Canada.
You may also recall that in previous posts, I’ve examined the impact of changing consumer attitudes towards housing. In particular, the shift in sentiment towards home ownership can be seen in the rise in ownership rates across all demographics. My belief is that house prices in Canada may have been modestly undervalued at the start of the millennium as house prices had largely been stagnant for the better part of a decade. It’s hard to know exactly when house prices caught up with fundamentals such as incomes, inflation, GDP growth, and rents, but I would suggest from the data that we’ve seen so far that house prices began to separate significantly from fundamentals right around the middle of the last decade. Incidentally, this coincides with a period of unprecedented loosening of CMHC insurance standards and downward trending interest rates.
Human psychology is a funny thing. While we all love buying consumer products on sale, we find it a frightening thing to buy assets like stocks, bonds, or real estate when they’ve fallen significantly in price. Bob Farrell reminds us that the public buys the most at the top and the least at the bottom in the stock market. I will suggest that this is equally true in other asset markets like real estate. Certainly the experience of the US bears this out. Having watched their real estate market erase some $6 trillion in household wealth, Americans have a decidedly more bearish perspective on the long-term prospects for real estate.
While the credit crisis has played a large role in reducing the amount of credit available to be lent, thereby making purchasing a house more difficult in some cases, the fact remains that the perspective of the American consumers has changed greatly since the crash. It’s an interesting phenomenon that rising house prices create demand for houses while falling prices destroys demand. We saw this for ourselves in 2008-2009 as house prices fell, home sales stalled, and home builders quickly put on the brakes. You’ll note the fall in house prices slightly preceded the fall in housing starts (source):
Granted the panic of 2008-2009 was an extraordinary event in its scope, but certainly not extraordinary in the manifestation of the great human emotion of fear. It certainly highlights the reality that housing demand typically softens along with house prices.
This brings us to the topic of today’s post: How much of a boost has this increased demand for housing had on employment and GDP growth across the country? In answering this question we also get a hint at the potential economic and employment fallout from a realignment in house prices with measures of fundamental value.
In today’s post we’ll look at BC east to Ontario. In part two we’ll look from Quebec east. Note that the data set for the percentage of GDP derived from residential construction unfortunately ends in 2008. You’ll note the sharp decline in some provinces in 2008 as the Great Recession began to pull at construction. It would be a pretty safe bet that 2009 saw a flat to modest decrease in construction as a percent of GDP, with 2010 seeing a significant rise in most provinces in line with housing starts (Alberta being the notable exception as house prices and housing starts are well below their 2008 peak).
With that said, I’ll let the graphs do the talking…
Note that every single province is well above its long-term trend line in both the percentage of employment derived from construction and construction jobs as a percentage of total employment.
With interest rates set to rise, credit conditions tightening, and domestic demand arguably satiated, it’s hard to see where this sustained demand will come from to begin with. Furthermore, housing starts have outpaced net household formation (immigration plus ‘organic’ household growth) for the better part of a decade now, to the tune of some 30,000 units annually. I believe that this demand has been absorbed largely by the expansion in home ownership rates, a trend that cannot possibly last indefinitely. As a best case scenario, I see this as a drag on employment and economic growth.
However, the best case scenario is far from assured. With the possibility of a significant nationwide housing correction far from negligible, the risk remains that demand could fall significantly which would have significant implications for economic growth and employment, as construction has been a major boost to overall employment, particularly coming out of the recession.
Lest you’re inclined to suggest that immigration and investment from wealthy foreigners will replace the demand, allow me to remind you of the following: 1) Even with current immigration trends in place, total population growth is set to slow. 2) Even wealthy foreigners are subject to the same irrational thought patterns as everyone else. I’ll suggest that much of the foreign investment we are seeing would decrease substantially in the event of a significant house price correction, exacerbating the problem.