40 Million Canadians!

The estimated population of Canada has reached 40 million (link to Statistics Canada information). Although reaching that level is not particularly important, it highlights a shift that is somewhat surprising for those of us not paying close attention to Canadian statistics. The figure above highlights the increase in Canadian immigration, particularly after the pandemic dip (which reflects the border closing). I have never needed to pay attention to Canadian demographic data before — since population growth was quite slow due to falling rate of births. Although immigration was a source of population growth, it was not too significant. However, population inflows are a factor that cannot be ignored, and they matter for the “Canadian Housing Crisis” debate.

One thing to keep in mind that I believe the series I plotted above includes net international student flows, which are large. The United States made it more difficult for foreign students to enter, and so there was a hefty reallocation into Canadian universities.

(Statistics Canada has an interactive dashboard of population statistics here, for people who want to take a look at the data presented in way better than I have time to do.)

Housing Bubble (or Not?)

This leads into the status of the Canadian Housing Bubble. Researchers at the Dallas Fed have created a database of international house prices, and I have seen people plot the same chart multiple times, comparing the house price to income ratio of Canada versus the United States. The chart looks crazy, but I believe that it is missing some context. All the versions that I have seen have dumped multiple countries into the same chart, I have instead just shown Canada. I have not had time to look at the data, but it seems consistent with other data that I have seen. (One of the problems with Canadian data is the limited availability of housing data.)

• The top panel shows nominal house prices (according to whatever series they used) and nominal disposable incomes. I have rebased both series to 100 in the first quarter of 2000, for reasons to be explained. The immediate problem with these data is that they are indices, while the sensible initial comparison is nominal house prices to nominal incomes.
• The bottom panel shows the ratio of the two indices (rebased to 100). Since this is a ratio of an index to an index, its level has no economic significance; all we can so is see whether it is rising or falling.
• I chose 2000 as the rebase point because that is roughly when Canadian house prices took off, forming a hockey stick chart. (The house price data chosen by the Fed researchers puts the hockey stick somewhat later.) However, that level was not a “fair value”: house prices in Canada (outside of a few localities) was cheap. Winnipeg and Montreal (the two cities I have mainly lived in) essentially saw no nominal house price between 1980 and the mid 1990s (working from memory on the CREA house price series that I no longer have access to). We bought our first house (a 3 bedroom townhouse) in Montreal at the end of 1998 at a price that was about 150% of the median Canadian after-tax household income. I believe that a closet in London (England, not Ontario) would have cost about the same at that time at the prevailing exchange rates.
• The cheapness is not obvious in the chart above, but one may see that the bottom panel ratio shows it is roughly the same in 2000 as in 1980 — and interest rates were considerable higher in 1980.
• Real estate is local, and there were two large pockets of high house prices — Vancouver (and Victoria) and Toronto. Vancouver is easily understood — it is one of the few places in Canada where old people are not risking hip injuries stepping outside of their homes in January, and construction is confined to a handful of valleys amidst a mountain range. Vancouver house prices have been notoriously (relatively) expensive since the 1970s. Toronto has more open space around it, and what has happened there is that people have been forced to commute longer and longer distances to the city centre. It is not surprising that house prices close to Canada’s financial centre are high. Both Toronto and Vancouver had a condo bubble and bust in the early 1990s (coinciding with one in the United States).
• The hockey stick after 1998 was the result of the progressive loosening of mortgage insurance standards. (All mortgages with loan-to-value above 80% must have mortgage insurance, which must conform to a minimum standard.) This loosening allowed the rest of the country to emulate the experience of the United States where subprime lending became a force in the early 1990s, and also put more fuel into the Toronto and Vancouver markets (which bumped into maximum mortgage sizes).

The above background is aimed at the chart that I have seen reproduced multiple times that allegedly indicated that Canadian house prices were more “overvalued” than American in the mid-1990s. Putting aside Toronto and Vancouver, that was not true until the American housing market broke in the Financial Crisis.

I have been bearish on Montreal house prices since the mid-1990s, and I was concerned after 2010 with what I saw as excessive construction and the collapse in lending standards for mortgage insurance. However, the lending standards were tightened, and the immigration wave blew my “excessive construction” fears completely out of the water.

Grab Bag of Comments

• If one wants to dig into the state of the Canadian housing market, one needs to look into metrics of borrower vulnerability. That has been a topic on policymakers’ minds since the Financial Crisis, and there is now more data available. I have not had time to dig into these new data sources.
• Housing bears need to learn to be patient. As long as the labour market is in decent shape, nothing interesting is going to happen. My concern has always been that there will be a nasty self-reinforcing feedback loop: the high level of employment in construction means that if the housing market tanks, it feeds into the labour market. However, that has not happened, and the immigration wave has been enough to absorb any excess supply.
• There are pockets of silliness, possibly buoyed by dubious cash inflows from overseas. However, this is a story aimed at condo markets in some city centres, and we could just end up with a localised blow up (as in the early 1990s).
• I find that analysts spend too much time worrying about house prices. Unless you are buying or selling a property, the important concerns for housing economics are debt service and construction activity. What I am seeing locally is that there is such a backlog of construction and renovation projects that there is limited sensitivity to house prices.
• As for the drop in house prices at the end of the chart, I looked at the Teranet-National Bank House Price Index™️ and I see a roughly 10% round trip up then down from 2021 to 2022 to present. This is not incredibly surprising given the behaviour of interest rates over this period. Although the chart looks ominous, in the absence of another rate hike campaign, a “sideways correction” is an entirely plausible outcome. Conditions were unusual and 2022 and they unwound — which does not necessarily lead into “the bubble is popped and the housing market is taking the express elevator down!”
• Rising interest rates creates a strain on household finances — particularly since the longest period interest rates can be locked in practice is 5 years. However, a spike has already happened, and the Bank of Canada is well aware of this vulnerability on a forward-looking basis.

Ever since the Financial Crisis, there has been periodic excitement raised by foreign analysts predicting the collapse of the Canadian housing market. Unless the business cycle is upended elsewhere, I would remain cautious.

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(c) Brian Romanchuk 2023

Interest Rate Policy Versus Alternatives

One of the ongoing arguments about Modern Monetary Theory (MMT) that I run across is the general disdain for monetary policy among MMT proponents. (At one extreme, Warren Mosler argues that interest rate policy works in a way that is backwards versus the consensus.)

Sustainability And Canadian Housing

Economic data are starting to recover from the distortions created by the pandemic, and so lazier analysts like myself can get a better handle on the current state of the economy. Although I have an interest in inflation, I want to also see what is happening in the real economy.

Notes On Shelter Costs

Shelter is a necessity, and so it is certainly an important component of the cost of living. However, the issue that we are concerned with is inflation, as well as the narrower issue of how to shelter should appear in a consumer price index (like the CPI).

Different countries have different norms with respect to how shelter is provided, and those norms have changed over time. My comments here reflect the norms in Canada and the United States, but they should translate to other developed countries once we account for local idiosyncrasies.

NOTE: This article is a draft section from a chapter on asset prices and inflation. It is preliminary, and needs beefing up with data. It is in a far more tentative state than usual, as I will be iterating on it once the rest if the  chapter is finished. It needs more statistical data, and I am largely working from memory. However, chasing the data will take time, and I will only do so once the text is closer to a finished state.

Sustained Unsustainable Trends: Canadian Edition

I have not been commenting on Canadian data recently, but I just wanted to update the above chart of the debt-to-disposable income ratio. (It caught my eye as I was inserting the chart into my manuscript.) It was very easy to declare the rise in the debt-to-income ratio "unsustainable," yet it has been sustained for a long time.

Charts On Canadian Construction Employment And Recessions

I just wanted to post a couple of charts I plan on using in a chapter on the construction industry. It acts as an update on the Canadian employment situation, a topic I have not commented on in a long time. As the chart above suggests, not much has changed, but the construction industry is still of over-sized importance.

Real Estate And The Cycle

Real estate -- particularly residential real estate -- is an extremely important factor when discussing recessions in the modern era. To a certain extent, real estate is where economic theory goes to die. One possibility is that the theory was largely developed when the norms in real estate investment were conservative, so attention was moved to the industrial sector. However, the herd tendencies in the housing market may now overwhelm the industrial cycle.

Principles Of Canadian Municipal Finance (And Why A Land Value Tax Is Inferior)

The funding of Canadian municipal governments is not normally thought of as interesting topic; even Canadian fixed income investors are not particularly excited about it. However, there are two side issues that are of general interest. The first question is: what happens to Canadian municipalities if the housing bubble pops? (As a spoiler, not very much.) The second question is the feasibility of a Land Value Tax (LVT) which is a concept that gets some people on the internet very excited. I will then outline why a LVT is inferior to the Canadian property tax system (which is not that different than the American system for that discussion).

Canadian Housing And Perpetual Motion

Canadian policymakers have blundered into a perpetual motion machine, which is more commonly referred to as the housing market. By underwriting the credit risk of the mortgage market, the government has allowed the funding circuit to continue in an uninterrupted fashion. The lack of a crisis has frustrated economic bears, and there is no obvious catalyst for their vindication yet in sight. In addition to outlining the Canadian situation, this article discusses some of the theoretical issues, as well as the policy implications.

Housing Bubbles And Their Financing

Housing finance is interesting, and offers an interesting take on some theoretical issues. Although the theoretical issues sound abstract, they are critical issues in economies facing a housing bubble. This article looks at one aspect of housing finance: the limit to financing is credit risk, not funding. Monetary flows in a credit-based economy are circular.

Note: I hope to follow this up with one or two article discussing the Canadian housing bubble. This article covers some basic points, and I will get to the more hair-raising topics later. I have broken the discussion up as the full discussion would be too lengthy.

The Zombification of Canada

A series of policy errors has trapped the Canadian economy in a near-zombie status. Household debt levels are high, leading to a fragile system. The only benign way of reducing this fragility is to induce high wage inflation, which is precluded by the unthinking attachment to the inflation target. There is no reason to expect the system to collapse on any particular forecast horizon; rather the economy can muddle along in a low-growth path. The fact that the brain trust that inflicted this low-growth destiny on the Canadian economy in the name of improving economic efficiency is ironic, but this reflects the general failure of modern policymaking. The situation in Canada may mainly be of interest to Canadians, but it does provide yet another data point for the general thesis that trusting the policy preferences of the financial sector is inherently a bad idea.

Book Review: When The Bubble Bursts

Hilliard MacBeth published When the Bubble Bursts: Surviving the Canadian Real Estate Crash in 2015. It is mainly targeted at Canadians, but it would be of interest for foreigners who wish to understand what is happening in the Great White North. Although real estate bubbles are a familiar international phenomenon, there are some institutional differences that matter.

Canadian Housing Crash (Again)!

The news that some Canadian alternative mortgage lenders have had financing issues has brought around speculation about the Great Canadian Real Estate Crash. Certainly, the Canadian economy is extremely vulnerable to another global financial spasm like 2008. I am somewhat of a Negative Ned, and can think of many catalysts for such an event. However, barring such an event, the problems look like they can be contained managed.

Canada's Housing Market Hanging In There

The Canadian housing market has defied predictions of doom for years now. Given the questionable quality of Canadian house price indices, I spend little time pondering the direction in prices. Instead, I believe the focus should be on the income effects of residential construction. These effects are unfortunately overshadowed by discussions of debt and the alleged wealth effect created by home prices. Explaining why the Canadian housing market did not collapse like the American highlights the difficulties with mathematical economic models.

Canada Reaching The Wile E. Coyote Moment

It looks like the Canadian economy has run over the cliff; all that remains is the fateful moment when it is time to look down. The February Labour Force Survey was at best mediocre, but the ugliness lies in the details. Over the past year, 130 thousand jobs were created (a 0.7% annual growth rate), but 43% of those jobs (56 thousand) were in the Construction sector. The travails of Canada's oil and gas sector are highly publicised, but the collapse in construction employment is what will cause Canada to replicate the United States' downward spiral in the last recession.

Canada: Still Debalancing

The Canadian Labour Force Survey for December 2014 was released last week, and it dipped lower. The survey - the equivalent of the Household Survey in the United States - is noisy, but the overall picture remains of relatively weak job growth. Unfortunately, construction dominates the private sector contribution; other sectors have not been able to take over as a "job machine" during this expansion. This means that Canada has not been able to take advantage of avoiding the real estate collapse that hit south of the border and rebalance towards other drivers of growth. Instead, Canada has continued to "debalance", with construction remaining dominant. (Please see this article I wrote just over a year go to get further background on debalancing.)

[UPDATE 2015-01-15. There has been a wave of high profile layoffs and closures in Canada that have hit the news after this was written (link to the latest). It would take time for this to show up in the official data, but it could lead to recessionary psychology now being in place. An assumption behind this article was that the probability of a Canadian recession in 2015 was below 100%; I do not know whether the latest information puts that assumption in doubt. I prefer not to revise my text in order to account for new information.]

International Labour Market Comments

This is just a quick note related to the labour markets in Canada, the United States and Australia. The Canadian Labour Force Survey was strong in March, similar to the U.S. Household data. However, the housing market hangs over the Canadian economy. Australian labour data were weak in March, remaining on a sluggish trend.

It’s A Trap! (Review Of The Two-Income Trap)

The Two-Income Trap, by Elizabeth Warren and Amelia Warren Tyagi (her daughter), explains the dynamics that has left U.S. middle class families in a fragile financial state. The book is from 2003, and thus is from the era before the financial crisis. However, the problems they highlight still exist. In this review, I discuss the principle observations of the book, and the implications. The implications for planning personal finances for a couple are important. I will also touch on some of the policy issues they raise; although the authors attempt to strike an optimistic tone about solutions, I explain why I am somewhat pessimistic about this problem from a public policy standpoint.

Canada: Debalancing, Not Rebalancing

The Canadian Labour Force Survey is noisy month-to-month, but the trends in the data point towards a debalancing, not a rebalancing, of the Canadian economy. This poses an acute problem for policymakers; their working assumption is that the economy would reduce its dependence upon consumer-debt fueled growth as the business sector recovered from the financial crisis. Unfortunately, the consumer-facing sectors are the most labour intensive sectors, and they remain the driver for job creation.

Houses And Portfolio Allocation

Introduction

How should people view a house within their personal portfolio? For many North American households, their residence is their most important asset. As a result, it is a very important factor to take into account when planning for retirement. In this article, I explain how I prefer to view a house within a personal portfolio. (Throughout this article, I will use the term house, but the logic applies to condos as well.)

This article is generic, and is going to be read by an international audience. As such, I do not attempt to give advice whether buying a house is a good or bad idea for a particular individual. Additionally, my logic is based on conditions that may be particular for Canada and the United States; some factors I discuss do not apply in other regions.

The analysis framework is aimed at people who are a long way from retirement. Such people have a great deal of uncertainty in their financial planning due to the uncertainty about their future employment income, and their choice of where they live is driven by the location of their employer. A retiree has less ability to recover from a bad decision, but they should have more flexibility in choosing where to live.

Finally, in order to keep this article from getting too long, I will not cover the macroeconomic impact of the micro decisions people have been making about housing. But I feel that most households do not analyse their housing decisions the way I do here, and this represents one negative factor that hangs over the North American economies.

Housing: Asset Or Liability?

The key principle to keep in mind about housing is that it is very different than financial assets. Housing is an asset that loses money every year, up until the house is sold. (In the lingo of fixed income, it’s a negative carry asset.) Generally speaking, the larger the value of the house, the bigger the cost of owning it. And this is not even counting the financing cost; houses are typically purchased using mortgages, whereas few retail investors use debt financing to purchase other financial assets. The mortgage size (and interest costs) will increase in line with the value of the house.

Typically, the increase in home value is based on increasing home size (keeping other factors like the neighbourhood or age of the home comparable). As a result, there are four main factors that lead to housing costs increasing with the value of the home:

1. Property taxes are proportional to the value of the home throughout most of North America. (As an aside, there are differences how property taxes generally are handled between Canada and the United States. American municipalities tend to keep the property tax rate fixed, so that the tax take rises and falls with the housing cycle. Conversely, Canadian municipalities decide what level of tax they want to extract, and then adjust the tax rate to hit the revenue target. This makes Canadian municipalities a much better credit risk, although this may be a small consolation to taxpayers.)
2. Heating and cooling costs are typically increase as the home size gets larger. (This may be less of an issue in more temperate parts of the world.)
3. The bigger the house, the more stuff you can (and probably will) squeeze into it. Stuff costs money.
4. Maintenance costs will rise based on home size. This is an important factor to keep in mind for aging wood-framed houses, which is the standard Canadian home construction method.

A larger home also entails more home maintenance, which is an increased drain on what may be the most precious resource for working households – their time. Less free time entails monetary costs to compensate (eating out, paying for home maintenance services, the “need” for expensive vacations to reduce stress levels, and less time for part-time work).

If your financial plan is to live your life in a home you own, a more expensive home will generate increased negative cash flows throughout your life. This meets the definition of increasing a liability, not holding a larger asset. Plus, you have to sell other assets that generate income, and/or borrow, for the privilege of holding the liability. The only time the increased value of a home will increase the cash flows that you receive is when you sell the thing – but even then, your transaction costs will probably also increase (particularly in Canada). If you do die a homeowner, your estate will be larger if you have a more valuable home. But that is based on the assumption that you had enough financial assets to cover your spending when you were alive in order to leave an estate.

I have not forgotten that “you need to live somewhere”. Owning a home eliminates the need for paying rent, and home ownership was historically relatively cost effective, as long you did not need the flexibility of being able relocate. (As many have discovered in the United States in this cycle, being locked into a home can cost you potential jobs.) But when doing the rent versus buy decision, the real comparison is not necessarily for renting the same sized residence as you want to buy; the comparison is for a sensibly priced rental unit, which may be much smaller. If you are renting, you should not be accumulating piles of material goods, as you will have to move the junk repeatedly. You only need to rent a large house if you have already locked yourself into the treadmill of accumulating a lot of stuff that you need to pay to keep somewhere.

In summary, your residence is not really a portfolio asset; it is a lifestyle decision like deciding which automobile to drive (or not). Housing expenses have to be held under control within a budget, allowing you to accumulate financial assets that actually pay you to hold them.

Rental Housing As An Investment

Without the particular details of the individual situation, I cannot really say how to view housing that you rent to others is a good or bad portfolio asset. Property investment has probably generated a lot of rich individuals, but that is not necessarily because housing is a great asset. It is the only asset that retail investors routinely buy with leverage, and the magic of Other People’s Money magnifies returns - and losses. It is also an operating business that is relatively easy to manage; you mainly just need to deal with renters and maintenance. Returns on operating businesses should be better than the returns on assets you hold passively, although it represents a loss of time (which as I noted above, is a very crucial resource if you are working).

Things to keep in mind are liquidity and diversification. You have to have a liquidity buffer to allow you to hold on the assets in a period of interrupted cash flows (vacancy or losing your job). As for diversification, it is a basic principle of personal finance to avoid “putting all your eggs in one basket”. If you own only a small number of rental units, even slightly bad luck could generate a horrible occupancy rate – having a larger number of units increases the odds of having a an occupancy rate near the average. Having a properly diversified portfolio along with rental housing is difficult to achieve, unless your portfolio is relatively large.

But in addition to portfolio diversification, you need to factor in diversification versus the risk to your overall financial plans.

1. For most working age people, their largest source of cash flows comes from their employment. Having a large real estate asset could create a toxic correlation with your employment risks.House prices often soften in recessions, when you are statistically most likely to lose your job.
2. If you work in a profession related to real estate, your job outlook could crater at the same time as your home value. (This career correlation hit technology employees who invested in IT stocks during the 1990’s tech bubble.)
3. North American one-employer small town property values can collapse if that employer shuts down the business.

Mortgages: A Short Position In Bonds

To use financial market lingo, a mortgage is a short position in bonds. In other words, a negative bond position. Given that bond yields are currently very low in absolute terms, this may not be that bad a thing. But this can be problematic if rates are at more typical levels. Bond values increase during recessions, which are bad times (on average) for households’ cash flows. This creates an unwanted correlation between your financial net worth and the job market. This is probably not too big a deal; U.S. mortgages can often be refinanced, and Canadian mortgage durations are very short. But it is something to be kept in mind when looking at your total portfolio, as many household’s mortgages are larger than their holdings of financial assets.

Housing As An Inflation Hedge

Housing is typically viewed as an effective inflation hedge. This appears extremely useful, as there are few assets that are cost-effective inflation assets (see my comment on equities as an inflation hedge here). This is most important for retirees, as they need to control their expenses, and they will not have wages that presumably rise with inflation.

But for people a long way from retirement, most of the advantage given by inflation is the result of the fact that they probably have a large mortgage (a short bond position). Your negative cash flows created by the house will be increasing with inflation. Since your payoff from selling the house is far in the future, the increase in the future house value from inflation may be swamped by the fact that long-term interest rates will probably be higher (i.e., the discounted value of the house proceeds may be lower if inflation rises). Therefore, if you are young, upsizing your house may be counterproductive financially if you are attempting to hedge inflation.

Now that I’ve scared everybody, Happy Halloween (and have a good weekend)!

(c) Brian Romanchuk 2013