Canadian  Outlook: Soft Landing, Risk of Turbulence

Low interest rates have fuelled Canada’s housing market in the past decade, pushing prices to new highs in most regions. However, a weaker economy and new mortgage rules have dimmed activity recently. While resales are up slightly in the first eight months of the year compared with the same period last year, they have eased since the government tightened mortgage regulations in March.1 Sales are now close to their past-decade norm, and well below pre- and post-recession peaks (Chart 1). Residential mortgage demand has also moderated, but remains strong at 7.2% y/y in July.

House price gains are slowing. Although average resale prices rose a brisk 7.7% y/y in August (and 6.7% after adjusting for the upward bias stemming from sales in high-priced regions), the rate of increase has slowed from nearly 9% earlier this year. On a seasonally-adjusted basis, prices have flattened in the past six months. Steadier prices reflect balanced markets in most regions, as the current 6.2 months supply of unsold homes is within its normal range (Chart 2).
Housing activity should remain moderate in the year ahead. Tailwinds include low mortgage rates, relatively low unemployment and strong immigration.

A weak global economy and Europe’s debt crisis will likely keep the Bank of Canada on the sidelines until early 2013, while further easing measures by the Federal Reserve should supress long-term rates in both countries, thereby supporting affordability (Chart 3). Canada’s unemployment rate is expected to remain near the current 7.3% through 2012, about a percentage point below its two-decade norm, supporting homebuyer confidence. More international especially in major urban areas. Meanwhile, Canada’s relatively sound fiscal finances have made it a desirable destination for non-residents to park their wealth during CHART 4 these uncertain economic times.

Still, the housing market also faces several headwinds,  including high prices, elevated household debt and slowing employment. Prices have risen twice as fast as  incomes in the past decade, lifting the current ratio 16% above its norm (Chart 4). Although the current overvaluation is below levels that triggered price corrections in Canada in 1989 and the U.S. in 2006, it will remain a thorn in the side of first-time buyers. For bargain hunters, Canadian houses, on average, cost a record twothirds
more (in local currency terms) than U.S. houses (Chart 5). Mortgage growth is expected to moderate as Canadians turn more cautious in managing their debt. Despite slower personal credit growth, household debt hit a record 1½- times disposable income in Q2, as residential mortgages continued to outrun income (Chart 6). Meanwhile, job and income growth should moderate next year, as the economy is expected to grow just 1.8% versus about 2.2% this year.

The upshot is that home sales are likely to remain steady in 2012. Prices should also stay put, similar to Alberta’s experience of the past four years following its boom. However, the resource-rich provinces, notably Alberta and Saskatchewan, should outperform other regions since their economies are expected to grow the fastest.

Because housing is moderately overpriced in most regions (and considerably so in Vancouver), it’s vulnerable to a correction. The biggest threat stems from the perceived one-in-three chance of a recession, and the attendant loss of jobs. Another risk, though far smaller, is if interest rates spike higher next year. As shown in Chart 3, even a moderate 2-ppt increase in rates would severely impact affordability. Low rates are a threat too, since they could cause the market to heat up again, only to correct when rates eventually rise. More buyers are turning to variable-rate mortgages on expectations that rates could stay low for some time, or even decline.

The Bottom Line: After cruising at high altitudes for most of the past decade, Canada’s housing market is on track for a soft landing in the year ahead, though turbulent global economic skies could make for a bumpy ride.