Insights & Resources

The U.S. housing market was the epicenter of the 2008/09 financial crisis that had global ramifications. Toxic assets, built with derivatives and based upon questionable mortgages, made their way into many investment portfolios around the world. Not surprisingly, when that house of cards eventually folded, this sector of the U.S. economy was hit very hard. Fortunately, fundamental differences in Canada’s mortgage lending practices left our housing market less exposed. Nevertheless, our housing sector did see diminished activity. Between the period, which began with the end of the financial crisis and ended with the onset of the spread of COVID-19, the central banks of both countries adjusted administered interest rates only modestly. “Low for long” was the prevailing mantra. The housing sectors recorded significant improvements and a revival of demand was seen in both countries. However, as the new reality of decades-high inflation has settled in, both the Bank of Canada and the U.S. Federal Reserve have hiked interest rates more aggressively than has been seen in decades. The influence of significantly higher interest rates is now being felt in the housing market.

Statistics Canada reported that, on a monthly basis, its consumer price index (CPI) rose 0.3% (seasonally adjusted) in July 2022. This was the 24th consecutive monthly advance and follows June’s 0.6% advance and May’s 1.1% surge, which was the largest monthly gain since StatsCan introduced the current (seasonally adjusted) data series in 1992s. The broad index movement in June pushed despite the July increase, the pace of CPI growth slowed to 7.6% from June’s 8.1% reading, the largest year over year increase since January 1983 (8.2%). Much of the recent movement in the overall CPI reflects the price of energy products, which tend to flow through to all other components in the index. Diminished worldwide investment in traditional energy development projects over the past several years, coupled with increased demand and the conflict in Ukraine, have pushed oil prices sharply higher since the beginning of the pandemic. The CPI data show that gasoline prices stood with a 35.6% year-over-year advance in July and this now fully reflects the April 1, 2022 increase in the federal government’s carbon tax on gasoline (by 2.2 cents to 11 cents per litre). Historically, as Canada boasts the third largest oil reserves in the world 1 , this energy price move would have been accompanied by a rising Canadian dollar, which would offset at least some of the inflationary pressures. However, the loonie has fallen over the past twelve months. Not surprisingly, a similar story has played out in the U.S. The U.S. Bureau of Labor Statistics reported that their consumer price index was essentially unchanged in July. This was the first time that the index had not posted a gain since it recorded an outright decline (-0.1%) in May 2020. The flat monthly result permitted the annual inflation rate to ease lower to 8.5%. This is down from the 9.1% reported for June, but June’s pace of inflation was the fastest since November 1981 (9.6%). It remains unclear as to when these price pressures will actually moderate in a meaningful way.

Central Bank Response

Central bank response Early indications of inflationary pressures were largely ignored. In March of 2021 U.S. and Canadian CPI first broke above the nominal 2% annual growth rate broadly targeted in both countries. At the time, most discussion focused on the notion that supply chain disruptions would be corrected and any inflation that resulted from these issues would be transitory. The Bank of Canada’s Monetary Policy Report, published in April of that year, forecast inflation of 2.2% for 2021 as a whole and 2.0% for 2022. Following the Fed’s March 2021 policy meeting, they too published economic projections showing that their preferred inflation measure (Personal Consumption Expenditure Deflator or PCE Deflator) was expected to show an annual growth rate of only 1.8% by the end of 2021 and 1.9% by the end of 2022. In reality, the December 2021 figure came in at 5.8% (CPI was 7.0%). In June the PCE Deflator was up 6.8% (CPI was 9.1%). With the separation of actual inflation from stated targets, the dangerous precedent of rising inflation expectations has emerged. Accordingly, if workers’ inflation expectations are not materially dampened, tight labour markets will reignite wage-driven inflation, setting off a spiral higher.

As can be seen in the above graph, the central banks have finally come around and have tightened monetary policy more aggressively than has been seen in decades. The Fed has now raised interest rates at four consecutive policy windows. The 75- basis point (a basis point is 1/100th of one per cent) rate hikes on June 15 and July 27, 2022 were the first of that size since November 15, 1994 and took the cumulative tightening to 2.25%. The hawkish tone in the Fed’s accompanying commentary points to further steady tightening of monetary policy for the balance of 2022. Like the Fed, the BoC has shifted gears dramatically and has now raised administered interest rates at four consecutive monetary policy announcement windows. The same cumulative 2.25% increase in interest over a 133-day stretch is the most rapid tightening seen since rates were raised by 2.50% between January 15 and February 16, 1995 (36 days). This leaves the BoC in step with the Fed and most analysts suggest that further steady tightening is in the cards, domestically, for the remainder of 2022.

U.S.

Not surprisingly, activity in housing is inexorably tied to prevailing interest rates. Lower borrowing costs provide greater affordability, fuelling greater demand, and the fact that rates have been ‘low for long’ means that any changes to the status quo were destined to upset the market. The over-heated new home sales in the U.S. seen during the pre-financial crisis period would not reappear prior to the onset of COVID-19. As can be seen in the accompanying graph, new home sales hit an all-time high of 1,389,000 units (annualized basis) in July 2005. After plummeting to 270,000 in February 2011, they recovered to 1,036,000 by August 2020. Since then, however, a secular decline has emerged. The June data revealed a 590,000-unit pace, the weakest since the COVID-19 dampened result in April 2020 (582,000-unit pace). Further new home pricing has also seen a material change. In October 2004, the median price for a new home in the U.S. stood at a then-record $229,200. This represented a 18.1% increase on a year over year basis. As can be seen in the graph below, the annual growth in the median price turned negative during the financial crisis and eventually hit a pandemic high of 24.2% in August 2021. This has declined steadily since and the June 2022 report revealed a 7.4% figure. Looking back up the pipeline, housing starts have also been impacted by rising interest rates. As can be seen in the following graph, starts fell from a near-record2 of 2,273,000 units (annualized) in January 2006 to a low of 478,000 units in April of 2009, at the height of the financial crisis. By April of 2022, that figure stood at 1,805,000 units. Since then, it has fallen quickly to 1,446,000 in the July data.

Canada

Not surprisingly, activity in housing is inexorably tied to prevailing interest rates. Lower borrowing costs provide greater affordability, fuelling greater demand, and the fact that rates have been ‘low for long’ means that any changes to the status quo were destined to upset the market. The over-heated new home sales in the U.S. seen during the pre-financial crisis period would not reappear prior to the onset of COVID-19. As can be seen in the accompanying graph, new home sales hit an all-time high of 1,389,000 units (annualized basis) in July 2005. After plummeting to 270,000 in February 2011, they recovered to 1,036,000 by August 2020. Since then, however, a secular decline has emerged. The June data revealed a 590,000-unit pace, the weakest since the COVID-19 dampened result in April 2020 (582,000-unit pace). Further new home pricing has also seen a material change. In October 2004, the median price for a new home in the U.S. stood at a then-record $229,200. This represented a 18.1% increase on a year over year basis. As can be seen in the graph below, the annual growth in the median price turned negative during the financial crisis and eventually hit a pandemic high of 24.2% in August 2021. This has declined steadily since and the June 2022 report revealed a 7.4% figure. Looking back up the pipeline, housing starts have also been impacted by rising interest rates. As can be seen in the following graph, starts fell from a near-record2 of 2,273,000 units (annualized) in January 2006 to a low of 478,000 units in April of 2009, at the height of the financial crisis. By April of 2022, that figure stood at 1,805,000 units. Since then, it has fallen quickly to 1,446,000 in the July data.

Looking forward, most forecasts have become decidedly gloomy. Real estate brokerage Royal LePage4 shortened the timeline with its latest forecast. It reported that the price of a Canadian home in the second quarter of 2021 was up 12.1% compared to the previous year. However, it was down 4.9% compared to the prior quarter. This is the first quarterly decline in more than three years. Further, Royal LePage forecast that the annual growth rate will fall to 5.0% by the fourth quarter of this year. The Bank of Montreal’s economist Robert Kavcic likened the BoC July rate hike to “taking a hammer to the housing market.” and warned that “The Bank of Canada’s recent move to increase its key interest rate is setting up the housing market for an even deeper correction next year.”5 The Royal Bank of Canada is also calling for a historic correction. “RBC now expects home sales to fall nearly 23% this year and 15% next year, and national benchmark prices to drop more than 12% from peak to trough by the second quarter of 2023.” 6 In addition, the anticipated 42% drop in home sales from the 2021 peak would exceed the declines seen in the past four national downturns. In 1981-82 and 1989-1990 sales fell 33%. In 2008-09 they fell 38% and in 2016-18 they fell 20%. The forecast 12% decline in prices by early 2023 would also be the steepest correction in the past five housing downturns. In its July 2022 update CMHC acknowledged that “the high rates of house price increases during the last two years have been unsustainable.” 7 They provide two forecasts according to a moderate and high interest rate scenario. Under the moderate scenario, by mid-2023, national housing sales are forecast to decline by 29% compared to their level in early 2022. In the high interest rate scenario, a 34% decline is forecast for the same period.

Still, CMHC also forecasts a stabilization in interest rates some time in 2024 and “supported by rising household income and higher immigration, house prices are expected to return to positive but moderate growth.” As well, studies have shown that Canada has the fewest number of housing units per capita among all G-7 nations.8 In addition, approximately 1.8 million units would be required just to bring Canada up to the G-7 average. That is the equivalent to the cumulative total of the most recent ten years of housing completions. Over the longer term, stabilization in interest rates, immigration demographics, and the slow process of adding housing stock can be expected to form a foundation for the housing market.

Conclusion

• Decades high inflation rates in North America are being met with an aggressive response from both the Bank of Canada and the U.S. Federal Reserve. Higher interest rates will continue to have a dampening influence on the housing market.
• Longer term, support for the housing market remains in place. Supply constraints and evolving demographics point to steady demand going forward.
• As housing has been a source of growth in net worth for many Canadians, further increases in interest rates and a dampening of activity will likely raise investor concerns. Having a professional advisor and a well-built investment portfolio can help reduce anxiety during periods of significant change.

Disclaimer

The information contained herein consists of general economic information and/or information as to the historical performance of securities, is provided solely for informational and educational purposes and is not to be construed as advice in respect of securities or as to the investing in or the buying or selling of securities, whether expressed or implied. This document may contain forward-looking statements. These statements reflect what CI Assante Private Client and the authors believe and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Neither CI Assante Private Client nor its affiliates, or their respective officers, directors, employees or advisors are responsible in any way for any damages or losses of any kind whatsoever in respect of the use of this documentor the material herein. CI Assante Private Client is a division of CI Private Counsel LP. CI Assante Wealth Management is a registered business name of Assante Wealth Management (Canada) Ltd. This documentmay not be reproduced, in whole or in part, in any manner whatsoever, without the prior written permission of CI Assante Private Client.© 2021 CI Assante Private Client, a division of CI Private Counsel LP. All rights reserved.