Bubble Trouble?

When we last wrote about Canada and the worrisome expansion of its household debt stock and real estate bubble, we noted that there was a lot of misguided optimism regarding the durability of these trends – mainly as a result of their durability up to this point. In a way this reminds us of how bulls on the Nikkei rationalized the vast expansion in the p/e ratios of Japanese stocks in the late 1980s, or how tech stock bulls repeated the exercise exactly ten years later in the final stretch of the Nasdaq mania. The fact that multiple expansion had gone on for so long and had survived several major temporary setbacks convinced many people that these trends were unstoppable. It seemed safe to ignore the warnings that had been proliferating for quite some time – after all, the Cassandras had been proved wrong time and again. One could hardly blame them – once a market has seemingly left all rationality behind, it is difficult to tell how far things might be taken before the party is over. However, one must never lose sight of two decisive points: one day, the party will be over and once that happens, the subsequent hangover will be a mirror image of the exuberance that reigned on the way up.

Recent news from Canada indicate that the real estate bubble may be about to experience a bump in the road:

“Canadian housing starts fell twice as fast as economists expected in January, led by a drop in multiple-unit projects. Work on new homes fell 3.7 percent to a 180,248-unit annualized pace, the third straight decline, Ottawa-based Canada Mortgage & Housing Corp. said today. Permits for dwellings such as apartments and condominiums fell 6.0 percent to 102,289 units and single-family homes rose from the lowest since July 2009 in January, gaining 3.4 percent to 60,869 units.

Bank of Canada Governor Stephen Poloz expects a “soft landing” for the housing market after consumer spending and record debt accumulation led the world’s 11th economy out of the 2008 global financial crisis. CMHC said today’s figures are in line with its prediction that builders will slow new construction to avoid an inventory glut.

“Housing no longer looks to be a source of growth,” for the economy, said Avery Shenfeld, chief economist at CIBC World Markets in Toronto, in a note to clients. The Bank of Canada’s growth outlook calls for increasing exports and business spending to take over from consumers.

“A slower pace of construction activity to start the year is consistent with the wider theme of domestic fatigue that will inevitably put more pressure on net exports to drive the next stage of Canada’s economic recovery,” said Connor McDonald, economist at Toronto-Dominion Bank, in a client note.”

(emphasis added)

'Domestic fatigue' is going to 'put pressure on net exports to drive the recovery'? We wonder which economic theory this fatigue produces growth idea is based on. It is quite remarkable that the news are greeted with such equanimity. If CMHC (Canada's government-backed mortgage insurer, which in our opinion is an accident waiting to happen) judges that construction activity is declining out of fear of an inventory glut, then it is indirectly admitting that that the recent decline in the growth rate of transactions could indicate that the bubble is finally getting tired.

Consumer Confidence Takes a Hit

Concurrently it was reported that Canadian consumer confidence fell to an eight month low – following the unexpected decline in housing starts lower. Interestingly, one of the reasons why consumers are becoming concerned is the recent decline in the Canadian dollar's exchange rate. It appears that the outlook for the economy is generally souring though, with several factors likely playing a role.

“Consumer sentiment in Canada fell to the lowest since May on speculation the nation’s economic outlook is worsening. The Bloomberg Nanos Canadian Confidence Index declined to 56.0 in the week ending Feb. 7 from a previous reading of 56.6, the fourth straight drop. Deteriorating optimism was seen in every province except Quebec and across all age groups except the youngest, 18 to 29, and those older than 60.

Persistently low inflation, a widening trade deficit and the worst-performing currency in the Group of 10 this year are chipping away at the perception Canada is immune from the global downturn. Bank of Canada Senior Deputy Governor Tiff Macklem, speaking last week in Montreal, cited slack in the nation’s economy, retail competition and anemic worldwide prices for food and energy as among reasons for inflation remaining below the central bank’s target.

“Consumer confidence continues to slide largely on pessimistic views on the future strength of the Canadian economy,” said Nik Nanos, chairman of Ottawa-based polling firm Nanos Research Group. The year “has opened with dampened confidence.”

(emphasis added)

There is one obvious absurdity in the above excerpt, namely the assertion that 'persistently low inflation' has a negative effect on consumer confidence. That is a chimera that exists exclusively in the heads of Keynesian economists. Consumers love it when the inexorable climb in prices for once slows down a little. 'Retail competition' doesn't make consumers less confident – that is utterly bizarre reasoning. The danger of a contraction in the housing bubble however might:

“Consumers are the most pessimistic since May about the nation’s prospects. The share of survey respondents who say the economy will improve in the next six months fell to 18.0 percent from 19.9 percent, while the share of those who anticipate a weakening rose to 28.4 percent, from 28.1.

Data showing a softening housing market is fueling speculation real estate has ceased to be a catalyst for economic growth. The total value of purchases in six major Canadian real estate markets rose 19 percent to C$5.09 billion in January compared with the same month a year earlier, and the number of homes sold rose 7.3 percent, according to data compiled by Bloomberg News from regional real estate boards. In both cases, that’s less than half the annual pace in December.”

[...]

The proportion of survey respondents who think home values in their neighborhood will rise over the next six months fell to 36.3 percent last week from 38.1 percent, the largest drop in seven weeks.

The Canadian dollar is down 3.7 percent versus the greenback this year through Feb. 7, the worst performance among G-10 currencies, data compiled by Bloomberg show. The loonie, as the currency is sometimes known, depreciated past C$1.12 last month for the first time since July 2009 on speculation the Bank of Canada may lower interest rates.

“Household sentiment continues to slide on concerns over the deceleration in growth and the reduced purchasing power of the loonie,” said Joseph Brusuelas, senior economist in New York at Bloomberg LP.

(emphasis added)

It is rather amazing that a halving of the annualized growth of the dollar value in real estate sales from a full 19% to a still hefty growth rate of just below 10% is already seen as a sign of incipient trouble and manages to impact confidence. In any case, the astonishing extent of the growth rate late last year is probably indicative of a terminal bubble episode. More than a year ago studies already showed that about one third of Canadians had 'trouble sleeping' due to worrying over their personal debt loads. No wonder they are sensitive to the possible demise of the bubble (according to recent data, Canada's houses are the most overvalued in the world relative to rents – with the overvaluation clocking in at an estimated 80%).

It is of course contradictory to assert in one paragraph that people worry about 'inflation being too low' and to state in the next paragraph that they are worried about the 'reduction in the loonie's purchasing power'. Which is it? Only one of these statements makes sense, and it clearly has to be the second one. People are hardly worried that prices might not rise, if anything they are worried about the exact opposite: namely that the weaker exchange rate will make imports more expensive (as the Japanese have just found out, inflating oneself to prosperity isn't all it was cracked up to be).

Conclusion:

Perhaps it is just a temporary slowdown, but with bubble conditions as extreme and advanced as is the case in Canada, one must always be alive to the possibility that something more serious is afoot. These developments certainly bear watching.

Slip-sliding away – the Canadian dollar, weekly – click to enlarge.

The performance of the Toronto stock index since its 2008 top has more in common with emerging markets than the SPX. This is no doubt a result of weakening commodity prices. It is anyway noteworthy that the index still remains well below its peak of 2008 – click to enlarge.

Charts by: StockCharts