Carney, Flaherty & Mortgages - Oh My!
By: Justin G. Charbonneau, CFA, DMS, FCSI
Ever since the global financial crisis, Canada’s policy makers - both on the monetary and fiscal fronts - have been priming consumers for high interest rates and tighter mortgage regulations, given the economic risks from an overvalued Canadian housing market. Although Canada has so far avoided a disorderly unwinding of our housing market, the risk still remains to our banking system and to our personal balance sheets alike. So what do these policy changes mean for Canadian real estate, fixed income, and equity prices and more importantly, client portfolios?
First, it’s not a surprise the Canadian housing market is overvalued by any stretch of historical valuations in Canada and globally. Although Dealing Representatives may have a tendency to only worry about the assets they specifically manage for their clients, it would be an injustice to not include what risks that the Canadian housing market holds for clients with respect to their overall financial picture and their overall portfolio risk exposure. From a risk management perspective, including client assets tied to Canadian real estate, exposure should be a discussion point for advisors given the close positive correlations between Canadian real estate, and energy & materials – two of the largest S&P/TSX Composite sectors. Especially for Dealing Representatives and clients out West, you may be surprised at how much of your client portfolio exposure is tied to the resource sector bull market which is now 12 years into the making (some might say quite long in the tooth).
A common valuation method used globally based on average price vs. median family income shows that Canada’s residential housing sector is valued between ~4.5-6x. Figures on national average house prices taken from Canada’s Real Estate Board (CREB) and the national median family income taken from the government show that by historical measures, the risk to consumers of becoming house poor is high. This is a clear and present phenomenon, especially if Canada sees a prolonged slowdown in the resource space, a definitive risk if China cannot navigate a soft landing.
By contrast, and in its fifth year of decline from its own housing bubble, the U.S. residential housing market now stands at ~3-3.5x. As the May 2012, National Association of Realtors (NAR) housing statistics show, the median existing home price of ~$160,000 has fallen from a peak of ~$220,000. While median household income of ~$52,000 has stagnated since the global financial crisis, resulting in the US housing market valuation coming back into line with that of the late 1990s.
So how did we get here, and are house prices sustainable given current valuations?
Like the U.S., Canada’s policy makers fuelled access to cheap debt over the last decade, resulting in a credit boom like nothing we’ve ever seen.
Over the past 15 years, China’s insatiable demand for our resources has turned our once manufacturing powerhouse economy into a materials and energy haven. Now, our policy makers are clearly giving us the yellow light given a global economy in deleveraging mode, Europe facing its own debt crisis, and China’s growth rate falling back to earth.
The unfortunate reality is most Canadians haven’t woken up to the fact that our secular commodity bull market is at risk of coming to an end. Coupled with a government focused on implementing tighter monetary policy through unconventional regulation, lower commodity prices at the margin are heightening downside risks in our economy and, moreover, our housing market. That is the bad news.
The good news is a tighter unconventional monetary policy, weaker commodity prices and continued uncertainty over Europe, China, and the U.S. fiscal cliff mean Canadian baseline interest rates should stay lower for longer, thereby fueling the fire of the Canadian bond market. But haven’t we all heard the story that interest rates are historically low and have no where to go but up? Yes, however, the reality is most investors aren’t putting enough weight on the downside risks to our economy because the housing market has left many house poor, not to mention the slow bleed of commodity prices, thereby amplifying the need for lower rates.
The notion of rates normalizing to higher levels has been pushed further into the future, and with the risk of a housing correction in the magnitude of 10% to 15%, it is unlikely Carney will use abrupt interest rate hikes in such an uncertain environment.
For this reason, the corporate sector of the fixed income market remains very attractive, especially considering how tired clients are getting with low equity market returns. Corporate bonds with a term of 5-10 years continue to offer investors nominal yields in the 3-5% range, even higher for the non-investment grade bond offerings which, unfortunately, have equity-like risk profiles.
Add to this the global deleveraging cycle that is unlikely to bring an economic boom anytime soon, and Advisors may have a real risk to their book of business if there is too much resource and real estate exposure and not enough yield generation in your client portfolios.
Although government bonds are now in negative yield territory, corporate bonds and high yield debt continue to offer investors attractive yields comparatively speaking. Nevertheless, do not discount the shock absorber features of government bonds seeing how a good risk management strategy always incorporates unfavorable outcomes. Beware of bonds that promise euphoric yields because this might result in disappointment in equity-like downside, or a total loss of return of capital if the underlying issuer runs into re-financing trouble.
The other asset class that offers clients a lower risk profile along with consistent income generation in the 3% to 5% range is dividend-paying stocks across all market capitalizations around the world. Using our strong and some might say overvalued Canadian dollars to buy cheap US dividend-paying companies has never looked more attractive. Throw on top of that the US stock market which has just endured a lost decade and you have a real opportunity to invest in a slower global growth “two-speed world”. Put another way, for those clients who have a significant weighting to overvalued Canadian real estate and Canada’s resource sectors, you’ve just built in a contingency in case the secular resource bull market is indeed coming to an end.
Finally, exempt market securities involving US real estate should do especially well in a low rate environment given that US residential home prices are back to 1997s levels. Exempt securities, however, involve another risk which mainly lies with the underlying manager who needs to be more hands on and build continuity in their business model. Managers need to deploy strategies with conservative loan to value ratios, focus on positive rental cash flow, low carrying financing costs through secure and competitive lending, utilize regular income distributions, and take a reasonable management fee. That way, the likelihood of attractive returns for clients in an exempt product is high given the downside risk to US residential. Real estate appears limited compared to that of Canadian residential real estate.
The traditional asset classes of bonds, balanced portfolios, US blue chips, dividend paying equities, and private equity involving US real estate are back in vogue like mom’s good old home cooking for Canadian investors.
And as Dorothy famously once said, “There’s no place like home.”