Near-record stock valuations added to list of concerns for Bank of Canada

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The Bank of Canada has emphasized a concern for Canadians already fretting over the country's depressed energy sector and overvalued housing market: Stock valuations are near record highs.

The warning follows long-simmering concerns about a rising appetite for risk among investors searching for higher returns in an era of ultralow interest rates.

However, the central bank's interest in stock prices has increased the scope of these concerns.

In its Financial System Review, released on Thursday, the bank said that the valuation of the S&P/TSX composite index was "above historical averages and is close to all-time highs" when assessed using estimated earnings.

"A buildup of higher-risk positions, especially if accompanied by leverage, could lead to systemic stress if there were a sharp drop in asset prices," the bank said in its report.

The twice-yearly review focuses on the downside risks to Canada's financial system, without making forecasts for the near-term.

The bank said lower oil prices and high levels of consumer debt have raised the risks to Canada's financial stability, even as it suggested that the full impact of the depressed oil market is not fully understood.

"We don't have a full reading on the oil price shock yet," said Bank of Canada Governor Stephen Poloz at a news conference following the release of the report.

He said that the bank will understand more over the next four-to-five weeks.

The bank's report said the Canadian economy is diverse enough to withstand persistently low oil prices, but the energy sector nonetheless poses a threat to the country's employment and income levels, particularly in oil-producing regions.

The collapse in oil prices over the past year, to about $60 (U.S.) a barrel from more than $100, has exposed vulnerabilities in Alberta's housing market.

For now, though, the bank believes that the risks are localized.

"Although the low price of oil has increased the vulnerability of the Canadian financial system to future adverse shocks, it is unlikely, on its own, to trigger significant financial system stress," the bank said.

Nationally, though, high home prices and rising consumer-debt levels continue to send warning signals.

The bank said that yearly home price growth has slowed to about 4.5 per cent from 5 per cent in December, but prices continue to outpace income growth.

It reiterated that Canadian home prices are overvalued by 10 to 30 per cent, making the market susceptible to a correction if either unemployment or borrowing costs rise sharply.

"We judge that the vulnerability associated with household indebtedness is edging higher, and the overall risk to financial stability in Canada is slightly higher than it was at the time of our December [Financial System Review]," Mr. Poloz said, in a statement.

However, the Bank of Canada had some good news to pass along.

Despite weak economic activity in the United States in the first quarter, the bank expects economic growth to pick up, supporting the Canadian economy.

It was also identified rising bond yields, particularly on 10-year German Bunds, as a reflection of stronger-than-expected economic growth in the euro area and relatively upbeat news on inflation.

Indeed, the bank said that financial stress from the euro area was moderating because the potential for a sharp economic slowdown has declined since December.

Economists said the review does not reflect any shift in the Bank of Canada's next move on interest rates.

"We continue to look for the Bank of Canada to stay on hold well into 2016," said Benjamin Reitzes, senior economist at BMO Nesbitt Burns, in a note.

Randall Bartlett, senior economist at Toronto-Dominion Bank, said that the Bank of Canada's rate cut in January, in response to collapsing oil prices, amplified financial risks in some parts of the country.

"That's not to say it was misguided, but suggests that the Bank is unlikely to cut rates again given its concern about risks to the Canadian financial system," he said.