It's been interesting to watch the view on the Canadian housing market become progressively more negative. Eighteen months ago, the consensus was that the Canadian housing market was well supported by underlying fundamentals. A year ago, we were headed for a soft landing with flat prices. By late 2012, the consensus view was best summed up by TD economist Craig Alexander, who in November suggested that house prices in Canada would likely retrench on the order of 10 per cent nationally.
The current consensus is that we are not headed for a U.S.-style correction and that the economy will only be moderately affected by a housing slowdown. While I agree that a U.S.-style rapid plunge seems unlikely, those calling for a painless soft landing have a few difficult questions to wrestle with:
What will replace housing-related industries as a major driver of economic growth?
Construction and the FIRE industries (finance, insurance, and real estate services) collectively account for more than 27 per cent of Canadian gross domestic product. (The U.S. peaked at 24 per cent.) The growth in these industries during the current housing boom is quite striking. (See chart: Real GDP growth by industry)
Admittedly, these industries capture more than purely housing-related activity (there's more to the construction industry than just building homes, for example); however, a slowdown in the housing market will no doubt take some steam from these industries.
This is more than a little problematic when we consider that 44 per cent of all GDP growth in Canada since 2005 can be attributed directly to these industries. While a new catalyst for GDP growth could emerge to take the reins, this is far from assured.
What will replace housing-related employment in the labour market?
Final housing starts in Canada in 2012 came in just shy of 215,000 units. This compares with an estimated household formation rate in the 185,000 range. Over the past decade, Canada has averaged nearly 210,000 annual housing starts at a time when estimated demographic demand has been stable at 180,000-185,000 per year.
In other words, we've over-built. This is not at all uncommon during housing booms. As a result, the number of Canadians employed in housing-related industries has risen markedly over the past decade. (See chart: Percentage of labour force employed in real estate-related industries)
After a decade of significantly outbuilding demographic demand, the chance that we may see housing starts fall well below demographic demand strikes me as quite high. January's housing starts reading of 167,000 units annualized, the lowest level since the last recession, may be a sign of things to come.
During housing booms, the demand for additional houses accelerates. This demand can come in the form of rising household formation rate (think of young people jumping straight into home ownership so as not to miss the boom), demand for secondary homes, and speculation. However, when the boom ends, this demand tends to unwind also.
What would this mean for the labour market?
There are 1.3 million individuals employed directly by the construction industry. This represents roughly 7.3 per cent of all jobs in Canada. This is well above the historical average. To realign with the long-term average share of total employment, the number of Canadians employed in construction would need to fall by more than 200,000. If housing starts were to weaken even further than the current consensus, the losses could be even larger. And this does not take into account other industries such as those that service the construction industry.
Are we underestimating the effects of the "home as an ATM" phenomenon?
There was a time when Canadians looked smugly south of the border at those "crazy Americans" using their homes as giant cash machines. Pulling equity out of a home to finance spending, renovations, or consolidate high interest consumer debt was rampant in the United States during the boom years.
But the Bank of Canada has estimated that between 2006 and 2010 (the last year data is available), Canadians annually pulled nearly $60-billion of equity out of their homes. Compared with our total personal disposable income, this level of home equity withdrawal parallels what the U.S. experienced at its peak. In fact, home equity lines of credit have been by far the fastest growing credit segment since 2000.
In a recent working paper, Bank of Canada economists concluded that there is a strong relationship between house prices, debt, and consumption, noting that a 1-per-cent increase in house prices is associated with a 0.36-per-cent increase in consumer debt.
In short, over the past decade, Canadians have borrowed and consumed more than their incomes would warrant, and to a large degree, this can be tied to rising house prices. This overstretching has been a boon for the economy. Yet in other countries where prices have corrected or stagnated, people stopped borrowing as aggressively against their home equity. A soft landing in housing, coupled with new regulations aimed at curbing this trend, will unquestionably slow the pace of home equity withdrawal – likely quite dramatically.
The bottom line
My crystal ball works no better than anyone else's; I have no idea where house prices will be in the future. But I am deeply concerned with the clear imbalances that this current boom has created. And that raises an important question: If we are indeed headed for a soft landing, and if the economy and labour market is negatively affected by a soft landing in housing as I believe the data suggest, will it remain a soft landing?
Ben Rabidoux is a Canadian analyst and strategist with US-based Hanson Advisors.
Learn about his upcoming discussion in Toronto here: http://www.realestate2013.ca