In a Canadian housing market that remains stubbornly resistant to cooling, the country's builders appear to be preparing to pour gasoline on the fire. Whether it blows up in the economy's face may be a question of timing.
Most economists had expected the country's building permits to take a breather in July, after a builders had rebounded from their weather-slowed winter, sending the value of permits up 33 per cent over May and June. Instead, Statistics Canada reported that building permits jumped another 11.8 per cent in July, to an all-time high.
While both residential and non-residential permits set new record highs in July, the residential side was the clearly leading the charge, jumping 18 per cent in the month. That mainly came from a 43-per-cent spike in the most volatile, and most overheated part of the residential market: condos, primarily in Toronto and Vancouver.
The surprising surge in building permits implies that construction in Canada, particularly on the residential side, may remain stronger for longer than many experts had expected. The logic seems to be that with borrowing costs expected to remain low (the Bank of Canada has implied that it is unlikely to start raising its key interest rate until mid-2016), housing demand will stay brisk and construction will keep humming. It's a positive for Canadian economic growth – for as long as it lasts.
But we saw in other countries in recent years what can happen when overpriced, oversupplied housing markets hit the fan. At very least, there's a danger that builders will wake up one day and realize that they've massively overdone it, and construction will drop off a cliff – potentially slamming the brakes on the economy. (Let's not even get started on what happens if a glut in supply knocks the stuffing out of housing prices, and what that does to overindebted consumers who suddenly find their mortgage is worth considerably more than their house. Suffice to say that the word "recession" may well come up in such a discussion.)
And all it might take is the first hike in interest rates. Demand could falter, condo towers could sit empty, economic dominoes could fall.
Still, building permits are not the same as actual construction. Builders are getting projects on the launching pad, but they are under no obligation to launch.
And why might they be lining up more projects for takeoff right now? Perhaps precisely because there are higher interest rates on the horizon.
History shows that it's not unusual for building permits to surge in advance of an upturn in mortgage lending rates. It appears that builders rush to position their projects once they can see rate increases on the horizon – not only to capture consumer demand before rates start rising, but to take advantage of their own lower project financing costs. The acceleration of the Canadian economy since the spring may have been taken as confirmation that rates are headed upward – and, possibly, a bit sooner than we have been expecting.
There are some counterbalancing characteristics to all these economic moving parts. If construction ramps up in anticipation of stronger economic activity and rising demand (as it typically does), then when interest rates eventually rise in response to the arrival of this economic strength, the resulting slowing effects on building are offset by a broader economy that is firing on a lot more of its cylinders.
So we have a construction sector that is helping sustain growth at the moment while we wait for exports and business investment to catch up. If all goes as planned, by the time rate hikes arrive, exports and investment will be the driving forces and the economy will be healthy enough to afford for construction to take a back seat.
Of course, all things don't always go as planned. If builders get too caught up in salivating over low rates and racing each other to get cranes in the air, and misjudge the market's resilience or mistime the rate cycle, the risk is a sharp and sudden construction slowdown that undermines other parts of the economy before they are strong enough to stand on their own feet.
The surge in building permits isn't, in itself, evidence that this is happening. But it's certainly a reminder of the risk of any sector, particularly housing, playing chicken with economic turning points – and why the timing of interest rate increases is such a critical pivot point for the economy.
David Parkinson