Canada’s financial system remains vulnerable
Author: Mike Archibald
December 6, 2017
As widely expected, the Bank of Canada (BoC) held interest rates unchanged at their latest meeting, trailing the pace of the U.S. Federal Revere where a 25 basis point hike is effectively cemented for their upcoming December meeting.
This cautious rhetoric following a hawkish summer of consecutive rate hikes was confirmed in the Financial System Review, a semi-annual publication released last week by the central bank. According to the BoC, “overall risks remain elevated” with three key vulnerabilities highlighted.
Elevated Household Debt
Cited as Canada’s primary risk, record levels of household debt continue to trend higher with growth of mortgages and home equity lines of credit (HELOC). While HELOCs do offer the flexibility for borrowers to pay down outstanding higher-rate debt (ie. credit cards) and act on investment opportunities, the report finds 40% of HELOC borrowers do not make regular contributions to paying down the principal amount owing, instead covering only interest commitments. This could create significant vulnerabilities and potential asset price shocks should the housing market turn lower or unemployment rates increase, causing borrowers to liquidate other assets to pay down debt.
Household credit growth is mostly from mortgage lending (year over year growth)
Sources: Statistics Canada and Bank of Canada calculations. Last observations: Credit series, October 2017; disposable income, Q2 2017.
Housing Market Imbalance
The Canadian housing market remains dangerously inflated as employment gains, immigration and investor speculation have propped up prices. Toronto and Vancouver continue to be singled out in the report as being at risk for a material correction. The two regions account for around 50% of house sales by value in Canada. This imbalance across provinces creates a unique challenge for the BoC with expectations of calming these overheated markets while also spurring activity in the Prairies, all with the same set of policy measures.
House prices in the Greater Toronto Area are going through a period of adjustment following rapid growth in part due to Ontario’s Fair Housing Plan, which applies a 15% tax on non-resident purchases. If Vancouver is any indication, however, which implemented a similar initiative in early 2016, a pick-up in activity could be expected in the coming months. The 2018 spring selling season will be a crucial indicator in assessing the overall health of the broader market.
Regional differences in house price growth have decreased
(year over year growth in quality-adjusted benchmark prices)
Note: the lines represent averages of quality-adjusted prices weighted by the population of the corresponding consensus metropolitan areas as defined by Statistics Canada. The June FSR line is placed to indicate the most recent data available at the time of the report, not the publication date. Sources: Canadian Real Estate Association, Statistics Canada and Bank of Canada calculations. Last observation: October 2017.
Technology in the financial sector has exponentially improved the ease of payment and transfer of goods over the past decade. However, with this high degree of interconnectedness, risks are on the rise for potential cyber-attacks against large financial institutions. Given the globalization of many large financial and banking businesses, this issue stretches beyond Canadian borders and requires oversight both within and outside of Canada.
In the report, the BoC highlights their proactive approach in implementing oversight procedures along with collaboration within international committees, though this risk will likely remain present over the short- and long-term.
The report goes on to discuss other moderate-to-elevated risks to the stability of the Canadian financial system, including: brokered deposits, increased risk taking as a result of low market volatility and low interest rates, corporate indebtedness, an economic recession, sharp increases in long-term interest rates driven by higher global risk premiums and economic stress in China or other emerging market economies.
Importantly, the Canadian equity market continues to exhibit strong resiliency through these risks, warranting a “cautiously optimistic” view of future stock market returns. The first half of 2018 looks to offer continued upside as global growth continues to improve, and resource demand picks up. We believe an environment such as this is best navigated with a disciplined approach to investing, seeking sound opportunities and not chasing “fast money”.
Commentaries contained herein are provided as a general source of information based on information available as of December 4, 2017 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice.