Juggling Dynamite

As Canada’s manufacturing and oil sector shrunk over the last decade, real estate and residential construction became the economy’s largest sector accounting for 15% of GDP in 2019.  Low rates, lax lending and debt-enabling government policies helped Canadians to go on a self-destructive spending spree levering up property gains to extract more consumption and speculation all along the way.

In the process, Canadian households became the most indebted in the G7, owing $1.76 for every dollar of disposable income.  As I have noted in the past, households with the highest property values and incomes to be levered, also tend to owe the most debt.  Households in Vancouver and Toronto, with some of the highest average incomes in the country, and highest property prices in the world, owe a mind-blowing $2.30 and $2.09 of debt respectively for each dollar of disposable income and more than 50% of household income is needed for shelter costs alone. 

This kind of extreme leverage was always a train wreck waiting to happen, and COVID-19 is serving as this cycle’s derailing brick on the track.

Suddenly, properties that were set up as periodic vacation rentals are empty and incomeless, while many long-term rentals that were barely positive and negative-yielding–even with tenants–have also seen a stop in rents. A third of Canadian workers have filed for government income support in the last month alone.  In a letter to the federal government last month, Airbnb wrote that nearly a third of its Canadian hosts need rental income to avoid foreclosure or eviction.

Recessions that begin with highly levered businesses and households have historically been deeper and longer than average.  Today, Canada is entering its sharpest economic contraction on record owing a record $2.3 trillion in mortgages, credit card, and other consumer debt.  The math for owners, lenders and investors should be riveting.  See: Once called safer than gold, Canadian real estate braces for a reckoning:

The City of Vancouver fears it’s heading for insolvency after it surveyed residents and found that 45% of households say they can’t pay their full mortgage next month and a quarter expect to pay less than half of their property tax bills this year.

It’s a stunning contrast to 2016, when those lucky enough to own a detached house in the west coast city watched their net worth balloon on average by more than C$1,600 ($1,130) a day without ever leaving home. In one year, the city’s properties surged in value by C$47 billion, more than double the cumulative take-home income of all its residents…

“I think it is the Great Reckoning,” says Douglas Hoyes, a bankruptcy trustee in Kitchener, Ontario. “We’ve been in a period for so long where it didn’t matter what property you bought or how highly leveraged you were. Well, guess what? Now it matters.”

Undersaved, over-levered households and businesses were overdue for a secular shift to more self-preserving financial management well before the pandemic hit.  Now, new research points out that COVID-19 may well solidify that behavioural shift for years hereafter and fuel deflationary forces in the process.

A paper from the Centre for Economic Policy Research points out that historically, pandemics are associated with falling real rates, depressed asset returns, and excess saving for decades following such outbreaks.  See The long-run economic consequences of pandemics:

The great historical pandemics of the last millennium have typically been associated with subsequent low returns to assets. Measured by deviations in a benchmark economic statistic, the real natural rate of interest, these responses indicate that pandemics are followed by sustained periods – over multiple decades – with depressed investment opportunities, possibly due to excess capital per unit of surviving labour, and/or heightened desires to save, possibly due to an increase in precautionary saving or a rebuilding of depleted wealth.

A further implication of our analysis in the current low interest rate environment pertains to the secular stagnation hypothesis (Hansen 1939, Summers 2014). If the historical trends we have highlighted play out similarly in the wake of COVID-19 – adjusted to the scale of this pandemic – then secular stagnation would remain a concern for monetary and fiscal stabilisation policy for the next two decades or more.

The researchers note that a deflation-moderating factor this time may be where younger populations remain less physically impacted and longer living than in past pandemics.

Buying assets at historically discounted valuations is essential to improving prospective investment returns in this environment, but so too is the continuation of income payments  (interest, dividends, rents, royalties) on the assets, once purchased.  We are first likely to see more dividend cuts and defaults before investment yields can stabilize.

Forced deleveraging and the oil crash are compounding the COVID-19 costs and hangover for Canada.  Manulife chief economist Frances Donald explains it well in this clip.

Canada’s economy is far more vulnerable to COVID-19 shock than the U.S.: Manulife’s Donald.  Here is a direct video link.