Canada s Housing Becoming a Drag on the Economy

Global Multi-Asset Viewpoint Canada s Housing Becoming a Drag on the Economy SOLUTIONS & MULTI-ASSET GLOBAL MULTI-ASSET TEAM MACRO INSIGHT OCTOBER 2017 Canada s economy has been looking strong recently. GDP grew 4.5% 1 in the second quarter, and growth expectations have been moving upward (the consensus forecast for 12-month forward GDP has risen from 1.8% in mid-2016 to 2.2% today), 2 along with the synchronized global growth upswing. After a substantial deceleration, average hourly wage growth turned up from under 1% early in 2017 to 2.4% in October, 3 as employment growth picked back up to above 2% by the middle of this year from under 0.5% in 2016. 4 The Bank of Canada (BoC) increased its policy rate twice this year, by 0.5% in total, to 1%, 5 validating the improvement in Canada s economic outlook. The market is currently pricing two additional rate hikes over the next 14 months. 6 We expect that Canada s growth will slow closer to its trend rate of 1.5%, and that any inflationary pressures will be eliminated. We think the market s expectation of two rate hikes is overly-optimistic and that the BoC will likely hike no more than once in the next twelve months. The economic backdrop is precarious. We see Canada s economy as structurally brittle and cyclically extended. Canada has built up significant excesses in housing and credit. Canada s private nonfinancial debt-to-gdp ratio is the highest among major economies at 217% China is second highest at 211% and is now comparable with Japan s peak ratio of 220% in 1993. 7 In addition, government gross debt-to-gdp is at an elevated 90%, 8 which would make it more difficult to socialize problematic private debt. Canada s ramp up in private nonfinancial debt is relatively recent, with debt-to-gdp AUTHORS Display 1: Residential Housing at Highest Level in 50 Years Canada Residential Investment (% of GDP) Percent (%) 8.0 7.0 6.0 5.0 CYRIL MOULLÉ-BERTEAUX Portfolio Manager Head of Global Multi-Asset Team Managing Director SERGEI PARMENOV Portfolio Manager Global Multi-Asset Team Managing Director 4.0 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 2016 Source: MSIM Global Multi-Asset (GMA) Team analysis; Haver Analytics. Data as of October 31, 2017.

MACRO INSIGHT rising by 34% 9 over the past five years, more rapidly than in any other major economy except China. This has been the fastest pace debt accumulation over a five year period that Canada has experienced in the past 50 years. This dramatic increase in debt has led to excessive investment in arguably the least productive type of asset residential housing which peaked in the first quarter of 2017 at 7.8% of GDP. 10 (Display 1) This is the highest level in the past 50 years, and even higher than the U.S. pre-crisis peak in residential investment to GDP. Housing prices have increased 21% since the 2009 crisis, having barely corrected at the time. 11 In real terms, they are near alltime highs, compared to most major markets where prices are still below prior peak levels. As a result, housing affordability in Canada is nearly as poor as it has ever been: currently 47% of pre-tax household income would be needed to service the cost of owning a home (including mortgage payments, utilities, and property taxes). 12 Durables consumption, much of which is linked to housing activity, is also cyclically extended. Canada s car sales per capita, a major component of durables consumption, are at the highest level since the early 1990 s. The recent pick up in Canada s growth can be attributed to two developments, both of which are either reversing or no longer contributing to above-trend growth. First, the rebound in oil prices since early 2016 has helped lift real non-residential investment growth to 10.4% on average in H1 2017, after a downturn in the previous two years. 13 This has contributed nearly 100 basis points to GDP growth. We expect that oil prices are unlikely to rise much further from current levels. As a result, we expect non-residential investment to decelerate to a trend-like pace of 3-5%. Second, housing activity has improved as the Bank of Canada cut rates twice in 2015 and five-year bond yields fell from 2% in 2014 to 0.5% 14 in 2016 (most mortgages are priced off this five-year rate). Housing sales rose from about 37 thousand units per month in early 2014 to 46 thousand in mid-2016, a 24% increase. We expect a more pronounced slowdown in housing (as compared to non-residential investment). In fact, a slowdown in home sales has already begun. Sales peaked in March 2017 at 46,500 monthly units (seasonally-adjusted), and most recently were 41,000 in September, 12% below the March peak. 15 This decline is in part the result of deteriorating affordability, following increases in mortgage rates and home prices. We expect housing activity to deteriorate further. Since early 2016, five-year interest rates have increased by over 100 basis points from 0.5% to a recent daily high of 1.8%, 16 and mortgage rates have risen by 20 basis points from 2016 (3.7% to 3.9% today). 17 (Display 2) Based on the historical relationship between rates, home prices, and housing activity, we think the 20 bps rise in mortgage rates should cause housing activity to decelerate and residential investment to decline. Residential investment contributed 29 basis points to GDP growth in the first half of 2017. 18 Assuming mortgage rates and real home prices remain at current levels, we expect residential investment to fall 5.5% in 2018, detracting close to 40 bps from GDP growth. 19 Display 2: Housing Activity to Deteriorate Following Rise in Interest Rates Canada 5-Year Conventional Mortgage Rate vs. Government Bond Yield Percent (%) Percent (%) 5.5 3.5 5.0 4.5 4.0 3.5 0.5 2010 2011 2012 2013 2014 2015 2016 2017 Canada Conventional Mortgage Lending Rate: Five Year Term (LHS) Canada 5 Year Government Bond Yield, Led 1 Month (RHS) Forecasts/estimates are based on current market conditions, subject to change, and may not neccessarily come to pass. Source: Data as of October 31, 2017. Admittedly, mortgage rates have thus far risen less than five-year government yields. Historically, mortgage rates have tended to move closely with government yields, sometimes responding to changes in government yields with a delay of a few months. If this pattern were to continue we see no reason it would not mortgage rates would likely rise by an additional 80 basis points. This should lead to a more pronounced fall in residential investment of 10%, detracting about 80 bps from GDP. 20 3.0 2.5 2.0 1.5 1.0 2 MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET

CANADA S STRUCTURALLY BRITTLE ECONOMY It is likely that the impact of higher rates on housing and consumption will be disproportionately larger than what historical relationships might predict, because of how elevated housing activity is relative to historical levels, and because affordability is also extremely poor relative to history (as discussed above). We find that home sales tend to lead durables consumption by roughly six months. If the recent slowdown in home sales were to lead to a slowdown in durables consumption growth by about 5%, this would detract close to an additional 40 basis points from GDP growth (on top of the drag from slowing residential investment, noted above). Recognizing that activity levels in the housing market are overextended, Canada s financial regulator, OFSI, has continued to implement macro-prudential measures aimed at slowing the housing market further, with the latest measure set to take effect on 1 January 2018. 21 This will increase the stress test requirements on new uninsured mortgages, making it more difficult for this segment to obtain a mortgage, thereby depressing housing demand further. We expect Canada s GDP growth to slow to below 1.5%, which would be below trend, versus the above-trend growth rate of 2.1% expected by the consensus and the Bank of Canada. Recent data is supportive of this thesis and appears to indicate a significant weakening in growth. In August, monthly GDP declined 1.1% annualized, making it the weakest monthly performance since mid-2016, and bringing the 3-month annualized pace to 3.4% vs. a recent peak of 5.1%. Other hard data series have seen similar slowdowns over the past two to four months, including: industrial production at 4.8% QoQ through August vs. a recent high of 11.6%, real retail sales at 2.8% QoQ through August vs. a recent high of 10.5%, and export volumes at -16.2% QoQ through September vs. a recent high of 8.5%. Survey-based data has been weak for longer, with Canada PMIs having peaked in April and now pointing to 2.5% GDP YoY vs 3.7% pace in Q3. As a result, current economic growth appears to be tracking closer to 2.5% QoQ for Q3 versus Q2 GDP of 4.5% QoQ, and we expect it to slow further. 22 The Bank of Canada appears to face a quandary. On the one hand, the economy is fragile and growth is weakening (albeit from a high level). On the other hand, growth has recently been strong and inflation and wages have accelerated. Hourly wages bottomed in mid-2016 at 0.7% YoY and have accelerated to 2.4% as of October. 23 Core inflation (measured by the BoC as an average of trimmed, median, and common inflation) also bottomed at roughly the same time at 1.3% and has accelerated to 1.6% as of September. 24 (Display 3) Display 3: Core Inflation Remains Below Target of 2% Canada Core Inflation vs. Target Percent (%) 2.8 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 1992 1997 2002 2007 2012 2017 Canada Core Inflation (Average of Common, Median, Trimmed) Bank of Canada Target Source: Data as of October 31, 2017. This is why the Bank of Canada has been devoting much attention to the issue of slack in the economy in its most recent communications. It is true that the unemployment rate is at 6.3%, and is approaching the prior cycle low of 5.8%. But the Bank of Canada s more comprehensive labor market indicator (combining seven broad measures of slack) suggests a less tight labor market: it implies a further tightening of the labor market would be required to get back to prior cycle lows. On balance the degree of slack appears potentially larger than is implied by the headline unemployment rate. If we are right that the growth slowdown has further to go and that growth will return to a trend-like pace, we believe the recent signs of increasing tightness in the labor market will dissipate, albeit with some delay as typically occurs. Since core inflation remains at 1.6% (the average of the three measures), which is below the target of 2%, and the degree of slack is somewhat uncertain, we expect that the BoC will require strong above-trend growth to continue in order to continue raising rates. 25 The market expects 50 bps of rate hikes over next 14 months, whereas we expect one hike at the most. We expect 2-year yield will fall to 1.2% from 1.4% today. This would make the real rate differential less favorable for the Canadian dollar as we expect the Fed to continue on its course and raise rates three times by the end of next year. Assuming three Fed rate hikes with U.S. inflation at 2.1%, and one rate hike from BoC with stable inflation, the CAD would fall roughly -5% against the U.S. dollar. If the BoC keeps rates at current levels, the CAD could fall -10%. SOLUTIONS & MULTI-ASSET MORGAN STANLEY INVESTMENT MANAGEMENT 3

MACRO INSIGHT 1 2 MSIM Global Multi-Asset (GMA) Team analysis; Consensus Economics. 3 4 5 MSIM Global Multi-Asset (GMA) Team analysis; Bloomberg LP. 6 7 MSIM Global Multi-Asset (GMA) Team analysis; BIS. 8 9 MSIM Global Multi-Asset (GMA) Team analysis; BlS. 10 11 12 MSIM Global Multi-Asset (GMA) Team analysis; Bloomberg LP. 14 MSIM Global Multi-Asset (GMA) Team analysis; Datastream. 15 Canadian Real Estate Association (CREA) 16 MSIM Global Multi-Asset (GMA) Team analysis; Datastream. 17 18 19 MSIM Global Multi-Asset Team (GMA) Estimates. 20 21 Office of the Superintendent of Financial 22 23 24 25 MSIM Global Multi-Asset (GMA) Team analysis; Bank of Canada. 13 4 MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET

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