Sunday, 23 April 2017

Toronto House Price Boom: How Will It End?

Last year it was Vancouver house prices. This year it is the Toronto housing "crisis" that has politicians panicking. In March, the average Toronto house price was up 33% over a year ago. This news sparked a meeting of "three wise men" -- Canada's Finance Minister Bill Morneau, Ontario's Finance Minister Charles Sousa, and Toronto's Mayor John Tory -- to collaborate on appropriate actions to ease the panic. 

The three wise men agreed that they should refrain from adopting policies which would add to already overheated demand. Then within days, Ontario's Liberal government announced a "suite" of measures to respond to what they claimed was a public clamour for government intervention. Premier Kathleen Wynne and Mr. Sousa, not wanting to let a good crisis go to waste, seized the opportunity to impose a new 15% tax on non-resident buyers and tighten housing regulation in the worst possible way by imposing strict rent controls. Unfortunately, such actions that are more likely to worsen rather than improve the fundamental problem of insufficient supply of reasonably priced housing. 

I am returning to the issue of housing prices after writing about it in March, 2014 in Why So Paranoid About Canada's Housing Market, and again in June 2016 in China Stimulus and Vancouver House Prices

In March 2014, I argued that, while some high profile commentators thought Canada was in the midst of a housing bubble that was on the verge of bursting, my research showed that Canada's housing prices were still good value relative to house prices in other countries and that there was no reason to think that a Canadian house price bubble was about to burst. Looking back, that view proved correct. Far from bursting, house prices in Vancouver, in Toronto and in several other Ontario cities have since soared a further 50% or more.

In June 2016, after Vancouver house prices had shot up over 50% in just three years, I acknowledged that they had entered bubble territory. I pointed to the effect of spillovers from China's aggressive easing of monetary policy on house prices in cities in China and also in cities such as Vancouver and Toronto that are attractive to Chinese investors. I argued, "It is the job of Finance Minister Morneau, along with provincial and city officials, to decide what measures might curb the influence of foreign central bank stimulus on Vancouver and Toronto house prices and how these measures might be applied without bringing about [a] sharp house price correction". In July 2016, Vancouver introduced a 15% Foreign Buyer Tax. In November, the city followed up with a 1% annual tax on the assessed value of vacant houses. Vancouver home sales fell immediately following the introduction of the Foreign Home Buyers tax and prices experienced a moderate setback for a six months before starting to climb again recently.

Toronto's House Price Booms Sometimes End Badly

To read the local newspapers, you would think that Toronto house prices have never boomed before. There are widespread complaints that available housing data are insufficient to determine the causes of the recent rapid price appreciation. But it's not hard to find data that shows that Toronto has been here before. The chart below shows several measures of Toronto house prices dating back to 1969.

The data goes back furthest for the Toronto Real Estate Board average house price (TREB AHP). Also shown are Statistics Canada's Toronto New House Price Index (NHPI) and, more recently, the Multiple Listing Service Toronto House Price Index (MLS HPI) and the Teranet Toronto House Price Index. While the quality of some of these measures is better than others, all of them tell basically the same story. There have been three house price booms in the past five decades in which annual increases reached double digits for consecutive years and peaked at 30% or more.

The first episode, in 1974-75, saw average house prices rise 25% and 30% in consecutive years. In the second episode, in 1986-89, prices rose consecutively by 27%, 36%, 21% and 19%. In the current boom, 2015-17, average prices are on track to rise 15%, 20% and over 30% consecutively.

After the 1974-75 boom, price increases slowed sharply. After the much bigger 1986-89 boom, prices collapsed. The chart below uses the same data as above, but expresses it as drawdowns in prices from their previous peak.

What is clear from this chart is that the drawdown following the 1989 peak was by far the worst house price decline experienced in fifty years. Prices for both new and existing homes fell over 25% and did not hit bottom until 1996, seven years after the boom peaked.

How Did Previous House Price Booms End?

In 1974-75, the boom was ended by a North American recession triggered by the first oil price shock. House prices gains slowed markedly, but there was no crash. Unfortunately, at the peak of house price and rent increases in the runup to the 1975 Ontario provincial election, Premier Bill Davis succumbed to political pressure to invoke strict rent controls. Vince Brescia, past CEO of the Federation of Rental Housing Providers of Ontario describes the outcome:
The results were devastating. Rental housing supply screeched to a halt, vacancy rates quickly began to drop, rents began to rise and tenants couldn’t find apartments. Investors all pulled out of Ontario rentals; they could not operate under a system that incented owners to cut back on investment and let the buildings deteriorate.
The bust in the housing market that followed the 1974-75 boom was concentrated in the collapse of rental housing construction that dragged on for over twenty years and greatly curtailed both the quality and  availability of affordable housing in Toronto. 

The 1986-89 boom, the biggest Toronto house price surge of the past 50 years, was ended by a combination of rising mortgage rates, a short-lived oil price spike brought on by Iraq's invasion of Kuwait, and another North American recession. After the huge boom, prices plunged and would not recover to their 1989 peak until 2002. Toronto suffered through a lengthy house price deflation in the 1990s. 

Eventually, with the election of Conservative Premier Mike Harris on his "Common Sense Revolution" platform, rent controls ended in 1998 on buildings constructed after 1991. This move launched more than a decade of strong construction activity of both privately-owned and rental housing in Toronto that has changed the face of the city. 

How Will the Current Boom End?

The current Toronto house price boom is more pronounced than that of 1974-75 but less pronounced and extended than that of 1986-89. The chart below shows the three booms, with the start date set when annual house price gains exceeded 10% on a sustained basis. The horizontal axis shows the number of months from the start of the boom. The prices are in real terms (i.e. deflated by the CPI) to make them comparable.

The chart shows that the current boom has just about matched the 1973-75 boom in duration (at 33 months vs. 36) and that cumulative real price appreciation since the start of the boom has been 55%, about 12% more than at the peak of the 1973-75 boom. However, the current boom has not yet come close to matching the 1985-89 boom in either duration or cumulative real price appreciation. 

This implies that the current boom could go on for more than another year and prices could rise by a further 30% without exceeding the 1985-89 boom. However, that may seem unlikely because governments are already taking active steps to cool the market. 

The current boom bears more similarities to 1973-75, not only in duration and magnitude, but also in the types of government action taken to cool the boom, influenced by political pressure on an Ontario Premier ahead of a provincial election.

When the two previous booms ended real house prices fell. After the 1975 peak, real prices fell 12% over the next six years. Following the 1989 peak, real prices fell 35% over the next six years. Housing starts also went from boom to bust after the housing price peaks, as shown in the chart below. Following both the 1975 and 1989 peaks, housing starts plunged by more than 40% compared with their level at the start of the price boom.

The current boom lies in between its' predecessors. If we are seeing the peak now, it might be reasonable to expect real prices to decline 15-20% over the next six years. However, as occurred following the 1975 peak, construction of rental housing is likely to fall dramatically and the availability of affordable housing is unlikely to grow. 

Of course, if the current boom continues for another year and another 30% price appreciation, it would look more like the 1989 peak. In that event, a deep, long house price recession would become likely and future real prices might then be expected to decline something like 30-35% from the peak.  

Some may say that Toronto house prices will never decline. But they have in the past. Ben Bernanke famously said in July 2005, "We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize." That seems to be the hope of the three wise men. But Toronto's history clearly demonstrates that there is a good chance that, like its two predecessors, this boom will end badly.


Tuesday, 11 April 2017

What's Happening Inside Canada's Labour Market

Canadian economists were quite upbeat on the March labour market report. Headlines from the major  banks carried a common theme: 

  • "Canadian Jobs March On" (CIBC) 
  • "The Beat Goes On" (BMO), and 
  • "Canada’s job gains beat expectations again!" (RBC)
Sounds pretty good. But even as the economists purred over the job gains, they noted that wage growth was still quite soft. The reports, as per usual, focused on the minutiae of month-to-month changes in employment across different industries and among full-time and part-time workers, many of which were not statistically significant. It's rare for economists who face the daily grind of reporting on every economic indicator to step back and look at underlying trends inside the labour market. But doing so helps explain some seeming anomalies and overall paints a less rosy picture of labour market.

Hours Worked Tell a Different Story

While employment was up 1.5% in 1Q17 on a year-over-year basis, total hours worked by those employees at their main job was actually down 0.1% (even with a sizeable jump in hours worked in March). Main jobs are the source of the vast majority of Canadians income from work. Some, who cannot make a living wage at their main job, take on second or third jobs to supplement their incomes. Apparently, more people have had to take on extra jobs over the past year, as total hours worked at all jobs were up 1.4% in 1Q17.

When we look at hours worked on main jobs by industry, we find that several key industries with high-paying jobs have seen substantial declines in hours worked, while other industries with low-paying jobs have seen increases in hours worked, as shown in the chart below.

The biggest declines in hours worked over the past year have been in the resource sector, especially in the oil and gas industry. Manufacturing, construction and utilities have also seen substantial declines.  Large employers like health and social services and education have seen small declines. At the other end of the spectrum, decent gains in hours worked have occurred in accommodation and food services, transportation and warehousing, business services (which includes waste management) and finance, insurance and real estate. By far the largest gain in hours worked over the past year has been in public services (i.e. federal, provincial and municipal governments).

When one sees these changes in hours worked, it becomes much less of a mystery why wage growth has been weak. According to Statistics Canada's Labour Force Survey, the average hourly wage earned by employees at their main job was C$26.12 in 1Q17. But some industries paid much higher (or lower) hourly wages than the average, as shown in the chart below.

The resource sector, which experienced the biggest decline in hours worked, was the industry with one of the highest average hourly wage rates, over $13 per hour higher than the Canadian average. The utilities, construction, and education industries, which also pay above average wages all saw declines in hours worked. In contrast, the accommodation and food services industry, which pays the lowest average hourly wage -- $11/hr below the national average and $24/hr less than the resource sector -- was one of the industries which saw a meaningful gain in hours worked. The wholesale and retail trade, transportation and warehousing, and business services sectors, which pay below average wages, also saw increases in hours worked. The one anomaly is the public sector, where hourly wages are high and hours worked posted the largest increase of any sector.

It seems clear that Canada is experiencing decent total job growth, but that total hours worked for employee's main jobs have been flat, with high-wage industries reducing hours worked, low-wage industries increasing hours worked. This is not a sign of a healthy labour market.

Why is this happening?

If I had to come up with a story to explain the labour market developments of the past year, it would go like this. The collapse in the world price of oil, which began in mid-2014, resulted in a dramatic declines in hours worked in Canada's resource sector in 2015 and 2016. Declines in energy-related activities spilled over into the non-residential construction, utilities and manufacturing industries. These declines were probably magnified by a tightening of environmental regulations which stalled pipeline construction and carbon tax proposals by governments concerned with global warming. With weakness in key sectors of the economy and new left-of-centre governments in Ottawa and some provinces, hours worked in governments shot up. The sharp weakening in Canada's former industrial growth drivers triggered two 25 basis point policy rate cuts in 2015 and a 20% depreciation of the Canadian dollar relative to the USD. With interest rates falling to rock-bottom levels and the currency cheapening, housing prices in Canada's most cosmopolitan cities -- Vancouver and Toronto --  became extremely attractive to both foreign and domestic purchasers and the real estate industry boomed as the house price bubble inflated. The weakening of the currency made foreign travel more expensive for Canadians, while at the same time making travel to Canada less expensive for foreigners, benefitting the transportation, accommodation and food service industries.        

So, while many economists look at Canada's job gains over the past year through rose-coloured glasses, I see the changes occurring in Canada's labour market as signs of weakness in the the Canadian economy. More Canadians are forced to work multiple jobs to make a decent living. High-paying jobs are harder to find. Employment gains are concentrated not in a thriving private sector, but in low paying industries benefitting from a cheap currency, in a bubbly and unsustainable real estate sector, and in activist, meddlesome governments. 

Monday, 3 April 2017

Trump Trade Evolves: Global ETFs Portfolios for Canadian Investors

The first quarter of 2017 is in the books, so it's time to review the performance of our global ETF portfolios. The quarter kicked off with the inauguration of President Trump and ended with the Trump Administration's failure to win passage of a bill to repeal and replace Obamacare in the House of Representatives dominated by his Republican Party. 

Against this background, a Canadian stay-at-home investor who invested 60% of her funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a 1Q17 total return (including reinvested dividend and interest payments) of 1.7% in Canadian dollars. Had that investor diversified her portfolio to the global ETFs that are tracked in this blog, her returns would have been as much as twice that high. 

The weaker performance of the all-Canadian portfolio continues a trend that began with the election of Donald Trump as US President. However, the leading global ETF performers evolved in interesting ways in 1Q17 that reflected, in part, the markets' changing assessment of Trump's ability to implement his election promises. 

Global Market ETFs: Performance for 1Q17

The chart below shows 1Q17 returns, including reinvested dividends, in Canadian dollars (CAD), for the ETFs tracked in this blog. The returns are shown for the period from the US election in November through the end of 2016 (blue bars) and for 1Q17 (green bars). As the CAD appreciated 1.1% against USD, two of the best global ETF performers were Emerging Market equities (EEM) and Gold (GLD), each of which suffered big losses in the immediate aftermath of Trump's win. The worst performer in 1Q17 was the Commodities ETF, which had posted sharp gains immediately following the election. 

Global ETF returns were mostly positive across the different asset classes in 1Q17. In CAD terms, 17 of 19 ETFs posted gains, while just 2 posted losses. 

The best gains were in the the Emerging Market Equity ETF (EEM) which returned a strong 11.3%. The Eurozone Equity ETF (FEZ) was second best, returning 7.7% in CAD terms, followed by the Gold ETF (GLD), which returned 7.1% in CAD. Other solid gainers included the S&P500 ETF (SPY), the Japan Equity ETF (EWJ), and Emerging Market Local Currency Bonds. 

The worst performers were the Commodities ETF (GSG) which returned -6.5% and the Canadian Real Return Bond ETF (XRB) which returned -1.6%.

Global ETF Portfolio Performance for 1Q17

In 1Q17, the global ETF portfolios tracked in this blog posted solid returns in CAD terms. However, as with the performance of individual ETFs noted above, the performance of of the various portfolios evolved significantly in 1Q17 versus that of the immediate post election period, as shown in the chart below.

A simple Canada only 60% equity/40% Bond Portfolio returned 1.7%, as mentioned at the top of this post. While solid, the 1Q17 return was weaker than the all-Canada portfolio achieved in the period immediately following the US election and also weaker than the returns on the global ETF portfolios.

Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned 3.6% in CAD terms, continuing its strong performance in late 2016 and making it the best performing portfolio since the election. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, returned 2.8% in 1Q17, about the same gain it enjoyed in the immediate post election period.

A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 2.8% in CAD terms. This was a remarkable improvement over the return of -0.17% in the immediate post election period, as bonds and foreign currencies performed significantly better in 1Q17. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, returned 2.5%, also a significant improvement over the immediate post election period.

Key Events of 1Q17

In my view, the main events that left a mark on Canadian portfolio returns in 1Q17 were President Trump's setbacks and delays in implementing his election promises; the decision by the US Fed hike its policy rate more quickly than markets had expected; and stronger-than-expected growth of DM economies outside the US. 

Trump's setback on Obamacare, as well as the successful court challenges to his executive order temporarily banning immigration from certain countries, demonstrated both legislative and judicial obstacles to implementation of some of his election promises. Markets had cheered his promises to reduce regulation and cut taxes. He has made headway on cutting regulation but the setback on Obamacare has raised doubts about his ability to get controversial elements of tax reform through Congress. In addition, Trump has not yet followed through on his protectionist election promises targeting Mexico and China which had hammered Emerging Market stocks and currencies in the immediate aftermath of the election.  

The Fed's decision to hike in March dampened bond prices, especially for longer term bonds. Meanwhile, stronger-than expected growth in the Eurozone, Japan and Canada helped boost equity returns outside the US.   

Looking Ahead

At the beginning of 2017, I said that the most interesting question, in my mind, was whether the all-Canada 60/40 ETF portfolio would outperform the unhedged global ETF portfolios as it did in 2016. The answer, so far, is that since the election of Donald Trump the all-Canadian portfolio has returned to the pattern of the past five years, in which it lagged the performance of the global ETFs portfolios by a wide margin.

Three months ago, I said that answer to the question would be determined in part by the behaviour of commodity prices, the Bank of Canada and the Canadian dollar. Commodity prices which were expected to firm modestly, have fallen. The Bank of Canada has so far remained in no hurry to begin raising its' policy rate, even as the Fed hiked in March, sooner than expected. Despite weakness in commodity prices and a dovish BoC, the Canadian dollar, which was expected to weaken moderately against the USD, actually appreciated by over 1%. Upward revisions to expectations for Canadian GDP growth along with President Trump's limited success, so far, in implementing his policy promises has weighed on US dollar sentiment and helped lift the Canadian dollar. 

If Trump's plans continue to be thwarted or watered down by Congress, the trends of 1Q17 may be expected to continue. Emerging market equities, bonds, and currencies, which sold off in the immediate post-election period on fears of Trump's promises of protectionist policies, have further room to rally.  

The main risk to that outlook is that President Trump, stung by his early setbacks, redoubles his efforts on protectionist trade policies and tax reform, including some form of border tax.