Canadian Economic Outlook
Canada is a country that has a very interesting economy, what many people know is that it is an economy that is extremely tied to real estate. With an unprecedented hiking cycle what does that mean for an economy that is extremely interest rate sensitive? Well, it sure is not a positive thing, especially for a nation with one of the most indebted households in the world. However, more will come on that. Canada is also a nation that suffers greatly from lack of productivity, and this is a structural issue again with no change insight. So where does that leave us? This will be discussed further in this article.
In looking at Canada, the most logical place to start is with the Real Estate sector. The only thing that seems to be on every Canadians mind. It is all you see, and this makes sense with a larger share of the economy going to the real estate sector. Looking below Real Estate (not including construction) is about 13% of GDP. This is shown below (Figure 1).
So, it is not hard to see the importance of Real Estate in terms of its contribution to overall GDP. The other aspect we must look at is what about the Real Estate sector and whether the current rise is based on supply or demand. In the chart below (Figure 2) I take a look at months of inventory vs home prices. Looking at when months of inventory rises, this puts downward pressure on the home prices as there is more supply relative to demand. I show also in (Figure 3) another model that looks at supply relative to home prices. We can see via this model as well that Canada is currently in surplus of supply relative to current demand, and as such is putting downward pressure on housing prices.
This goes to show that there is more of a supply issue than a demand issue, and that supply plays a much bigger roll in dictating the price movements of houses in Canada. Now with that being said we need to dive into the issue of variable rate debt. For many of the readers in the United States, they might not know that all of Canada’s mortgages are essentially variable rate. You have 1-10 year fixed rate mortgages on different amortizations usually 30 years. This does depend on whether or not they are insured or uninsured, on uninsured mortgages you can only get mortgages within the 25 year mark. This will depend as well on the product certain products also operate under the 25 year amortization most again on the 5 year fixed. The rest are then going to be variable rate mortgages. Now with interest rates rising we are now seeing a collapse in the variable rate mortgage relatively to fixed rate issuance. There has also been significant easing in new mortgage issuance. This is pointed in the (Figure 4) below.
Below (Figure 5) highlights the issue of this. Looking at interest rate futures and using those to forecast the possible path of 5-year variable and 5-year fixed mortgages one can see that interest rate futures are pricing rates to move higher. This will increase further household debt-service-ratio on interest portion of the mortgage. The rapid rate shock especially on the new fixed will be serve for many, and this is going to definitely increase the cost of carrying a mortgage well beyond current capacity for many Canadians.
Looking at one final indicator, at least at the debt mortgage level it is looking at the level of mortgage and consumer credit relative to disposable income this is now at around 175%. What does that mean? In simplistic terms it represents $1.75 of mortgage/consumer debt for every $1 of disposable income (Figure 6). The current drive up from the low base which was COVID has been driven by declines in disposable income, and increases in overall interest and principle obligations. Absent another fiscal or monetary tailwind nothing will help to lower the interest rate sensitivity aspect of that ratio. More and more disposable income will have to be allocated away from consumption towards debt service. When I am talking about consumption I do not just mean consumption for wants but consumption of necessity. The increase in debt-service will cut more and more into the budget, and tighten the overall clamps on families who are already struggling in many aspects of everyday living.
Now let us look at the state of the actual economy. We know that throughout COVID we saw as mentioned above record amounts of Fiscal and Monetary stimulus. However, what are the measured impacts of this on the overall Canadian economy. Well the government expenditure multiplier is negative. The multiplier via my own calculations have Canada at about -0.03 which suggest as Canada runs additional deficit spending it will reduce private GDP by about 1.03 or 3% decline in real GDP. Thus what we are seeing is essentially short burst of economic activity that give a short shock to GDP, but is very short lasted. This then starts to decline. I expect that the government multiplier will get more negative in the coming years. Canada has an aging population so spending on health, and other aspects will make up a larger budget outlays. As those outlays start to increase and get every larger the government multiplier will get more and more negative. Below (Figure 7) we can see what is now happening with the every increasing government spending, and how we are now seeing a more persistent government multiplier.
Canada can now only generated .32 cents of GDP for everyone 1 dollar of debt. Let that sink in, the decline comes from how rapid Canada has expanding financialization relative to productive parts of the economy. This is what happens as the economy looks more towards financialization, and stops utilizing debt productively. Looking below (Figure 8) shows this, and what has happened within the utilization of debt over time. This is concerning because what this then means is that you have to use money today to pay off the debt, as the debt does not have a long term revenue stream that can be utilized to repay. This is something that is extremely worrisome from an economic standpoint, because again like Figure 7 we are seeing debt is becoming less and less productive, and the pay offs of debt are diminishing.
We can see this measured another way which is through the velocity of money relative to Government of Canada debt. Canada rapidly declining velocity over the last 29 years has been a large force in the interest rate cycle. This is consistent with higher levels of debt as interest rates fall the debtor becomes less inclined to spend, and those who own assets spend more. This can be seen below in (Figure 9).
Now with Figure 9 above there is something important to note about the declining velocity, debt is a constraint on velocity. So when we are looking at the total debt in Canada relative to changes in velocity of money, we can see an inverse correlation. This is important to note, because declining velocity will put a constrain on higher inflation. This is shown below (Figure 10), and when we are seeing the constraint on velocity if you believe that we are going to have higher inflation you would need to think that GDP growth will outstrip the growth in debt. Which in more simplistic terms means that debt has to be put to productive uses. Thus when we are looking at this means we will see more disinflationary forces than inflationary forces going forward.
Now there is another interesting aspect of debt, and it is how the debt effects the marginal propensity to save. The marginal propensity to save is essentially the percent change in savings divided by the percent change in income. This is a way to measure how much savings increase with any additional increase in income. So lets say you see an increase in a dollar of income and you save 80 cents of that your MPS would be .8. The other .2 in theory would be utilized for consumption. Now below (Figure 11) we can see that Canada MPS actually falls negative. In theory the MPS should be between 0 and 1. However, in highly indebted societies or societies that utilize debt the MPS can actually be negative. We are now seeing this in the Canadian economy, and we are continually seeing as debt increases the MPS falls negative and vice versa. This is important to note, as it shows one a majority of the increase in income goes towards consumption, and thus the savings buffer is low.
There is somethings that are worrisome, and that is the fiscal impact is now declining. Below (Figure 12) we are now seeing that the fiscal impact is declining, and this could put downward pressure on the ability of GDP growth to be able to grow. The fiscal impact plays a huge roll in growing GDP. This is something important to note from the fiscal aspect. As unless the government starts spending again (which it does seem they will do) GDP growth is going to be very stagnant and growth is going to be weak.
Below (Figure 13) I look at what has now happened within the multiplier, and this shows the productivity issue that Canada is facing. The Canadian economy is not utilizing productive loan growth to juice GDP. What we are now seeing is that due to this, productive investment has declined, and residential investment has risen. Increased debt burdens main cause. The further the productivity decreases and the higher residential real estate share of GDP grows the more the multiplier is constrained.
Canada also suffering from structural issues. Multifactor productivity has been dead for a decade, consumption outstripping new investment in capital stock, declining aggregate output, and declining labor force. This is large explainer of why wages have been stagnant in Canada. If Canada wants to truly turn the economy around, and increase the overall standard of living one thing that needs to be focused on is increase multifactor productivity. Below (Figure 14) we can see how this flows through into changes in GDP. However, to get real long term economic growth, this is what the government needs to be doing is increasing investment whether it be through lower tax rates, or through targeting government spending. This could insure higher levels of growth, and therefore higher wages and standards of living for all Canadians.
Below (Figure 15) I look at the marginal propensity to consume relative to the labor force especially within the service sector. The service sector is 2/3 of the Canadian economy. With the declining marginal propensity to consume this is concerning for forward looking employment, as well as the Canadian economy as a whole. The slowing in consumption which is the inverse of the marginal propensity to consume (change in consumption divided by change in disposable income) is important to recognize for economic growth. When an economy is all based on consumption and services when this slows this leads to a very large contraction in overall economic growth.
Below (Figure 16) the last thing we will look at is employment. Employment is one of the most lagging aspects of the business cycle. Below in this chart I look at the probability of a recession in t+12 month, and utilize this to see what has historically happened with recessions and unemployment. When the indicator predicts a recession there is usually a lag before we see an increase in unemployment. So for everyone who thinks that because the labor market is tight the economy is strong needs to recognize that this is lagging, and should not be taken as a sign of overall health.
In (Figure 17) we look at increases in proposals, insolvencies, and bankruptcies against the probability of recession in the next 12 months. Again usually there is a lag in the increase of proposals, insolvencies, and bankruptcies, but what is interesting is that this time these have risen along with increased probability of recessions. This is something that is concerning, as we have not even see unemployment increase. When employment ticks up, this will further dampen capacity to service debt, and I expect this to get even worse from a consumer standpoint. Once the capacity to pay is gone this will do a lot to dampen the ability of people to be able to continue to service their debt. This is something to be kept in the back of the minds of any, as we go forward in this year. It should be noted that these proposal, insolvencies, and bankruptcies are coming off a low base, but still should not be overlooked.
In conclusion there is a lot of issues looking forward in the Canadian economy. This is not an attack on Canada, but something that we should all be aware of when we are speaking with policy markers or thinking of ways we can bring about change. The only way to do this is through seeing the issues that we have within the economy. This way we can come together to find ways to tackle these issues. There is a lot of issues within housing, productivity, GDP, consumption, and standard of living. These things need to be addressed. Thus far I do think that there will be headwinds within the Canadian economy that need to be addressed.