Tapped out

By Guest Blogger Ryan Lewenza

The average Canadian household is pooched! This is the current thinking of many economists, investors and blog dog readers. Taken a step further, the Canadian stock market is doomed and we’re just one mistake away from becoming a banana republic. This is, of course, hyperbole and nowhere close to reality, but there’s no denying the tenuous financial state of many Canadian households.

This week I try to cut through the BS and fearmongering and try to provide a reasoned and rational assessment of Canadian household debt and consumer spending habits, and the potential impact on our overall economy and stock market.

A bit of background first.

Over the last two decades we’ve witnessed a huge change in Canadian spending habits and our acceptance of higher debt levels. Without a doubt a key driver of these changes has been our two decade plus housing bubble, which has led to households taking on more and more debt to fund rising home price purchases. The chart below captures this relationship perfectly.

Since 1999 Canadian mortgage debt has risen from $395 billion to $1.53 trillion currently, this equates to a 270% increase! Over this same period, national home prices have increased by a staggering 242%. See a connection here? To further hit home the point I calculated the correlation between the debt levels and home prices and it’s a very high 0.99 (+1 indicates a perfect positive correlation). Correlation doesn’t imply causation, but in this instance, it’s clear as day that rising home prices are the main culprit of our rising debt levels.

Canadian Home Prices and Debt Levels

Source: Bloomberg, Turner Investments

Now, with interest rates on the rise and home prices trending lower, the natural inference is that we’re all pooched with consumer spending and our economy likely heading materially lower. I don’t necessarily buy this.

While I see consumer spending and economic growth slowing due to the higher rates and lower home prices, I don’t see some catastrophic decline in our economy as so many doom-and-gloomers predict. Below is a good chart that shows the relationship between home prices and retail spending. Historically, when home prices decline we see a contemporaneous decline in retail spending, which makes sense. With our view that Canadian home prices will continue to trend lower this year this should weigh on consumer spending and why we’re forecasting Canadian GDP growth to slow from 2.1% in 2018 to roughly 1.75% this year. But critically I don’t see this softening in consumer spending derailing our economy and leading to recession.

Canadian Home Prices and Retail Spending

Source: Bloomberg, Turner Investments

Here are a few reasons why:

• First, other areas of the economy could pick up the slack like business investment, exports and government spending. I see exports picking up this year on a decent US economy and the conclusion of the NAFTA negotiations, business investment could pick up on a rebound in oil prices and the recent Federal government changes to allow faster depreciation expensing, and it’s clear that T2 is willing to spend money like a drunken sailor on shore leave, all of which could offset some of the weakness in consumer spending.
• Second, is to look at the US experience following the financial crisis, where US home prices declined and US consumers significantly paired back their debt load (debt-to-income declined from a record 170% to 130% currently), while the US economy was still able to grow around 2%. Many believe that our high debt levels and declining home prices are going to result in some huge collapse of our economy when more likely it’s just going to result in slower GDP growth, similar to what we’ve seen in the US.

Finally, looking at the impact to the Canadian stock market, I see consumer spending having a much smaller impact on TSX returns versus the performance of commodity prices and the US equity markets. Some years ago I completed an exhaustive study of the main drivers of TSX returns and found that of all the variables I tested, commodity and S&P 500 changes were the most meaningful in driving TSX returns. Below is my model that illustrates this and why I focus a lot of attention on forecasting commodity and S&P 500 prices in trying to determine where the TSX is heading.

Commodity and US Stock Performance Largely Drives TSX Performance

Source: Bloomberg, Turner Investments

So there you have it. I see lower Canadian consumer spending over the next few years due to rising interest rates and lower home prices, but see this concern as being overhyped by the doom-and-gloomers. At the end of the day, the direction of commodity prices and the S&P 500 will continue to be the main drivers of the TSX, and based on these factors, we see the TSX doing just fine in 2019.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.