We continue to maintain a defensive position across our portfolios. Valuations of the largest sectors of the Canadian and US markets remain at historic highs. We have countered against this environment by increasing exposure to cash, government bonds, and commodities. At this time, we seek to protect our wealth rather than engage in excess risk taking.
It has been said the riskiest thing in the world is to believe there is no risk. In that light, 54% of Canadians recently polled by Angus Reid believe “house prices will never come down”. The most unanticipated and therefore significant risk to Canadian investors is an unwinding of the Toronto housing bubble. Housing has become the top driver of employment and economic growth in Canada, accounting for the bulk of GDP gain last year. Such gain cannot be expected to continue indefinitely.
It is reasonable to believe the unwind has already started. Demand for GTA homes, as measured by the sales-to-new listings ratio, continues to drop from the Spring high. This measure usually leads price by 4-6 months, and suggests further price weakness ahead.
A material decline in prices could present two key risks for investors. First, bank earnings could be impacted as new mortgage growth slows, and loan losses rise. Canadian banks on average have reserved only 0.25% of the total value of their mortgage books for losses, a historically (too) low amount. While it is true mortgage arrears today in Ontario are 0.10% (matching the 1990 low), historic data show arrears rise to about 0.50%-0.70% as a bubble unwinds, a 5x-7x increase from the current level.
The larger risk is to general employment. The number of realtors in Toronto has surged 77% since 2009 to more than 48,000 people. By comparison, there are only 13,500 realtors in Chicago, a city with similar population. Over the last year, sales commissions from real estate totalled about 2% of Canadian GDP, a historic high. As experienced during prior real estate cycles, realtors and other ancillary service providers (construction being the largest) could see demand for their services decrease, leading to a rise in general unemployment and further loan arrears.
These issues are compounded by household leverage, primarily in the form of home equity lines of credit (“HELOC”) and second mortgages. Ontario’s largest debt consultancy Hoyes-Michalos points out that over recent months they’ve noticed an increase in the number of Canadians borrowing against their homes to avoid filing bankruptcy. They add, “this is a temporary fix that will become much more complicated in the very near future.” Rising short term interest rates are the primary motivator.
For the sake of comparison, we can look at global housing bubbles of the past fifty years, looking for commonalities, signposts and benchmarks. We observe an average price drop of 35% from the peak, with most of the drop occurring within 3 years of the peak. Bonds, precious metals and cash (our largest holdings) tend to appreciate in real terms through these historic periods. Should a similar correction materialize in Toronto, we have taken the early and precautionary steps to protect our wealth.
Portfolio construction and company-specific notes are available for clients only.
Toronto has more housing than you thought https://www.bloomberg.com/news/articles/2017-08-14/toronto-has-more-housing-than-you-thought-canada-eco-watch
The retail renaissance is underway https://latest.13d.com/has-disruption-from-ecommerce-run-its-course-6222c9544fd9
As always, please let me know if you’d like to chat about financial planning, long term investing, other private investment opportunities.
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