The economy is like trying to steer a cargo ship but the captain is missing and all the wheels are the wrong size. If you change the angle of the ship heading by 1 degree, you won’t notice the subtle change for the first few minutes, similarly the Bank of Canada’s (BoC) interest rate decisions can take 12-18 months to show up in the data. Well here we are around 21 months since the first rate hike in March 2022 and we’re finally starting to see those decisions showing up in the economy.
I’m not going to pretend I can predict the future, but I do want to talk about some economic signs that I’ve been reading about recently that point towards the next step in the BoC’s rate setting to be more holds and eventually a rate cut. If I’ve learned anything about this past interest rate and inflation cycle, it’s that things take longer than most forecasters had predicted.
To being the discussion I wanted to talk about the most recent Monetary Policy report from the Bank of Canada published October 2023. It indicates slightly negative GDP growth in the second quarter (Q2) of 2023 and a return to positive growth in the third quarter (Q3) of 2023. (*Note: Statistics Canada recently reported Q3 GDP as declining 1.06% and revised Q2 up from -0.2% to +1.4%) Their overall projection for 2023 is positive GDP growth. However, the per capita GDP declined 1.6% compared to last year. In my opinion per capita growth is a better indicator of the direction the economy is heading since Canada has a rapidly growing population. This effectively means that on a per person basis spending is declining and our economy is slowing. Additionally, businesses aren’t borrowing as much money to fund their capital expenditures because of the high interest rate environment; more business investment generally indicates a growing economy.
Secondly, the most recently reading of CPI inflation from the Bank of Canada was 3.1% in October 2023 which is getting very close to the BoC’s target range of 1-3%. A decline in gasoline prices was the largest contributor to the lower inflation reading. This also happens to be one of the more unstable components that make up the Consumer Price Index (CPI). Depending on what is happening globally energy costs can be very volatile. On the flip side the BoC has stated that supply chain issues have very significantly improved compared to this time last year. As a result, the bank will likely want to wait and see how things play out in other sectors of the economy in the coming months before making any more rate decisions. I don’t anticipate their decision will come quickly since there are still large components of CPI like energy, and rents which are continuing to be inflationary.
Thirdly, as it relates to housing. The housing market has seen a significant increase in supply over the past 3 months with the fewest number of sales for an October period since 1999 according to an Urbanation based on TRREB data. Due to the higher interest rates many people are opting to rent rather than purchase which has put a significant amount of upward pressure on rental prices. We are entering a seasonally slower time of year where many people tend to put off looking for new housing until the new year, so there has been a bit of a short term softening in rental prices.
However, if housing prices continue to remain elevated while interest rates are high, rents will also continue to climb. Sellers are having a hard time coming to terms with the value their home will sell at right now because there is so much competing inventory on the market. People who took on variable rates during 2021 and the beginning of 2022 are the ones who are hit the hardest right now with their borrowing costs more than doubling since then. Banks have been very accommodating to borrowers in some cases extending amortizations to 40 years or beyond in order to keep people in their homes, which has kept mortgage delinquency rates near all time lows and partly why we haven’t seen any significant increase in bank sale homes or general fire sales.
Continuing on the resale housing side of things, the average selling price of a resale home has increased from this time last year. This is mainly due to a skewing in home sales towards higher priced homes and a significant reduction in activity in the first time buyer category. Move-up buyers are finding homes more affordable comparatively to a year or two ago. Meanwhile, first time buyers are finding themselves priced out because purchasing power has declined 40% from the low rates at the end of 2021. An interesting development in the downtown Toronto core (C01) market is that condos are now oversupplied with 7 months of standing inventory. Part of the explanation for this could be that many investors took on variable rate mortgages during 2021. Since 40% of condos in downtown are investor owned if they bought at elevated prices its likely they are now negatively cash flowing and spending a good chunk of money every month to own their investment which partly explains the flood of inventory.
This presents a very good opportunity if you are a first-time buyer and want to break into the downtown condo market. Finding a tenanted property could provide more of an advantage to getting a good price. Due to many other buyers purchasing as investors they will likely want a vacant property and will not want to take on a tenant because the rents will likely be too low to carry their new mortgage and applying for an above guideline rent increase in a rent controlled unit can be challenging.
If you earnestly plan to move into the condo and live there for at least one year you can give the tenant 90-day notice and have them move out and move in yourself. Then down the line if you were to move out you might be able to hang onto the property and rent it for market rates and use it to leverage into your next property. If my prediction that interest rates will come down in the coming years turns out to be correct, your property will likely see accelerated appreciation as rates get cut, as well as lower mortgage payments if you were to take on a variable rate mortgage.
In a few years you could refinance and lock in a fixed rate then take out some of the equity from the property to the point where it would can cash flow neutrally. You can then use that cash to put a down payment on the next property, rent out the old one, repeat. Even if you don’t want to refinance, I think a lot of would-be investors and first time buyers don’t quite understand the opportunity that this market presents with the ultra slow sales, pick of the litter (lots of supply), and a consensus view that rates will be coming down. The market is essentially giving potential buyers an easy lay-up to make their investment work in long term in exchange for short term pain. Obviously there are risks to this like anything, but barring anything crazy like another pandemic, I think we are very very close to a market bottom and I believe that people will look back on this time and say “I wish I had.”
Fourth, there is a somewhat concerning development. According to Urbanation new construction home sales have hit a 10 year low which does not bode well for the future supply of housing. One of the only ways that new housing supply gets built in the Greater Toronto Area is through new construction condos. However, there is a slow development happening in the purpose built rental space. Governments at all levels are beginning to put real money towards building this type of housing again, but it will take years for this to make a significant dent in the housing supply.
In the meanwhile the housing supply outlook is somewhat grim for the next decade or so. If the replacement cost of a condo continues to remain much higher than the current market value of a similar unit, investors and end users are unlikely to see the value in purchasing new construction which could cause a noticeable slowdown in new housing starts (construction) which will constrict housing supply even more. On the flip side, developers are providing an unprecedented amount of incentives, including rental guarantees for multiple years, zero development charges, and very extended deposit structures in order to try stimulate sales.
In conclusion, the housing market is showing signs of a slowing as rates stay high. Pricing remains elevated due to a lack of overall supply in the market, the rate of population growth in the GTA as well as the resiliency in employment and accommodating banks. The continuous influx of new people to Canada could potentially slow the decline of inflation compared to the US. Ultimately, people still need a place to live which should continue to stimulate a floor level of sales until the interest rate environment loosens a bit at which point home sales a prices will likely stabilize and begin a slow climb upwards. Although inflation is coming down, the bank will likely not make a decision on rates until the less volatile or “core” components return back to normal levels. Expect things to continue to move slowly like the freighter ship with a slow return to a normal inflation levels as very slow rate cuts in the new couple of years.
Talk soon,
Oliver Foote