After Home Capital, Canada's Whole Economy Suddenly Looks Frail
(Bloomberg) -- The story Canada has been telling itself about its economy is starting to sound like wishful thinking.
It’s too early for the meltdown at Home Capital Group Inc. to show up in the data -- and, with just 1 percent of the national market, the mortgage lender may be too small to do so anyway. But it’s already had a big impact on how investors and analysts are weighing the country’s weaknesses against its strengths.
Boom-times in Vancouver and Toronto look increasingly like the spillovers from debt-fueled housing bubbles, the kind that wrought havoc in so many Western countries last decade. A banking system long considered among the world’s soundest got hit by a Moody’s downgrade this week. The government has touted a transition away from commodity-dependence and toward hi-tech smarts; Canadians are waking up to the possibility that their economy got hooked on real-estate instead.
None of that is to say that Canada has become a basket case overnight, of course. Still, expectations that it’ll grow faster than developed-world peers this year -- as forecast by the Bank of Canada -- may be unsustainable, according to Craig Fehr, Canadian investment strategist at money-manager Edward Jones & Co.
“Every time I see estimates for 2 plus percent GDP growth this year I just think they’re far too rosy,” he said. “It’s a function of the imbalances that exist in the economy.”
Housing is exhibit no. 1. Estimates of its direct contribution to the economy exceed 20 percent.
The figure is much higher when secondary effects are included, from lawyer fees to higher government revenue to increased retail spending driven by homeowners’ inflated sense of their own wealth, as house prices in some regions shot up more than 20 percent a year. Consumer spending as a share of gross domestic product is hovering around the highest since possibly as far back as the 1960s.
“The question is just how will the economy look as that ceases to contribute quite so forcefully,” said Eric Lascelles, chief economist at RBC Global Asset Management Inc. “All bubbles come to an end. I think it could be an interesting year or two ahead.”
Both home-ownership and consumption are being financed by record levels of household debt. Canada’s traditional remedy for commodity busts involved scraping together enough foreign financing to cushion the initial blow, then depreciating the currency to stoke manufacturing and exports.
This time, after the oil crash of 2014, there’s little sign of an industrial revival. There has been plenty of overseas borrowing: External debt was about 60 percent of GDP a decade ago; now, at C$2.3 trillion, it’s larger than the economy. But much of it has been channeled to households.
As a result, they’re “indebted to a level that is unprecedented,” said Michael Emory, chief executive officer of Allied Properties Real Estate Investment Trust, who describes that as the economy’s biggest concern. “Canadian consumers historically have been very prudent with the levels of debt they bear,” he said.
Moody’s Investors Service cited the private-debt burden when it cut ratings on the country’s six biggest banks, expressing concern about asset quality.
That backdrop makes the Home Capital crisis more threatening than it otherwise might have been. A run on deposits, even at a small lender, sparks concern about contagion. Default levels across the system remain low, but could rise if the economy slows and financial conditions tighten.
(Watch a TOPLive blog of Home Capital’s earnings call here.)
Which they likely will, according to David Rosenberg, chief economist at Gluskin Sheff & Associates Inc. in Toronto, who expects credit growth to tail off. “That alone will probably cause the Bank of Canada to keep interest rates that much lower for longer,” he said.
Investors looking for the drama of a full-blown financial crash may be disappointed.
Even while downgrading Canadian banks, Moody’s acknowledged that they “maintain strong buffers in terms of capital and liquidity.” Regulators keep a relatively tight grip on the system.
And history shows that, when forced to confront problems, the industry tends to circle the wagons. Home Capital’s troubles, for example, have prompted other lenders to step up to limit the fallout. MCAP Corp. agreed to pick up C$1.5 billion in mortgages and renewals from its rival, according to the Globe and Mail. Investment funds at Canadian Imperial Bank of Commerce are buying Home Capital’s equity.
All has that contributed to a rally in the shares this week. They’re still trading at less than half the level of a month ago, and plunged again at the market’s opening on Friday after company management said on a conference call that there’s no immediate prospect of additional asset sales.
Canada’s wider financial markets have been lackluster rather than dismal. The loonie is down 1.9 percent this year, the most among 16 major currencies tracked by Bloomberg. The main stock gauge has underperformed other developed countries, but it’s still up 1.7 percent.
So investors aren’t exactly flashing warning signals. Still, they’re finding more things to worry about than was the case a month ago.
When the U.S. housing bubble collapsed, it triggered first a financial crisis and then a recession. In the event of a replay north of the border, Canada might avoid the first pitfall, if its banks are as sound as everyone says. That doesn’t mean its economy won’t get hurt in the fallout.