By David Rosenberg and Krishen Rangasamy

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David Rosenberg: Canada's housing bubble has finally popped — don't underestimate the impact Back to video

The Canadian housing bubble has popped, with prices down 14 per cent from the peak reached in the first quarter of the year. Looking at home affordability — the ratio of mortgage payments to income — we estimate it will take another 25 per cent drop in home prices for affordability to return to its historic average. That would chop roughly $1 trillion in home equity, enough to generate serious negative wealth effects.

Tack on the impact of the Bank of Canada’s policy tightening on interest payments by households, and it’s not hard to see consumption spending treading water come 2023.

Simply put, a recession beckons in the Great White North. As such, investors would do well to stay away from stocks tied to consumer discretionary goods and services, and residential homebuilding, while increasing exposure to Canadian government bonds, which should benefit from the inflation-busting impact of the recession.

Housing bubble has popped

Anybody looking at the MLS Composite Home Price Index can confidently say Canada’s infamous housing bubble has finally popped. The peak was reached back in March and home prices have fallen in each of the subsequent seven months.

One can thank the Bank of Canada for this because its 350-basis-point interest rate increase since February, coupled with quantitative tightening, represents the most aggressive pace of policy tightening on record. The bubble had zero chance of persisting under such conditions, a point we’ve made repeatedly in our publications this year.

Since March’s peak, house prices have fallen roughly 14 per cent. The question now is how much more can home prices fall? There are massive uncertainties at hand: for example, the future direction of rates, labour market, fiscal policy, etc. But we can form an opinion by looking at home affordability to gauge the extent of overvaluation in home prices.

What it takes to bring back home affordability

And here we’re talking about the ratio of mortgage payments to income. Thanks to the Bank of Canada’s rate hikes, the ratio has soared this year, well past the historic average. For affordability to return to the average, we will need either lower mortgage rates or a massive home price correction, which we estimate to be 25 per cent on top of what we’ve already seen so far this year.

What would an additional 25 per cent drop in house prices do to the economy? Here, too, there’s a lot of uncertainty about the extent of the corresponding hit to residential construction and consumption, but the end result is unambiguously negative.

Take consumption. An additional 25 per cent drop in house prices would wipe out roughly $1 trillion in home equity. And if you consider the Bank of Canada’s estimate of a housing wealth effect of six cents on the dollar, that translates to a consumption drop of $60 billion, or four per cent of annual consumption.

Wealth effects could be more powerful than you think

The overall hit to consumption is, of course, much higher than that. For starters, there is reason to believe that housing wealth effects have become more powerful since the central bank published its estimates more than 15 years ago.

The home equity share of household net worth has climbed quite a bit over the past 15 years, reaching a record 41 per cent at the end of the second quarter in 2022. That share probably dropped in the third quarter amid the further correction in house prices (we’ll wait for updated Statistics Canada data to confirm), but not that much considering financial assets (also a large chunk of net worth) didn’t do great either during the quarter.

Regardless, the negative housing wealth effects are not to be underestimated given the sizable share of home equity in the net worth of households.

In addition to the likely stronger-than-expected negative housing wealth effects, there are also more direct negative impacts of higher interest rates to consider: for example, higher mortgage payments (which leaves fewer dollars to spend elsewhere) and lower purchases of big-ticket items (autos and appliances purchases are often made with credit).

The increase in mortgage rates through September of this year cost Canadians (with existing mortgages at the start of the year) an extra $17 billion in interest payments. And that’s not even counting the impact of higher rates on payments related to newly originated mortgages this year. With the Bank of Canada making clear additional rate hikes are in the pipeline, the pain (both direct and indirect) will become more intense for consumers in 2023.

Bottom line

The ongoing housing price correction has room to run. Another 25 per cent decline in house prices would be necessary to bring affordability back to its historic average. The associated drop in home equity, which we estimate to be about $1 trillion, would take, at minimum, a four per cent bite out of consumption from negative housing wealth effects alone.

Tack on more direct impacts of higher interest rates, and it’s not difficult to envisage consumption spending subtracting from the annual GDP growth in 2023 for only the fourth time on record. The fact that the other three instances (1982, 1991 and 2020) were all recessions should tell you everything you need to know about next year’s economic outlook.

For investors, such a dull outlook warrants shunning consumer discretionary and residential homebuilding stocks, while increasing exposure to Canadian government bonds, which stand to benefit as the recession takes the steam out of inflation.

David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. Krishen Rangasamy is senior global economist there. You can sign up for a free, one-month trial on Rosenberg’s website.

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