Ever since the global financial crisis, Canada’s policy makers have been priming consumers for high interest rates and tighter mortgage regulations. Although we’ve avoided a disorderly unwinding of our overvalued housing market thus far, the risk still remains to our banking system and personal balance sheets alike.
So what do these changes mean for Canadian real estate, fixed income, and equity prices?
First, it’s not a surprise our housing market is overvalued.
This affects all client portfolios, regardless of how much direct real estate exposure they have. Canadian real estate is positively correlated with the energy and materials sectors, which comprise more than 50% of the S&P/TSX Composite.
Advisors out west may be surprised at how much of their client portfolio exposure is tied to the resource sector bull market, now 12 years in the making.
Our residential housing sector is valued between 4.5-to-six times the average price versus median family income, based on figures from Canadian Real Estate Association and the government.
By contrast, the U.S. residential housing market is valued at about three-to-3.5 times the average price versus median family income, according to the National Association of Realtors and most recent U.S. Census.
Are house prices sustainable given current valuations?
Most Canadians haven’t woken up to the fact that our secular commodity bull market is coming to an end. Coupled with a government focused on implementing tighter monetary policy, lower commodity prices at the margin are heightening downside risks in our economy and housing market.
However, the good news is a tighter unconventional monetary policy, weaker commodity prices, and continued uncertainty over Europe, China and the U.S. fiscal cliff mean Canadian baseline interest rates should stay lower for longer, thereby fueling the fire of the Canadian bond market.
Haven’t we all heard the story that interest rates are historically low and have nowhere to go but up?
Yes. But the reality is most investors aren’t putting enough weight on the downside risks to our economy because the housing market has left many house poor, not to mention the slow bleed of commodity prices, thereby amplifying the need for lower rates.
The notion of rates normalizing to higher levels has been pushed further into the future, and with the risk of a housing correction in the magnitude of 10% to 15%, it’s unlikely Carney will use abrupt interest rate hikes in such an uncertain environment.
For this reason, the corporate sector of the fixed income market remains very attractive, especially since clients are getting tired of low equity market returns. Corporate bonds with a term of five-to-10 years continue to offer investors nominal yields in the 3%-to-5% range, and even higher for non-investment-grade bond offerings (buyer beware—junk bonds have an equity-like risk profile in times of recession or crisis).
Add to this the global deleveraging cycle that’s unlikely to bring an economic boom, and you may have a real risk to your business if there’s too much resource and real-estate exposure, and not enough yield generation in client portfolios.
Although government bonds are now in negative yield territory, corporate bonds and high-yield debt continue to offer investors attractive yields. Still, don’t discount the shock absorber features of government bonds: a good risk management strategy always incorporates unfavorable outcomes.
Beware of bonds that promise euphoric yields north of 8%. Buying them could result in equity-like disappointment, or a total loss of capital if the underlying issuer runs into re-financing trouble (a real risk if the European debt situation takes a turn for the worse).
The other asset class offering clients a lower risk profile with consistent income generation in the 3%-to-5% range is dividend-paying stocks in global market capitalizations.
Using our overvalued Canadian dollars to buy cheap U.S. dividend-paying companies hasn’t looked more attractive in the last 15 years, especially due to the natural hedge features of buying U.S. denominated assets. Add in the U.S. stock market, and you have a real opportunity to invest in a two-speed world.