Canada’s Economy Could Get Much Worse

It’s early September as I write this, and the news is filled with talk of a Canadian recession. Yet for all the focus on the possibility that the Canadian economy is contracting, most commentators are incredibly sanguine.

Many economists are not yet willing to actually concede that Canada has been in a recession. Indeed, the C.D. Howe Institute’s Business Cycle Council, comprised of 12 high-profile economists, asserted in late July that “data did not provide evidence that Canada had entered an economic downturn”. As reported by the Globe and Mail, the Council does not believe that two consecutive quarters of negative GDP growth (which we now know Canada experienced in the first half of the year), by itself, defines a recession. Rather, they insist that there also must be a “pronounced, pervasive and persistent decline in aggregate economic activity.” By their criteria, they say Canada is not in recession.

Another group of economists insists that any recession is now over and growth will return. Overwhelmingly, both private sector forecasters and the Bank of Canada predict that growth will reappear in the second half of the year. And for its part, the International Monetary Fund even increased its estimate for Canada’s 2016 GDP growth, to 2.1%. So the consensus is clear: Canada’s economy has seen the worst.

My view is starkly different. I believe Canada is headed for a very serious recession, one that will make the current weakness pale by comparison.

As I see it, the Canadian economy of the last decade or so has been very heavily influenced by two large asset bubbles. The first bubble was in commodity prices, and it was largely predicated on the story of an ascendant China. When the financial crisis became acute in 2008, everything from copper to crude oil sank as speculators abandoned these markets en masse. This was the end of what we might call Commodity Bubble 1.0.

Then an amazing thing happened: all the rescue measures by governments and central banks created another bubble in resources as investors feared runaway inflation. Individuals, hedge funds and pension funds, among others, overran these tiny markets, usually via derivatives but sometimes also through the purchase of physical assets. Thus, from the depths of the crisis, Commodity Bubble 2.0 was born. It peaked in 2011 and crashed beyond dispute with plummeting oil prices in the latter stages of 2014.

Canada is a resource economy, and it benefitted greatly from bubbly commodity prices.  Whether it was potash in Saskatchewan, nickel in Sudbury or oil in Alberta, the boom in resources created jobs in commodity sectors and spurred significant levels of business investment. Those good times have ended, punctuated by oil companies laying off workers and curtailing projects.

The struggling Canadian economy of mid-2015 is one reeling from resource prices imploding. And I fear things could be about to get worse.

As most people know, there’s been a lively debate about whether a housing bubble exists in Canada. Once again, bank economists and other pundits seem relaxed. Most forecasters predict a “soft landing” for house prices, certainly not the kind of drop that would deal the economy another serious blow.

I think house prices will crash. For one thing, housing markets across Canada have been buoyed in recent years by soaring commodity prices. That support is quite evidently gone. 

More importantly, though, Canadians have gorged on cheap credit brought about by low interest rates. Statistics Canada reported in June that the household debt to disposable income ratio stood at 163.3% at the end of the first quarter. To put this number in context, consider that in 2000, Canadian household debt was closer to 100% of disposable income.

With rates at rock bottom levels, people have been able to borrow to buy houses that would have been out of reach in previous years. In fact, Canadian mortgage debt now stands at over $1.1 trillion, versus just over $500 billion in 2000.  This credit boom has in turn pushed prices for houses to the moon. By some measures, we have exceeded the gains experienced during the U.S. housing bubble.

This is a recipe for trouble. The bursting of the commodity bubble means that many consumers simply will not have the income to buy houses at current prices. Countless others have already been priced out of the market. This is happening as some areas, most notably the Toronto condo market, are seeing significant overbuilding.

To understand just how vulnerable Canadians are to a housing crash, just imagine the personal balance sheet of someone who has recently bought a house in a major urban centre. On the one hand, they have an asset that is currently worth a lot. On the other side, they have a large liability in the form of a mortgage.

Now imagine that house prices start tumbling. The asset is now worth less, but the liability does not go down with it. And if house prices fall far enough, many Canadians could be under water on their mortgages. It’s one thing if all these households can continue to service their mortgages, but a housing crash would doubtless cause a serious spike in unemployment given the economy’s reliance on the real estate and construction industries. Consumer spending would also be hit, as the ability of consumers to tap home equity lines of credit evaporates.

I realize that this is a very alarmist scenario. It’s certainly not one I am wishing upon our country. But for all the complacency that currently abounds, I think Canadians should be aware that we face a much deeper downturn than virtually anyone is predicting. 

Andrew Hepburn is a freelance writer based in Toronto. He specializes in economic and financial issues. From 2006 to 2009 Andrew was a Research Associate with Sprott Asset Management in Toronto focusing on commodity markets. He is a graduate of Queen's University. He can be reached at ahepburn20@hotmail.com.