Canada's housing market is looking increasingly like a bubble in the making, Edward Jones said today in a report.
"Canada's housing market escaped the recent severe downturns in the U.S. and other countries. However, today's conditions in Canada share some characteristics of those countries prior to their downturns, leading us to take a cautious stance on housing investments," wrote analysts Kate Warne and Craig Fehr, adding that Canadians should prepare for "the possible impact" of a housing downturn.
An asset bubble forms when cheap money causes speculators to flood into a market, driving prices higher despite weak underlying fundamentals. With unemployment high and the economic recovery on shaky ground, the rapid recovery of Canada's real estate market has many economists concerned that prices could head lower. Prices have gained almost 20 per cent in the last year, as a lack of inventory and easy access to cheap money has propelled Canadians toward home ownership.
The analysts said three factors must be in place for a bubble to form - prices that are too high compared to historical averages, easy credit, and lax government policy that allow people to get in over their heads. Last month the federal government made it more difficult to obtain a mortgage, requiring all borrowers to qualify at the five-year rate when applying for credit rather than the variable rate, which can be much lower.
"We think the first two conditions characterize the current Canadian housing market," the report states. "To avoid the third condition, the government is taking steps to tighten mortgage availability, and regulation remains relatively tight. While we believe any housing downturn in Canada won't be as severe as the recent U.S. experience, the increasing likelihood of a cooling housing market still poses some risks for investors who are not well-diversified."
While the economy has shown signs of strength, the analysts suggest the pace of recovery in the housing market has been too high to be sustainable.
Economist Will Dunning takes a look at what he calls a bubble scare in this Let's Talk Investing video
"Housing prices have outpaced the overall economy, including unemployment trends and gross domestic product (GDP) growth," they state. "As a result, our stance on Canadian housing market risk is becoming increasingly cautious."
Tighter lending standards, rising interest rates and mortgage costs, an increase in new supply and consumer deleveraging could all conspire to take the market lower, they said. Any slowdown has implications for the broader economy, they said, particularly when it comes to consumer spending.
About 30 per cent of all mortgages taken out between 2007 to 2009 have terms of less than three years, they said, which means they will likely be renewed at higher rates.
The extra costs could keep people from spending on other items -a 3 per cent increase in mortgage rates would mean an extra $444 a month for a mortgage of $254,514, they said. That would shift $1.82-billion of Canadians' $911.5-billion in annual discretionary spending toward mortgage costs.
"In addition, Canadian consumer debt has risen steadily for several years, reaching new highs as measured by debt as a percentage of disposable income," they said. "Thus, consumers don't appear to have the flexibility they might have had in the past."
Last week, Gluskin + Sheff economist David Rosenberg suggested Canada's housing market was in for a 20 per cent price correction. He said government intervention and easy money has helped the market get ahead of itself.
"The question is not whether home prices slide especially in bubbly Toronto and Vancouver, but just how much froth is there to come out," he said.
As rates begin to rise and more supply comes on the market, he said the market will be under a lot of pressure to keep advancing.
"The housing market in Canada, the goose that laid the golden egg for the broader economy, is now going to be operating without the crutch of massive government support. It will be fascinating to see how this all plays out."