By now everyone is probably well aware of the changes that have been made to Vancouver housing and to residential housing across the nation. A simple recap follows, along with how we think this could affect our investing and portfolios.
First, back in late July, the Province of BC put in a 15% Foreign Buyer's Tax to take effect Aug 2nd. As I wrote here in early July, highrockcapital.ca/pauls-blog/open-letter-to-prime-minister-trudeau-and-finance-minister-morneau-on-the-state-of-the-housing-markets-in-toronto-and-vancouver in a Open Letter to our PM and FM, I thought this had the potential to create a huge policy error. A nation running current account deficits as large as we do in Canada, can ill-afford to push foreign capital out of the country. Well, thankfully, it was just the Province of BC that signaled a denial of foreign capital, not the country as a whole. I don't have any statistics , as of yet, but certainly through the sensationalism in the press (and it may very well be true) it sounds like Vancouver area house prices are dropping. If the intended consequences were to hammer domestic home owners, then...solution provided by the Provincial government. Let's see how this plays out.
Just today, Kathleen Wynn came out and said Ontario will not follow BC's lead in strapping on a foreign buyer's tax. Thank God. Maybe the Liberal government of Ontario has seen some hard numbers out of Vancouver. Whatever the reason, I am glad they didn't. Wynn did go on to say they are exploring options and monitoring how the federal government's new mortgage rules will impact housing. Smart to wait.
On to the federal government's new mortgage rules. Earlier this month, the federal government put new rules for mortgage borrowing in place beginning Oct 17, 2016. Old rules stated that those who put down less than 20% Equity on a new home purchase had to pass a "stress test" and have mortgage insurance through CMHC. And those who put down more than 20% Equity were not subject to the same stress test.
The stress test is meant to save home buyers from themselves. That is to say, that the federal government put measures in place to ensure that those who are buying a house, even with more than 20% Equity, will be able to afford all of their monthly expenses especially if rates rise. The "stress test" uses a much higher (off-market) rate than a current mortgage rate. For instance, a 5yr mortgage is around 2.60% but the new rules force borrowers to use the Bank of Canada rate of 4.64% for stress testing purposes to ensure they can afford their mortgage and other expenses if rates should rise. Draconian? Perhaps. If a 5yr Government of Canada bond is around .65% today and a 5yr mortgage is around 2.60% we can say that a 5yr mortgage is ~2.00% higher than the 5yr bond yield. Now if we look at the Forward Bond Curve in Canada, we can see that the 5yr in 5yrs time is trading at about 1.80%. If we add 2.00% for the mortgage spread to that, we would get a 5yr mortgage in 5yrs time at 3.80%; a fair bit lower than the new stress test level of 4.64%. Maybe a bit draconian.
The obvious effect on anyone buying a home with a mortgage is that they will need to a) buy a lower price home and/or b) qualify for less of a mortgage. So if the federal government's stated goal in the first half of the year was to "take measures so that the affordability of a home is accessible for more Canadians who increasingly look at markets like Vancouver and Toronto as significant barriers to achieving their dreams and their successes", have they accomplished their stated goal? I think not. Part of the problem is that the BC foreign buyer's tax was local and, as I suggested in my July Open Letter, that foreign money will just go to other jurisdictions, like Toronto for instance. And also, the federal government's new mortgage rules are put in place across the entire country. How do you feel if you are 30yr old, living in Saskatchewan and have been saving up to buy your first house? Now you probably need to save more and for longer.
A question we get asked by a few clients (I ask myself all the time...and I am a client of High Rock too!) is will housing prices decline? I am not 100% sure but my bet is they likely will (eventually) but I think it will be very local. For instance, I would not be surprised if the Vancouver market declined somewhat but keep in mind Vancouver is a great city...you can ski, golf, sail, bike ride, hike all in the same day and then go to a world class restaurant for dinner. What's not to like?
As for Toronto, as I said in the July Letter, it is the fastest growing city in the developed world, and a world-class city at that. Comparing Toronto to any other large world-class city, especially financial centers, and you will find it is cheap as all-get-out. I worked at Merrill Lynch for almost 18yrs and in my earlier days there I had opportunities to work in London, Hong Kong and NYC. Now I must admit that I live in a nice neighborhood about 7kms north of our office which is downtown with a two-car driveway and a pool. A nice house, to be sure, but I can also tell you that I saved and sacrificed like crazy (and still do) to live in that house and in that neighborhood. Point is, if I were to have worked in any of those other major financial centers that Merrill Lynch was thinking of sending me to way back then, I would have been commuting about 1.5 hours to get something close to what I have 15 minutes away and I would have paid 2-3 times as much. Cheap on a global basis. And the move higher in Toronto housing over the past year is simply a catch-up with other major centers and also to other asset classes, which have been ramped up due to easy monetary policy. Just as an aside, and going back to the example I used in July's Open Letter, I wonder how many investors who own Royal Bank of Canada (RY) stock own it with borrowed money or margin? I think I read a week or two ago that Toronto housing prices are +20% over the past year. Well RY stock is +16.75% on a total return basis over the past year (and BNS is +21%)...about the same as the Toronto housing market. Should the federal government step in and put new borrowing or margin rules in place to ensure that RY (and all stocks) don't "run up" so much in any given year and destroy the dreams and successes of investors who don't own RY or BNS stock? Just a pet peeve I have.
Enough about those views. So what exactly is the federal government doing? I think what they are doing is addressing the Personal Debt to Disposable Income ratio that has skyrocketed to a new all-time high at 167%. Think about it, they can put a ceiling on the housing market while still allowing the Bank of Canada to maintain lower for longer high powered interest rates (ie. government bond yields). Lower high powered rates will help the economy to recover as it keeps the corporate borrowing cost of capital low and new mortgage rules will ensure that the consumer doesn't take advantage of those low rates, at least on home purchases.
To conclude, what does this mean for our portfolios? First, we have no direct exposure to any mortgage lenders, mortgage servicers or mortgage insurers. My view is that mortgage lending volumes will undoubtedly decline. I believe this has largely been reflected in the underlying securities in these various companies but I am not 100% sure how this will all play out. My biggest fear is that housing prices decline more rapidly than anyone (including the federal government) had planned and given the consumer is already leveraged at 167% of disposable income...we would be in a heap of trouble as the housing market is the asset supporting all that debt. So with that view on the consumer, we shy away from the Consumer Discretionary sector. Also, we think that bond yields are likely to stay lower for longer in Canada and we are largely positioned for that, although we did take some profits last quarter as we noted some subtle changes occurring in the way the bond market was behaving. Also, as Scott said in his blog this morning, cash is as asset class that we still maintain a good weight in, so we are naturally defensive. In our Tactical Model, we still press forward with our strategy of owning very specific, well-researched stocks, bonds, convertibles and preferred shares (one very specific one).
Whew, that was a long one.