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Potential Impact of a Housing Sector Pullback

By Chris Kerlow, CFA

Housing-related expenditures are becoming an increasing component of our economy and have helped propel Canada to its current status as one of the fastest-growing developed nations in the world. The prolonged run in home sales, coupled with price appreciation, has tripled the contribution to GDP during this cycle, according to RBC economics. On Thursday, the Bank of Canada released their semi-annual Financial System Review, which centered around the vulnerabilities of elevated Canadian Household indebtedness and imbalances in the Canadian housing market. With legislative changes in two of our largest metropolises, Toronto and Vancouver, seemingly taking grip, and the pressuring of alternative lender Home Capital Group, we wanted to consider the investment implications a potential pullback in the housing sector would have for Canadian investors.

 

BoC Says Impact of Housing Sector Pullback Limited

During his webcast on Thursday, BoC governor Stephen Poloz noted that the risk of a housing correction is growing over time, not becoming less. This only highlights something that is quite apparent to all Canadians. However, they labeled the risk of a housing correction as moderate. They think the impact of a pullback would be limited but still cause financial stress. This is because of the vulnerabilities caused by a supply and demand imbalance and increased household indebtedness are being offset by growth and strength in other parts of the economy. “The reliance is rising in the background, even if the vulnerabilities are rising in the foreground,” said Poloz.

Observers are quick to draw parallels to the American housing market that catalyzed the great financial crisis in 2008. The reality is Canada’s situation is quite different. Underwriting standards are much more stringent, delinquency rates are much lower, and in some cases lenders have recourse to other assets. There is also much less securitization of mortgage debt because our banks keep most of their mortgages on the balance sheet, unlike other countries that off-load a lot of that debt.

 

Allocation to Canadian Banks in our Portfolios

The growing level of household debt and exposure to Canadian housing was cited as one of the reasons Moody’s downgraded the credit rating of six of the Canadian banks on May 10th. The level of exposure across the banks varies, but mortgage lending is a bread-and-butter business for all of them. Canadian banks are core holdings in all of our mandates; however, they make up a sector we have a hard time justifying being market-weight in, when they account for 23% of the index. The prolific growth in bank earnings and other financial institutions have growing net income of the financial sector to account for, and Canadian banks now account for more than 52% of the TSX’s net income. Within our portfolios, we are more allocated to banks that have larger contributions from capital-market divisions and U.S. operations, such as RBC, TD and BMO.

 

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Learn more about Redwood Tactical Asset Allocation Fund (RTA) and Redwood Core Income Equity Fund (RDE)

 

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