With interest rates still near all-time lows all along the yield curve, CFA Society Toronto’s 2012 Annual Interest Rate & Inflation Luncheon featured two prominent economists discussing the Canadian and global macroeconomic environments, including a discussion of the Canadian housing and associated industries.

Paul Ashworth, Chief North American Economist, Capital Economics, put forward a strong case that any recovery in Europe will be severely hampered by the productivity gap between member states. Germany is far more competitive than some peripheral countries, where unit wage costs have risen substantially since the euro was introduced in 1999. Some of these smaller economies, such as Greece, have been running large account deficits for the past decade, and these deficits have been a drag on the economy. In the case of Greece, in 2008, the government spending deficit as a percentage of GDP ballooned to 15 percent. He compared this to the U.S., where a 5 percent deficit raises concerns.

GDP growth in the smaller countries has not been export driven. While real GDP in Europe overall has not appeared to be too bad on the surface, strength in Germany has masked weakness in other countries, and public consumption has been boosted by government spending, which has fallen apart recently. Portugal, Ireland, Italy, and Greece all have public sector debt running at over 100 percent of 2011 GDP. Ashworth argued that the austerity measures announced will not work in Europe, pointing to the extreme levels of unemployment in many peripheral countries. These countries will have to choose between a decade of austerity or a more extreme option—default and exit from the Eurozone—to solve their lack of competitiveness. In his view, high unemployment in some countries will create opportunities for political parties to gain support by pursuing more extreme measures—“the political vote is not always a rational one.”

He said he was surprised at the strong performance of the euro and ascribed it to market participants believing that either the debt crisis will end with Greece or that over the longer term northern European countries will take over the euro.

Ashworth commented that U.S. domestic conditions are looking better, and signs of a real recovery are beginning to appear at last, despite the possible susceptibility to external shocks, particularly from Europe. There are indications of some life in the housing market, along with income and credit growth. While this does not mean that there are no structural problems, it is not all doom and gloom.

Canada has held up well, he added, thanks to our strong housing market and strength in commodities, which have supported our growth in real GDP. However, he had some words of caution. Some of the reasons that were used to justify housing prices in the US in the mid-2000s are now being used to rationalize Canadian markets. He added that if—or when—the housing construction and renovation industries go into a slump, they will have a very noticeable negative effect on the economy, potentially shaving 3–4 percent off Canadian GDP and constraining growth.

Derek Holt, CFA, Vice President, Scotia Capital Economics, began his presentation with a lively rebuttal to Paul Ashworth’s comments on the Canadian housing situation. While he also saw the market topping out (rates of homeownership are now approaching 70%) he did not think it would be anything similar to what happened in the U.S. for several reasons:

• Credit quality is much higher in Canada, with far lower instances of mortgage arrears. While the percentage of mortgage portfolios 90+ days in arrears can top 8 percent in the US, in Canada it has always been below 0.6 percent.
• In Canada homeowners leverage their properties much less than in the US. Real estate debt as a percentage of total real estate assets is approximately 35 percent in Canada, versus 50–55 percent in the U.S. Similarly, total household liabilities as a percentage of total assets are much lower than in the U.S.
• It is a myth that only the major cities are driving the housing market in Canada. In fact, they are not even the hottest markets. Rather, it is smaller places such as Regina, St. John’s, and Saskatoon that have seen a 200 percent cumulative house price gain since 1999 (based on MLS® average house prices).
• Financial institutions in Canada enjoy stronger capitalizations and have a totally different funding model, relying more on deposit financing. Underwriting criteria are much stricter, and business lines are more diversified.
• Debt to income is not as important a ratio as debt to assets.

In his address, Holt also disagreed with suggestions that Europe would break up, mainly because there is no mechanism for it to happen. He expects growth to be flat in the EU overall for 2012, versus modest growth in Canada, the U.S. and Japan. He championed the case that the bond market still has a way to run for a number of reasons, including that the U.S. Federal Reserve will likely step in with additional stimulus measures this summer; China has grossly undeveloped infrastructure and will need to invest; and equities are pricing in good news already, hence they do not represent a major challenge to bonds. He also concluded that the Bank of Canada will keep rates on hold until at least 2013, partly due to the Fed’s easing.