CIBC Weekly Market Insight – April 1, 2010 – Benjamin Tal, Senior Economist


1. It seems that the Bank of Canada is signalling that it will begin raising rates in the summer, if not sooner. What is the expectation for the overnight rate for the next 24 months?
By now it is clear that the Bank will move by June or July. However, we expect that the first leg of tightening will be moderate (only 75 basis points in Q3 of 2010) and the bulk of the tightening will be in 2011. Look for the overnight rate to reach 2% within 24 months.

2. How do you see the Canadian yield curve reacting to that forecast?
We expect some flattening in the yield curve in the next six months as short-term rates catch up with-long term rates. But we also expect to see a steeper yield curve down the road; the need to raise short-term rates will be limited by a softening economy in the second half of the year,  deleveraging by consumers and government policies that will start acting as a negative for the economy. At the same time, we expect some upward pressure on long-term rates due to fiscal consideration and some inflationary fears.

3. Some of your peers have commented on the Bank of Canada raising the overnight rate while the Federal Reserve Bank maintains a near-zero target for the federal funds rate. Is this really a sustainable course of action for the Bank of Canada and how do you see this playing out?
No. That’s why we expect the first wave of tightening to be limited. There is a limit to what extent the Bank can fly solo without the Fed. Note that it happened in the past-1992 and 2002-where the Bank moved independently of the Fed only to reverse these moves a few months after. We think that most of the increase in rates will be in 2011 when the Fed starts moving.

4. Briefly, what is your thesis on the outlook for the US and Canadian housing markets?
Over the past two years, the degree of volatility observed in the Canadian housing market has been unprecedented. Within this short time frame, house prices fell by almost 13%, only to rebound by an impressive 21%. Meanwhile, resale activity is now rising by close to 67% on a year-over-year basis after falling by close to 40% in 2008. Housing starts are presently 33% higher than in April 2009, despite dropping by more than 50% earlier in the recession. In fact, no other segment of the economy has rebounded as quickly as the housing market, making it one of the real surprises of this recession. This rapid uptick in housing activity, in the face of recessionary conditions elsewhere in the economy, raises concerns about its sustainability. It’s causing some to wonder whether house prices are rising too quickly given current economic fundamentals.

Using a recent International Monetary Fund (IMF) housing valuation model as a base, and updating it to reflect the most recently available Canadian data, we estimate that the Canadian housing market as a  whole is beginning to overshoot its ‘fair value.‘ At just under $350,000, the current average price of a home is estimated to be roughly 7% over what would be consistent with current housing  market fundamentals, including interest rates, income growth, rents and demographics. However, that modest overshooting is far from uniform across the country. Those figures are skewed to Western Canada, which has seen the most dramatic swings in house prices over the past 24 months. That market now appears to be overvalued by roughly 10% to 15%, suggesting that the imbalance in the rest of the country is much more modest.

Note, however, that overvaluation does not necessarily mean a bubble or a dramatic price correction. Given that the current overvaluation is occurring in a context of historically low interest rates, what we are most likely witnessing is a temporary period of exuberance that is ‘borrowing’ activity from the future; households are taking advantage of lower rates, and  accelerating their borrowing and home purchasing activities. To the extent that current activity is simply a redistribution of sales from the future to the present, the housing market of tomorrow may be in store for a more muted level of activity. Housing starts will also catch up with the sudden spurt in demand, with the increase in supply helping to moderate price trends. Rather than plunging, house prices are more likely to stagnate in coming years (or fall modestly in the most overheated markets) as fundamentals catch up with a market that has gotten ahead of itself.

As for the US, its economy may be on the mend, but a full-fledged recovery in the residential real estate market is still years away. After an unprecedented multi-year collapse, most housing indicators have stabilized. Yet, whatever signs of improvement do exist are more a function of a badly damaged market- and the distorting effect of temporary tax incentives-than evidence of a sustainable rebound. Starts, sales and prices look okay now, but we anticipate further weakness ahead as supply continues to outpace demand, mortgage rates head higher (with the Fed ending its purchase of MBSs) and the government’s generous home buyer’s tax credit finally expires. That will have significant implications for related equities which have already priced in a steady recovery in the US housing market. In the final analysis, the end of unprecedented government tax support for housing, along with the looming overhang of supply and a higher cost of  borrowing, will keep new home building activity trudging along at historic lows over the next two years. We could see prices drop again by 5% to 10%.

5. More generally, how do you see the US and Canadian economies faring from 2010 through 2012?
No economic recovery goes in a straight line and the current one will be the most non-linear of them all. As in the US, many of the chief drivers of the Canadian recovery will run out of fuel by mid-year and will give way to sub-par growth in the second half of the year. In both countries, we will see GDP growth of close to 3% in 2010-this number will mask above-potential growth in the first half and below-potential growth in the second half. As for 2011, we also do not see a very strong economy. We will have a few negative factors such as the end of the inventory cycle, deleveraging by consumers, a stagnating residential housing market and a government that will be acting as a negative for the economy as a whole. This will limit the need to raise rates to the sky but it also means that both economies will probably grow below 3% in 2011.

6. What sectors appear poised to outperform in this environment and why?
Timing is very important here. We expect some damage to interest rate-sensitive stocks following the first move by the Bank, (as is always the case) we will then see the market start upgrading its expectations regarding future rate hikes. This will provide a buying opportunity since we believe that actual rate increases will be less than what the market will end up discounting (for the reasons mentioned earlier). Also remember that the market as a whole tends to move higher during the first six months of monetary tightening. If you look at the average of all the tightening cycles since 1958, you see that during the six months leading to the first rate hike, the market on average rose by 22% (annualized) and during the first six months after the first move, the market rose by 8% annualized-an interesting statistic. As for specific sectors, based on past sensitivities to interest rates changes, look for apparel and consumers durables, technology and health care to outperform in the coming six months. Beyond that, switch to interest rate sensitive sectors such as financials, capital goods and utilities. From a long-term perspective we are still bullish on commodities since we think that demand from emerging market will surprise on the upside in the coming years.

7. Do you have any other advice for equity investors in 2010?
Here we want to focus on the nature of demand. We are already in the midst of a significant
redeployment of cash into the market. We are talking about cash that was sitting on the sidelines for a while and now is finding its way into the market-roughly $120 billion of cash that is being redeployed. It is ‘conservative’ money since most of it is held by people age 55 plus. Thus we think that this situation is positive for defensive, dividend-paying stocks. And if we are right and rates do not rise significantly during the first wave of tightening, these stocks will remain very  attractive. So we think defensive investment with the focus on high-paying, dividend stocks will be the winners in the next two to three years.


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