JUNE 15, 2011
CGAAC report revisited:
I’d like to revisit that fantastic CGAAC report I began discussing yesterday as there are some more key quotes and stats worth highlighting. If you haven’t read the entire report yet, it is well worth your time. Here are a few more quotes that jumped out at me:
“At any point in time, households’ primary goal is to satisfy current needs by allocating a portion of disposable income to spending. The part that is not spent is saved to be used for consumption in the future. One of the important functions of savings is that it allows individuals to apportion their consumption over time. Insufficient savings, thus, may jeopardize household’s
financial situation throughout the life continuum and at retirement, leading to a decline in optimum living standards.
In its previous household debt reports, CGA-Canada highlighted the fact that Canadian savings patterns has been deteriorating during the pre-recession years of strong economic growth and identified this trend as worrisome; particularly taking into account that the number of Canadians entering the phase of life when they are expected to accumulate their retirement savings (aged 45-64) was increasing. Although, at that time the lack of active savings (i.e. part of disposable income put aside) was noticeably compensated by passive savings through appreciation of housing and financial assets, that wealth was not distributed evenly among households.”
Our low savings rate is a topic of frequent discussion on this site. While a lower savings rate might be justified as interest rates have fallen, dampening the appeal of short term savings vehicles, that hardly explains the entire phenomenon, particularly as demographics would suggest that savings should be accelerating. I believe this is one of the key trends that will begin a mean reversion at some point over the next few years. Those who understand that increased savings rates equates to a reduction in the velocity of money will understand that increased savings coupled with decreased demand for debt will exert deflationary forces on certain asset prices.
As the report also alludes to, many boomers will soon be faced with the reality that they are woefully underprepared for retirement. When that happens and the savings rate begins to rise, it cuts directly into consumption, a key component of economic growth.
“Perceptions of households, though, do not seem to be well aligned with the actual trends observed. As perceptions often form the foundation of behavioural choices, misalignment of perceptions and reality may lead to further escalation of household debt which is not supported by financial fundamentals.”
Love it! The ‘perception’ being referenced here is the perception that households can manage their existing debt or even add to it when all evidence points to the contrary. That statement that perception forms the root of choices is incredibly important in understanding what continues to sustain a housing market that is at extreme levels of valuation relative to underlying fundamentals. As I often say, over the short term, markets are driven by sentiment and perceptions. Over the long term, fundamentals win out. Unfortunately, the point at which fundamentals suddenly matters is impossible to predict, but with human emotion being so fickle and with our inherent tendency to think as a herd, expect that when the realization dawns on people that debt is a four letter word and perhaps a house is, after all, just a place to live and not a lottery ticket, the shift will quite likely happen suddenly.
“The positive signs of improving labour market conditions portrayed by the unemployment rate and the hiring intentions of firms may be deceptive. The market’s ability to keep up with the increasing population continues to be weak (and even deteriorating in some of the provinces); the long-term unemployment rate continues to increase while the decline in the proportion of discouraged workers has not yet materialized. Weak labour market conditions may suppress the short-to-medium term growth in earnings while increased and more prolonged absence of employment may decrease individual’s life-long earnings.”
I maintain that the current economic recovery is not a typical post-business cycle recession recovery. The influence of exceptionally accommodative credit conditions and the (waning) influence of stimulus spending continues to drive a portion of the recovery. Certainly business investment has been brisk, but would it have been without the exceptional steps taken by central banks and governments globally to stem the tide....and more importantly, will it continue to be a pleasant surprise if the global economy falters, as it surely would without the ongoing fiscal and monetary intervention? Regardless, the current recovery is far from normal and is certainly not as strong as most believe.
“It has now become clear that the assumptions regarding growth in income and wealth used to make borrowing decisions prior to 2008 will no longer materialize as the economic outlook has become much more volatile and subject to influence of diverse, often external factors. The assumptions used to make current borrowing decisions need be adjusted to account for economic
shocks to which the household sector continues to be exposed. The case for accumulation of savings has not materially changed and a balanced approach to spending, saving and paying down debt may be a more desirable option than venturing into consumerism culture that has become typical for Canadian households over the past decades.”
Another great point. A credit bubble can only occur when the prevailing mentality is that the future will be bigger and better than the present. Since economic growth will drive my income higher, why not buy today and pay out of the increase in my future income? With consumer debt levels at such extreme heights, it suggests that the broad consensus is that the economy will experience few hiccups, interest rates will remain low, unemployment will only move lower, and wage growth will be strong. Yet as the clouds continue gathering on the horizon, it is becoming increasingly obvious that the pay increases needed to support a perpetual 7% expansion in consumer debt are far from likely.
“Today, ‘wants’ of individuals are often skewed towards indulging in pleasures of consumption which also serve well the ‘wants’ of policy-makers who recognizes that strong household spending is essential to the growth of the Canadian economy. The ‘needs’ of building up savings for achieving high level of living standards tomorrow is likewise well recognized by both individuals and policy-makers. However, acting on this recognition is often a challenge, particularly so because apportioning of individual income and wealth over the span of the lifetime is a matter of personal choices and freedoms.”
Great point and I agree to an extent. However, if we ask ourselves what is truly driving the increase in debt levels, the answer is primarily the rise in house prices which has had the two-pronged effect of increasing mortgage debt and encouraging the massive growth in lines of credit, collectively accounting for roughly 80% of all consumer debt outstanding. We know that home equity extractions via lines of credit are highly correlated with house price increases. And we can also strongly argue that the house price increase has been primarily fed by a loosening in mortgage lending standards at CMHC.
So here’s the situation: The authors are right that taking on debt is a matter of personal choice. But what they miss is that it is the explicit guarantee of the mortgage principal by the Canadian taxpayer that has provided the ‘choice’ for the individual in many circumstances. We can argue whether or not CMHC should exist in any form, but certainly we should be able to agree that providing mortgage guarantees so that first time buyers can have access to more and cheaper credit so they can buy granite and stainless steel is well outside the original mandate of CMHC. If maximum insurance ceilings were reinstated (they were removed in 2003), it would put an immediate damper on the pace of mortgage expansion, which would put downward pressure on real estate prices, which would reduce the demand for home equity lines of credit. Follow my drift?
Finally, a few graphs towards the end of the report caught my eye:
Over 20% of respondents could not handle an unforeseen expense of $5,000. It's one reason I advocate having an emergency fund with at least 3 month's living costs set aside.
These are rather striking. A majority of respondents listed 'day to day expenditures' as a reason why their debt was increasing while another large chunk highlighted 'leisure' as one of the primary reasons. Scary stuff. As we discussed in an earlier post, the availability of lines of credit mask the true state of many debtors. If (when) house prices realign with fundamentals, one of the key drivers of credit availability dies with it. THEN we will see who has been swimming naked.
I’ve got to leave it here for now. Carney also made an important speech today that I will comment on tomorrow. For now, there are more important things in life than the wide world of finance and economics. There’s a hockey game on....