Housing market vulnerable to downturn, Merrill warns

Canadian households are holding record debt, and facing a possible rise in unemployment. Merrill expects the jobless rate to rise to 8%. And yet, it notes that recent surveys reveal that Canadians believe real estate is a good long-term investment and are harbouring little concern that it is over valued.

Merrill is more worried, it says that, in contrast to the U.S., Canadian home prices set new highs in 2011, and “are now showing many of the signs of a classic bubble.” It estimates the housing market nationwide is about 10% over valued, and this is with record low mortgage rates. “Under more normalized interest rates, home prices would actually look 25% overvalued based on current prices,” it says.

“One of our biggest concerns is the condominium market, which is probably in the late stages of an inventory cycle. The Toronto condo market in particular is likely in the late stages of an inventory cycle. We estimate there are already enough units in the pipeline to satisfy fundamental demand for the next five years,” it says.

Financial stocks will likely feel the brunt of a downturn. Merrill notes that Canadian building supplier stocks and non-bank financial stocks, which are directly exposed to the housing market, turned negative in April and are signaling a softening of housing activity. “However, housing-sensitive financial stocks are only down 13% from April and will likely fall further as home prices and home sale activity slows into 2012,” it says.

“In our bear case we would expect these stocks to significantly underperform the broad market. Home builders and housing sensitive financials could see another 20% decline if the economy deteriorates more than we expect,” it warns.

However, it notes that weaker housing prices are not a significant threat to bank balance sheets, as about 75% of the mortgage market is fully insured by the federal government. The bigger threat to the bank balance sheets, under its bear case, is where the condo market has a more severe contraction resulting in high commercial lending delinquencies, it says.

“Although we believe the banking sectors balance sheets are relatively protected from fall home prices and unlikely to experience similar solvency issues to US & European banks, the banking sector is still likely to underperform,” Merrill says, noting that unsecured consumer debt on bank balance sheets has risen, and the loan growth environment is likely to be very difficult over the next few years.

Merrill still expects the Bank of Canada to cut rates further in 2012. “With the Canadian economy flirting with recession in the first half of 2012, we expect the Bank of Canada to cut rates 75 [basis points], back to the effective lower bound of 0.25%,” it says.

And it suggests that mortgage regulation could be tightened further in 2012, noting, “Recent comments from chartered bank executives suggests financial institutions are urging further tightening since individual banks are reluctant to tighten lending for fear of losing market share to competitors.