Canadian households are richer today than they have ever been. Higher equity prices and swelling real estate values have boosted wealth to record levels. But both those drivers are sure to subside in the years ahead. When that happens, will investors know how to save?

A new report from Bank of Nova Scotia reveals that Canadians are rolling in wealth. Total household net worth is up 10% over the past 12 months, to just shy of $5 trillion. Over the past three years, net worth has increased by almost a third — or about 20% when adjusted for inflation and population growth. Moreover, increases in household wealth have outstripped income gains. Net worth now represents more than 600% of personal disposable income — a new high — up from about 400% in the early 1990s.

The report points to a period of strong economic growth, falling unemployment and rising asset prices (both in stocks and houses) as the chief reasons for the increase. While the economy has been healthy for some time, the behaviour of asset markets has been the bigger factor in building wealth. The bull market for stocks in the 1990s, followed by the bull market in housing since the turn of the millennium and the return to strong stock markets over the past few years has meant households have relied on market gains for much of their newfound net worth.

Household assets have been particularly powerful sources of wealth creation in the past three years. Scotiabank’s report indicates the total value of household real estate is up 26% since the beginning of 2003. And the value of financial assets has gained even more, up 34% in the same period.

The effects of these financial asset gains are evident on the balance sheets of basic savings vehicles, such as pension plans and mutual funds. According to the latest data from Statistics Canada, the value of trusteed pension fund assets increased 4.7% in the first quarter of 2006 over the previous quarter — the seventh straight quarterly increase — pushing the value of pension assets to almost $840 billion. And as of Aug. 31, the Investment Funds Institute of Canada reports, mutual fund assets were slightly less than $610 billion, an increase of almost 12% over the past 12 months.

StatsCan cites market appreciation as the biggest factor behind the first-quarter gain in pension assets (almost 40% of pension assets are held in stocks). Similarly, mutual fund assets are up by more than $60 billion over the past year. Yet, through the first eight months of 2006, net sales amounted to less than $13 billion, implying market gains have been the overwhelming source of asset appreciation.

With households’ assets generating such strong returns, people have turned away from traditional saving and redeployed money they might have saved in the past to fund greater consumption. In 1990, households saved about 13% of income. In 2006, that is down to about 1%, Scotiabank notes.

This decrease in saving may be a rational response to strong asset returns, but there are dark clouds on the horizon. Many economists expect the global economy to slow. As that happens, the forces that have helped create record household wealth may be undermined.

Weaker worldwide economic growth can be expected to filter into Canada, hampering income and employment growth here. As the global economy comes off the boil, commodity markets are expected to tumble — and commodity markets have been one of the chief drivers of Canadian equity markets. If this happens, the equity-driven wealth effect may dissipate as well, restraining domestic demand and further stunting the economy.

And what about housing, the other big source of recent wealth creation?

One of the glaring weak spots in the global economy is the U.S. housing market, which appears to be slowing considerably. The Canadian housing market has been ebullient, but economists are not predicting a similar slump in that sector here.

In a new report, National Bank Financial Ltd. notes that, while Canadians have seen housing prices run up, similar to prices in the U.S., there is not the same oversupply in Canada. NBF also notes that some U.S. housing markets have experienced lots of speculation; a new survey from the U.S. Federal Reserve Board finds 17% of lending is going to housing not occupied by the owner, almost the triple the amount of such lending in the 1990s. This is one factor, peculiar to the U.S., that makes its market more vulnerable than Canada’s.

@page_break@Moreover, the gains in Canada’s housing market have been regional. Recent strong gains in the West have been supported by an economic boom there; in the rest of the country, price action has been modest. As a result, while price appreciation in certain Western cities may appear unsustainable, a crash in national prices is not expected.

Longer term, however, the outlook is for much slower price increases than have been evident in the past few years. According to a report from TD Bank Financial Group, the biggest factor driving housing demand is demographics. As population growth eases (Statistics Canada predicts population growth will slow to 0.6% from 1% by 2030) and as the population ages (dropping new household formation growth rates to 0.8% in 2030 from 1.4% in 2007), it is expected that housing demand will soften.

REAL INCREASE ONLY 1.9%

“All this points to weaker demand growth for housing and more modest price gains than in the past,” TD says. However, it tempers concerns that the aging population could have a dramatic negative effect on housing demand and prices, pointing out that increased longevity and tighter labour markets may provide positive offsets.

What can Canadian households expect in housing price increases over the long run?

TD notes that, over the past 25 years, prices have risen an average 5.6% a year. But, factoring in average inflation of 3.7% over that period, the real increase is only 1.9% a year.

Over the past 10 years, however, the Bank of Canada has kept inflation around 2%, and TD believes there is every reason to expect it will be able to sustain this performance. Assuming that is the case, house prices may deliver a 4% annual gain in real terms. TD suggests this assumption is reasonable for the next 15 years or so: “But as the demographic pressures build, particularly after 2025, there is a risk that the trend rate of price growth could slow to 3%-3.5%.”

In the long run, returns from financial asset are also expected to be much lower. Earlier this year, TD predicted financial as-set portfolios would return 6%-7.6% annually (depending on asset mix) over the next 10 years.

With the housing-driven wealth effect unlikely to be sustained and equity markets probably reverting to single-digit returns over time, Canadians will have to be reminded how to save the old-fashioned way. “Looking ahead, many households may need to revisit their investment strategies as the heady pace of home and equity price appreciation inevitably slows,” counsels the Scotiabank report. “Generating even modest wealth gains may require boosting traditional savings and/or reining in discretionary outlays.

“From 2000-2005, conventional saving by Canadians accounted for just 10% of personal sector wealth accumulation, compared with almost 30% in the 1990s,” it reports.

In 2005, saving accounted for just 3% of the $351-billion increase in national household wealth, it adds, with the remaining 97% coming from asset gains.

With the drop in savings out of income and with asset allocation shifting away from deposits, the result is increased portfolio risk, leaving household finances and domestic demand more exposed to market weaknesses. Scotiabank reveals that stocks and mutual funds now represent about 37% of household financial assets, double their allocation in 1990. They also now account for about 21% of total household assets, more than double the 9% share these assets had in 1990. Most of these are relatively illiquid because they are held in tax shelters such as RRSPs.

Another 37% of household financial assets is devoted to pension funds and insurance (and, as StatsCan figures show, pension plans are highly invested in stocks); this is up five percentage points from 1990. These higher allocations to riskier, illiquid assets have come largely at the expense of cash and deposits, which account for only 11% of financial assets, down from 19% in 1990.

This shift to higher-risk assets is even more acute when you consider that these equity and mutual fund investments are highly concentrated in Canadian markets. In spite of the lifting of the foreign-property rule, Canadians remain heavily home-biased in their investment portfolios. The share for foreign equity funds, for example, has fallen to only 22% of mutual fund assets from 38%, according to a TD report.

That TD report stresses that investors need greater foreign diversification for all the usual reasons — the Canadian market is a tiny portion of the global capital markets, it is heavily weighted in resources and financials, and is highly cyclical. Indeed, NBF recently reported that the Canadian market has been more highly correlated with emerging markets than with U.S. or EAFE (Europe, Australasia and Far East) markets over the past few years.

Increasing foreign diversification would be a smart move for many Canadian investors. Given that so much of households’ recent wealth creation has been market-driven, investors would be well advised to diversify to maximize returns and/or minimize risk in the years ahead.

The wealth effect is wonderful while it lasts, but Canadians will have to save more and save smarter to keep setting such records in the future. IE