Market Sense and Sentiment

[Bernard Ng]

U.S. housing woes may bode ill for Canada (this one is for Canadian, but provides some bond buying insight)

http://www.theglobeandmail.com/servlet/story/RTGAM.20060501.webstmain29/BNStory/SpecialEvents2/home

CAROLYN LEITCH

From Saturday's Globe and Mail

People in cities all over North America have stories to tell about the jaw-dropping prices purchasers are paying to buy a house these days: One house hunter in Toronto last week found an appealing, traditional family home with an asking price of $1.9-million.

It was in the pleasant Lytton Park neighbourhood with a swimming pool in the leafy backyard, so she considered making an offer well below the list price, which even some real estate agents admitted was a bit rich. Before she had the chance, the house had sold for $2.15-million -- the first day it hit the market.

South of the border, the stories have a new twist: Now homeowners are shaking their heads at how long properties are languishing in markets that used to be blistering. Add in the economic data and it's pretty much official: The juggernaut housing market in the United States is faltering.

Despite a bit of a bounce in March, U.S. house sales have been weakening, and many economists think we're seeing only the beginning of a lengthy downturn.

But what really has economists concerned is not so much the decline in the market: Many are more worried about the evaporation of the "wealth effect" as homeowners on both sides of the border begin to realize that house prices don't move relentlessly up.

Indeed, the unprecedented runup in the North American housing market has produced a huge swell in assets on household balance sheets and led to a rapid rise in refinancing and home equity loans as homeowners have increasingly treated their houses as giant cash machines.

Housing-fuelled consumer spending has been a major force in North American and global economic growth over the past several years -- and poses a major threat if it dries up.

However, Michael Gregory of BMO Nesbitt Burns Inc. doesn't think Canada's real estate market is heading for a fall. But that doesn't mean this country will be immune to the effects of a U.S. downturn.

"Perhaps the more important part now of the housing sector is through the wealth effect," he says. "As consumer spending slows, that's going to pull down the whole U.S. economy, and of course Canada will feel that."

Last week, the United States saw stronger-than-expected reports on consumer confidence and existing home sales. Economists were further surprised on Wednesday when data showed that new-home sales rocketed up 13.8 per cent in March from February's number. While economists had expected a slight rebound after February's 10.9-per-cent drop, the jump was much bigger than expected.

The numbers indicated that U.S. house sales are slowing but the market is definitely not in freefall, Mr. Gregory says.

In Canada, housing starts in the first quarter of 2006 turned out to be the strongest in two decades as relatively low mortgage rates, a strong job market and the wealth effect kept people feeling bullish.

At Merrill Lynch & Co. Inc., chief North American economist David Rosenberg says better-than-expected U.S. new-home sales in March are partly a result of price cuts offered by builders.

Mr. Rosenberg sees many ominous signs: Over the past 12 months, actual sales are down 0.7 per cent in the United States, but the inventory level has ballooned 39 per cent and an astounding 85 per cent in the condominium market. This backlog of unsold inventory will only get worse before it gets better, he warns.

Meanwhile, spending on home renovations is slowing, mortgage applications have taken a dive in April, and a recent survey of home-buying intentions recorded the lowest reading since November of 2004.

Plans to buy appliances dropped to an eight-month low, says Mr. Rosenberg, who believes housing bubbles in many areas of the United States could turn to busts.

In Canada, says Craig Alexander, vice-president and deputy chief economist at Toronto-Dominion Bank, rising home prices have been a big reason why the net worth of Canadian households has grown by more than 20 per cent in the past few years.

But Mr. Alexander believes that the wealth that existing homeowners have accumulated is as safe as, well, houses. For most parts of the country, supply and demand will come into better balance and house prices will continue to rise -- if at a more moderate pace. The likelihood of outright declines is very slim, in his opinion.

"When we look across Canada, with the exception of Vancouver, we think what we've been seeing is strong fundamentals driving strong housing markets," Mr. Alexander says. "We don't think there's a bubble in Canada in any regard."

In Toronto, bidding wars are already less rampant as supply and demand come into better balance.

And while he expects markets to lose some steam in Central Canada and the Maritimes, house prices in Calgary will likely continue to climb, he adds.

Like most economists, Mr. Alexander is more worried about the United States where markets in parts of California, Nevada, the Eastern Seaboard and the South have swelled to potential bubbles.

But speculators and investors have been much more active in the United States, the economist says. If they start unloading properties as prices go down, the psychological impact on this side of the border could be significant.

"If you had speculators in the U.S. exiting the market because they discover that they can't make the money they had anticipated, that same message might get sent to Canadian speculators as well."

Mr. Alexander says British Columbia has a strong economy supporting house prices, but he sees signs the markets in Vancouver and Victoria have been driven higher by speculation as well.

"As an asset class, real estate has done extremely well," Mr. Alexander says. "So it isn't surprising that some people might be thinking about real estate as an alternative investment."

Weaker U.S. markets could do a lot to quell that enthusiasm and may even lead to a reversal in overheated West Coast markets, he says.

"At the end of the day, it probably won't alter buying behaviour for Canadians that are looking for homes as a principal dwelling. I think the bigger impact will be on individuals looking for an investment and double-digit returns."

In New York, Mr. Rosenberg's view is that higher interest rates, higher energy costs and a fizzled-out housing market are going to act as significant drags on consumer spending.

It is, he acknowledges, not a view that is widely shared on Wall Street, where investors are loading up on hard assets such as gold, silver and real estate.

Mr. Rosenberg says he is not buying this whole "hard-asset" view: He thinks the hardest asset of all -- the house -- is already rapidly deflating in price and resale prices will likely start to deflate this summer.

This will have considerable impact on consumer spending and saving behaviour, in his opinion, considering that U.S. households now hold real estate worth $20-trillion (U.S.), compared with just $10-trillion in equities.

His advice? Buy bonds.

"While this is not a popular call today, those who decide to start chipping away at this Treasury market with yields moving further above the 5-per-cent threshold may yet come out the winners when we tally the total annual returns by the end of the year."

He sees the current bear market in bonds as a good buying opportunity for investors with at least a one-year time horizon.

Mr. Gregory at BMO Nesbitt Burns still sees some risk in the bond market, but he says bonds could become more attractive in the next few months if the U.S. Federal Reserve Board keeps the brakes on the U.S. economy with interest rate hikes.

For stocks, the outlook is mixed: Lower bond yields are generally good for equities, but a U.S.-led slowdown in the global economy would likely drag down Canada's stock market with its heavy weighting in natural resources, he says.

He notes that some investors fear the Fed could overshoot on interest rates and that a lot of air could rush out of the housing market in a hurry. While he's not expecting the worst-case scenario of a global recession and a collapse in house prices, the risk exists, he says.

"I think it's a legitimate worry."