August 2015 Canada s debt burden By Richard J. Wylie, CFA Vice-President, Investment Strategy, Assante Wealth Management Much ink has been spilled over the past several years regarding the extent of the debt burden on Canadian households. The Bank of Canada has made it clear that household debt is a growing problem. In a largely overlooked report, Statistics Canada announced on June 12, 2015 that Canada s household debt level had actually declined during the first quarter of 2015. The reversal was nominal, but it raises questions about the future direction of accumulated household debt and its economic implications. While debt is a financial tool used by many Canadians, seeking professional financial advice can help reduce the risks associated with taking on debt. 170 160 150 140 130 120 110 100 90 80 Q1 1990 Q1 1996 Q1 2002 Q1 2008 Q1 2014 Canadian household debt As a percent of disposable income As can be seen in the above graph, the reasons for these concerns are justified. While the ratio of credit market debt to disposable income moved lower in the first quarter, it did so only marginally, and from an all-time high. This figure stood at 163.6% in the final quarter of 2014 and edged down to 163.3% in the first quarter of this year. When the fourth quarter statistics were released, some analysts pointed out that the 1 of 6
figures were higher than a similar ratio reported in the U.S. immediately preceding the Great Recession of 2008-09. Other analysts pointed out that, like many other statistics, the figures published by Statistics Canada were calculated differently than their U.S. counterparts. Regardless of the actual debt level, Canadians typically have a greater equity stake in their homes than Americans, and this tends to be the largest asset offsetting the debt. Assets and debt servicing Unlike the U.S., where interest paid on mortgages is deductible for income tax purposes, the Canadian homeowner faces a different set of tax rules. As well, the experience is further differentiated by the more stringent mortgage lending policies that prevail in Canada. This has resulted in a relatively stable debt-toasset ratio even through volatile market periods. As can be seen in the graph below, there was a slow rise from the low of 15.3%, established in the second quarter of 2000, to the pre-financial crisis level of 17.7%. Asset valuations, particularly those of financial assets, were reduced significantly during the crisis and the figure rose to a high of 20.3% during the first quarter of 2009. The ratio has subsequently retreated to the 17.8% figure reported in the first quarter of 2015. Even with these swings, the ratio has moved in a narrow range for approximately 25 years. 25 Debt to assets As a percent of total 20 15 10 5 0 Q1 Q1 1996 Q1 2002 Q1 2008 Q1 2014 2 of 6
One of the key implications of the low interest rate environment has been the commensurate reduction in the cost of servicing debt. Even as the debt to disposable income ratio has increased, the debt service ratio (interest costs as a percent of disposable income) has fallen. As can be seen in the chart below, in the first quarter of 2015, this ratio stood at 6.4%, the lowest level reported since these statistics were first recorded in 1990. 11 10.5 10 9.5 9 8.5 8 7.5 7 6.5 6 Mortgage and consumer debt service ratio Interest paid as a percent of disposable income Q1 1990 Q1 1994 Q1 1998 Q1 2002 Q1 2006 Q1 2010 Q1 2014 Interest rates The underlying effect is that even though the debt burden is higher, it is more affordable in a lower interest rate environment. As well, although the Bank of Canada has been vocal about its concerns over household debt, it cut interest rates again on July 15, 2015. As can be seen in the next chart, this was the second downward adjustment of 2015 and it took interest rates back to the level previously established on March 3, 2009, during the financial crisis. The press release that accompanied the announcement underscored the bank s concerns over domestic economic growth rather than worries that it would inadvertently foster additional debt accumulation. Nevertheless, interest rates in the U.S. now appear poised to move higher. Even though rates will likely move higher stateside before they do domestically, they will likely rise here eventually. 3 of 6
% 14 Administered interest rates 12 10 U.S. - Fed funds Canada - Bank Rate 8 6 4 2 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Source: U.S. Energy Information Administration Job market Through monetary policy, the U.S. Federal Open Market Committee s mandate is to foster maximum employment and price stability. While the Bank of Canada does not have the same statutory mandate as its U.S. counterpart with respect to employment, it still looks to the relative health of the Canadian job market as an indicator of whether or not there are likely to be wage-driven inflationary pressures in the near term. As can be seen in the next graph, the pace of Canadian job growth can be best described as lacklustre. With employment growth hovering near the 1.0% mark, there is clearly no imminent threat of a tight labour market translating into inflationary pressures. 4 of 6
5.0% Canadian employment growth 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Inflation The annual change in the consumer price index in Canada fell from 2.4% in June 2014 to 1.2% in March 2015. Amid the drop in overall price pressures, the Bank of Canada s target core rate which, among other items, strips out energy prices, actually rose from 1.8% to 2.4% over the same period as shown in the next chart. Since then, it has shown little material change. In either case, the weak economic environment is unlikely to result in a significant acceleration in inflation over the near term. As a result, the risks of a dramatic upward shift in interest rates as a response seems remote and it is widely expected that when rates do rise, they will do so gradually. However, even if an individual s debt load is not a concern at present, it would be prudent for all borrowers to examine the implications for their own borrowings before any interest rate hikes emerge. Taking advantage of professional financial advice can help to alleviate concerns about the impact of rising interest rates. 5 of 6
3.5% Canadian core inflation 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Bank of Canada target band 0.0% 2008 2009 2010 2011 2012 2013 2014 2015 Source: Bank of Canada, Statistics Canada Conclusions A direct comparison of Canadian and U.S. debt figures may be misleading. However, there is no doubt that Canadians now face a debt burden that is greater than historic norms. At present, interest rates remain near all-time lows and the debt burden is affordable. By the same token, rates cannot be expected to remain this low forever and any increase will negatively impact this affordability. Interest rates are soon expected to rise in the U.S. While economic fundamentals suggest that the Bank of Canada s interest hikes will not follow immediately, it is likely that they eventually will. Making use of professional advice for all aspects of one s personal finances ensures that borrowers and investors are well positioned for changing market environments. The information contained herein consists of general economic information and/or information as to the historical performance of securities, is provided solely for informational and educational purposes and is not to be construed as advice in respect of securities or as to the investing in or the buying or selling of securities, whether expressed or implied. Neither Assante Wealth Management (Canada) Ltd. nor its affiliates, or their respective officers, directors, employees or advisors are responsible in any way for any damages or losses of any kind whatsoever in respect of the use of this report or the material herein. This report may not be reproduced, in whole or in part, in any manner whatsoever, without the prior written permission of Assante. Copyright 2015 Assante Wealth Management (Canada) Ltd. All rights reserved. 6 of 6