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Capital Debt Market Update - Spring 2022
March 7, 2022
Back to normal? And what will normal be?
It is almost 2 years since the onset of a world changing dynamic. Lock downs have altered our habits, changed how we work and created unprecedented low interest rates. While there have been short periods where the pandemic was not disrupting the economy and the well being of our society, learning how to live within the bubble has become a fact.
We have all adapted to this in different ways. Though we continue to have personal and governance restrictions impacting us all, on a broader basis this does impact the business environment. Each person or corporation has to make decisions based on perceived comfort levels. At the same time “Covid fatigue” is becoming more normal while other factors are influencing how we see the coming year impacting the availability of debt and the trend in borrowing costs. So, what will create the biggest impact on the real estate lending market over the coming year. Inflation has set a 30 year high but how much of that is the elastic rebound resulting from emergence out of the pandemic. Supply chain issues continue to impact the delivery of materials for the construction industry creating a host of issues. The ability to control prices for construction materials has all but vanished for most and the labour market remains an out of balance sector of the economy.
Since the 50’s the response of the Bank of Canada to battle inflation was to suppress inflationary pressures by increasing interest rates. This model is based on both wages and prices having a direct correlation, with unemployment and inflation traditionally having an inverse relationship or, inflation is low when unemployment is high. The uncharted territory we are about to enter into might require guidance that is not based on historic approaches. From a period where Quantitative Easing was implemented to support our economy, to the coming Quantitative Tightening approach, interest rates remain attractive based on historic analysis. Statistics indicate that the BoC currently owns approximately 42% of the bond market as contrasted to the US which owns 28%. The maturity profile suggests that in the order of 50% of bond holdings mature by the end of 2024. Careful attention to how the BoC deals with this component of the balance sheet may have more direct impact on inflation and change the narrative on where/when interest rates stabilize.
It gave me pause to remember that in the mid-70’s when wages were increasing at double digit numbers annually and inflation was running at between 8% - 12%, the Federal government imposed wage and price controls through both mandatory and voluntary structures. The finger was pointed at wage increases (12% to 14%) as the primary driver, and in the end the programs were deemed to have been failures. One can only hope that this lesson has been learned.
On the bright side, real estate transactions and debt placements through 2021 were occurring at an accelerated pace and are spilling over to 2022. The availability of debt capital remains strong in Alberta, and as usual, most competitive in British Colombia. In Alberta net migration for the 3rd quarter of the year was 16,690 as contrasted to the same period in 2020 which was negative 1,214. Lower cost housing and greater job opportunities are cited as the keys. This should continue throughout 2022 and have a positive influence on the real estate markets.
Looking forward there is a strong sentiment that The Bank of Canada (BoC) will raise rates, the question is when? Although the current health measures in some provinces and Covid impacts on the economy may cause the increase in rates to be delayed there is another major factor that is driving the rate decision, that being consumer price inflation (CPI). In December, CPI hit its highest level since 1991, and in consecutive months has well surpassed the Bank target of 1% - 3%. The Bank of Canada has forecasted that rate increases are certain in 2022 rather than the original forecasts early in the Covid epidemic which suggested 2023. The inflation we are experiencing is a key driver.
The Bank has a difficult decision to make balancing their “tools” to combat inflation and the fact that a large portion of consumer debt is based on floating rates which would put many Canadians in a position where they do not have the capacity to make debt payments, especially once Government supports are no longer in place. Housing prices are also a concern as fewer individuals will be able to service loans or qualify for new home purchases if their mortgage rates increase. We do know that the Bank will use interest rates as one of their main tools in combating inflation, but it is yet to be seen if the economy is strong enough to handle this increase. Although the decision on the Bank rate has a correlation to bond rates, we are under the assumption that this has at some level been priced into the sharp increase we have seen in the bond market over the past few months. This can be further proven by the fact that bond rates seem to have somewhat stabilized since the first announcement, though they are trending higher. Although, we have become used to an extremely low-interest rate environment the imminent increase in rates is not doom and gloom as we are moving towards a healthy rate environment for the economy.
The cherry on top: Tax hikes. The federal government increased its carbon tax and alcohol taxes twice during the pandemic. Taxes now make up between 31 and 42 per cent of the pump price of gasoline, depending on the province. Taxes also account for about half of the price of beer, 65 per cent of the price of wine and more than three quarters of the price of spirits.