The Pending Canadian Crisis

Wise financial practice states not to spend more than you make. This practice done correctly keeps you out of tight situations and gives you the ability to weather storms that inevitably come your way. The same practice applies to countries as well. When an economy is running hot, companies and individuals take on too much debt because interest rates are low, and the debt is easy to borrow. Their goal in doing this is to maximize every ounce of cash they can get their hands on for growth. Income may be steady or rising during this time, and there seems to be no care in the world to finance that next purchase.

However, an economy does not always run hot. When downturns occur, the spending these individuals and businesses did on credit can really come back to bite them. This cycle occurring at an individual level is troublesome, but when it happens at scale, serious economic repercussions begin to unfold. Monitoring for troublesome debt levels is where the debt-to-income ratio provides great high level insight. A debt-to-income ratio of 100% means to pay off your debt, it would take 100% of the income you brought in for the year to go right toward paying off the debt. That practice would not leave a dime to be spent on outside expenses. This practice is not feasible for most companies or people. Unless you had a huge savings of cash on hand, the only way the debt burdened lifestyle is maintained is by paying small payments on the debt plus interest until it can reach manageable levels again or defaulting on the debt occurs.

Canada currently has a debt-to-income ratio for the average consumer of over 180%. Compare this to the Great Financial Crises (GFC) in 2008 where America had a debt-to-income ratio of 120% at the peak. The average Canadian consumer is already well above this mark and that trend is not showing any signs of reversal as seen in Chart 1 below.

Chart 1: Household Debt to Income for Canada From 2004-2022 (Source: Koyfin)

With the average Canadian consumer in a very fragile financial position, it is a matter of time before a spark ignites this potential debt spiral the whole country has been building for decades. And I believe that spark was just lit in 2022.

Variable Interest Rate Mortgages Are Becoming Standard in Canada

In the United States, mortgages are mostly acquired at a fixed interest rate over the life of the loan. This practice allows the borrower to know exactly their payment schedule upfront each month for up to 30 years. The borrower then can plan their spending around this major payment that usually makes up 50% or more of their income. When mortgages are put on variable interest rate schedules though, the borrower’s financial situation can change in a hurry. Most families budget around this very large chunk of their income, and a major swing to the upside could wipe out all their discretionary spending.

Canada has more than 50% of all new mortgages on variable interest rates now because the spread between the variable interest rate mortgages and fixed interest rate mortgages is the largest it has been for years. Banks entice individuals with variable interest rate mortgages by lowering the first-year’s interest rate below the fixed rate mortgages. This looks attractive at first, but once the loan begins, the interest rate can rise and more than offset the incentive of the first year’s lower interest rate. Bank’s profit off this tactic handsomely. Variable interest mortgages also make up roughly 30% of all outstanding mortgages in Canada according to a study done at Bloomberg. This means that 30% of Canadian homeowners are at high risk of having their monthly expenditures disrupted as mortgage rates climb with rising interest rates. The Bank of Canada has raised interest rates already this year, and it raised rates by another 0.75% in September alone. Additionally, the Bank of Canada is expected to continue the interest rate increases in October. In January 2022, the bank’s rate was 0.25% and in the last 9 months, the rate has climbed to just over 3%. This amount does not seem material at first, but lets look at it from a consumer perspective. A 1.25% increase in a mortgage rate with a balance of $400,000 and an original interest rate of 4% is equivalent to a monthly payment increase of $300. For this example, we can assume most variable rate mortgages increased by at least 1.25% this year, with some increasing even more. A few borrowers may be running their budget lean and could absorb that $300 monthly increase in mortgage payments, but with inflation at 40-year highs and debt-to-income ratios of 180%, do you believe everyone will take a $300 increase in monthly housing payments in stride? What about a $600 increase if the Bank of Canada raises interest rates for the rest of 2022? If we take the GDP from Canada in 2021 as a benchmark, a $300 monthly decrease in discretionary spending for 30% of Canadian households equates to 0.5% of annual GDP. This is conservative. At $600, this gets to be over 1% of annual GDP for Canada just in interest expense from rate increases in 2022 alone and that is just the beginning. We have not even looked at inflation costs for food and energy, which is covered next.

Chart 2: Variable Rate Mortgage As A Percent of New Canadian Mortgages From 2013-2022 (Source: Bloomberg and Office of the Superintendent of Financial Institutions)

Chart 3: Variable Rate Mortgage As A Percent of Total Canadian Mortgages From 2016-2022 (Source: Bloomberg and Office of the Superintendent of Financial Institutions)

Canada’s Economy Is Not Insulated For This Coming Financial Shock

According to Statista, the Canadian economy is primarily concentrated in Real Estate, followed by Energy/Mining, Financials, Manufacturing, and Construction. This seems rather diversified on the surface, but digging in a little deeper you can see the cracks appear. To start, having variable interest rates on a large portion of mortgages could cause a severe problem in the Real Estate and Financial sector as borrowers default on loans or are priced out of the market completely. This would have a cascading effect on the economy as not only would defaults effect the Financial and Real Estate sectors, but if someone cannot pay their home mortgage, the chances of them paying for more manufactured goods and new construction projects will be low as well. Only with the issue of an increase in mortgage rates we discussed earlier, four of the top industries in Canada are going to suffer downturns. Adding to the storm, food inflation is the highest it has been since the 1970’s. As you can see in Chart 4 below, the last time food inflation in Canada stayed persistently above 8% was in the 1970’s when food inflation hit over 20% per year. I am not predicting for food inflation in Canada to reach these levels again (though it is possible), but even a sustained period of food inflation above 8%, on top of housing payments increasing for a large portion of Canadians, will drastically reduce discretionary consumer spending in the economy in all five of the major Canadian industries.

Chart 4: Food Inflation In Canada From 1955-2022 (source: Koyfin)

The energy sector in Canada does have a tail wind recently with higher oil prices, but the weak Canadian dollar in the face of strong commodity prices is not a great set up for Canada. Adding to this, if Canada goes into a recession, the population will be spending less on travel and goods, which will hinder the energy sector for Canada overall. I believe the energy sector has artificially propped up the Canadian market so far in 2022.

Polarizing Political Decisions Growing In Canada

The last piece of the puzzle here is politics. This trend is certainly not unique to Canada, however political decisions are a major concern for the Canadian country and economy. Canada has long been viewed as a safe haven for foreign assets, especially in the real estate market. This does not seem to be the case anymore after the trucker protests early in 2022 caused the Canadian government to freeze the assets of hundreds of people without due process. This is a major red flag for investors and foreign assets that were previously pouring into the country. If the Canadian government would freeze the assets of its people in an instant, what happens if the country does not get along with the foreign countries these investors are from and does the same thing to their foreign assets parked in Canada? Foreign investors will begin divesting assets from Canada causing price declines for Canadian citizens. At first these price declines would seem beneficial for Canada. However, further investigation says the opposite as selling begets more selling, and that could cause a panic in markets with an economy that is already fragile.

In conclusion, the increasing mortgage rates and food inflation is causing a strain on Canadian consumers. As discretionary income becomes less plentiful, the fragile economy will begin to crack causing further stress on the economy. Additionally, foreign investors have little incentive to move money into Canada after seeing recent political decisions unfold. The weight of debt piling on Canada’s economy for decades is about to break through. It takes only one spark and a little bit of kindling to build a forest fire. All of the pieces seem to be in place for Canada’s economy to take a serious hit.

Disclosure: Funds Tetelestai Capital controls are short Canadian stock indices

Note: This post consists of high level commentary on research conducted by Tetelestai Capital, LLC into Canada and related investments. Though compelling, your own research should always be done before investing into any security. The risks mentioned in this post are not all encompassing either. This post should not be viewed as investment advice. Tetelestai Capital is not associated with any of the investment companies or products mentioned in this post. If you have any questions about the research Tetelestai Capital conducts, please reach out through the website for more information.