Get Ready for the Fall Selling Season
By Dr. Peter Andersen

The economy is looking stronger. Interest rates are still low and consumer confidence has not been shaken by the oil price spike. Existing home sales have exceeded expectations and are heading for a record this year, which will positively affect new housing markets and renovation. Federal and provincial governments, except for Ontario, have budget surpluses, allowing for more government spending and perhaps even tax cuts.

Job growth supporting housing
Growth in Canada's economy is estimated at about 3.0 per cent. Exports are still soft because of a high Canadian dollar. Manufacturers are pessimistic about the short-term outlook for output and worried about surplus inventories. Nonetheless, service industries and goods-producing sectors not exposed to international competition are doing well. The result is an economy that will provide net employment gains. Manufacturing job losses are causing concern in local markets, but overall the job market will continue to support Canada's housing industry, especially in western Canada.

Interest rates going up
Real GDP growth in the United States is at least a full percentage point above the longer-term trend in capacity. The U.S. economy now appears capable of sustained above-potential growth into 2006, which implies tighter product and labour markets, the return of pricing power, larger wage increases and accelerating core inflation. If so, the Fed is not close to ending interest rate increases.

Watch what the Fed does
By this spring the Fed could have pushed up the rate on three-month U.S. Treasury bills to about 5.00 per cent - double the current rate. Given our expectation of an extended economic expansion, it would be surprising if the yield curve would invert. The yield on the benchmark 10-year U.S. Treasury note, currently around 4.20 per cent, could be 5.25 to 5.50 per cent before mid-2006, pushing the 30-year fixed mortgage rate, currently about 6.00 per cent, up above 7.00 per cent. Canadian rates would follow, but from a lower starting point.

Oil prices have not caused an inflation problem
Apart from the direct effect of higher energy costs, the price of oil can indirectly affect consumer prices in many ways. Motor transport costs affect a wide array of products, and packaging relies heavily on plastics. Building materials are also energy-dependent, directly and indirectly. Nonetheless, the core year-over-year rate of consumer price inflation is only 2.1 per cent in the U.S. and 1.5 per cent in Canada.

Low inflation puts limits on the bank of Canada
The Bank of Canada has inflation as its first priority, rather than other macro-economic indicators such as economic growth and unemployment rates.
With core inflation running this low, the Bank of Canada is expected to begin small rate increases of about 25 basis points each, starting September 7, and similarly in October and December. It will then be a difficult call on whether to increase rates at the January 2006 interest rate date. The result is that Canadian rates, which will climb from a lower level than U.S. rates, may not match the U.S. rate increase pattern. The current effective rate for a variable rate mortgage is 3.50 per cent and the true rate is as low as 4.50 per cent for a 5-year mortgage.

Worried about housing bubbles?
There is no definitive measurement for real estate pricing risk, although affordability calculations are a good place to start.
The National Association of Realtors affordability index reveals vulnerability in American markets, while in Canada affordability has also deteriorated but is still relatively healthy, by historical standards.
Most local market price booms have been followed by price appreciation slowdowns, rather than declining house prices. The residential price "busts" have been in markets with problematic local economies, such as in Calgary and Houston in the mid-1980s when oil prices collapsed. A prerequisite for a housing bubble is an underlying economic collapse, which we don't forecast.
Rising interest rates will not turn a housing boom into a bust and cause problems for U.S. or Canadian economies in 2006. Interest rates would have to rise much more sharply than we are forecasting, and an economic downturn would have to materialize.

Housing starts are deceptively strong
In July, the national housing start rate hit a new high for the year of 242,300 units (seasonally adjusted), up from an upwardly revised rate of 241,300 units in June, prompting widespread increases in housing starts forecasts. Our forecast remains at 220,000 housing starts in 2005 as it had been higher than the consensus. The recent housing start strength is attributable to multiple unit construction, much of which it high-rise condos, while single-detached housing starts are showing large declines, especially in Ontario.
Canada's existing housing market is doing much better than expected. Resale activity is heading for another new all-time high, with large sales increases in Alberta and British Columbia driving the national numbers.

Renovation will be the growth sector
Canada's renovation market seems capable of an annual increase of at least 10 per cent this year and forecasts are in the high single-digit range for 2006. Record level resale activity has built a basis for future renovation spending, estimated at about $40.7 billion this year, up from $37 billion in 2004. Forecasts call for it to close in on $44 billion next year.
Renovation, already larger than new home construction, will be the industry's growth sector. Our long-term housing starts forecast calls for continuing annual declines in starts throughout the rest of this decade. Fortunately, continuing high levels of immigration will support Canada's housing markets. Last year, 235,800 immigrants came to Canada, for the fifth consecutive year of more than 200,000. HB