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Canada – Looking Forward Will We Remain a Safe Harbour in the Storm? October 2008

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Canada – Looking Forward Will We Remain a Safe Harbour in the Storm?

Stormy Waters Ahead The global economy is in the midst of a slowdown that may flirt dangerously with a recession. Why? The answer is clear: crises in the global market for two commodities which come in limited supply: energy and credit. To one degree or another we all have a basic understanding of the credit crunch spurred by the subprime crisis. In 2005 housing prices in the US peaked and in 2006 values began to decline. This resulted in high defaults on subprime and adjustable rate mortgages (ARM). The rights to the mortgage payments, as well as the risk, were sold to institutions throughout the world as mortgage backed securities (MBS) or collateralized debt obligations (CDO). In turn, as the losses from US foreclosures accelerated through 2006, and continue to do so in 2008, it became clear the fallout would be felt on a global basis. As of the end of September, reported global losses tied to subprime were approaching $600 billion. Unfortunately there are many analysts that predict losses will reach as high as $1 trillion as more ARMs are adjusted in 2009-2010 and banks uncover more losses. The US Mortgage Bankers Association reports the number of loans in the process of foreclosure has reached new record highs. The total inventory of homes in the foreclosure process reached 2.75% in the second quarter of 2008 and the share of mortgage loans with overdue payments rose to 6.41% of all mortgages. The collapse of Bear Stearns has been echoed in the rapid downfall and federal intervention to shore up Fannie Mae and Freddie Mac, the cornerstones of the residential mortgage market in the US. Fannie Mae and Freddie Mac combined own or guarantee almost half of the $12 trillion US mortgage market, the demise of which would result in a tidal wave across global financial markets. In addition, the downfall of Lehman Brothers, the rescue of Merrill Lynch by Bank of America, the rescue of Wachovia by Wells Fargo, the seizure of Washington Mutual (the nation’s largest savings and loan) subsequently acquired by JPMorgan Chase, and the federal bailout of AIG (the world’s largest insurance company) points to tumultuous times in the US financial market which will continue to be felt across the globe. European governments are having to step in with major bank bailouts of their own. The UK Treasury Board seized Bradford & Bingley, the second bank to be nationalized in the UK this year. Governments in Belgium, the Netherlands and Luxembourg stepped in to shore up both Fortis (Belgium’s largest retail bank) and Dexia. Germany organized a credit lifeline for bluechip commercial real estate lender Hypo Real Estate Holding AG. Even the government of Iceland has had to essentially nationalize its entire banking system. This could just be the tip of the iceberg.

A Safe Habour in the Storm

To make matters more challenging, escalating oil and commodity prices have been driving up inflation around the globe. A mixture of rapidly growing demand for energy in still booming economies such as India and China, a decline in the number of oil discoveries being made, political instability in top oil exporting countries, and to a degree investor speculation have all played a role in the rapid rise of energy prices. The recent pullback in oil prices at the time of writing reflects the current fluctuating market conditions but in all likelihood prices will stabilize above the $100 per barrel range. Other commodities have also felt upward price pressure due to increasing demand, including food and base metals, fuelling the run up in global inflation. Where prices go from here is anyone’s guess. Due to Canada’s historically paralleled economic performance with the US, many often voice concern that it is only a matter of time before Canada faces the same hardships that the US is enduring. Despite strong ties, Canada is slowing decoupling and becoming more independent. Nevertheless, Canada is unquestionably tied to the world economy. While it would be naïve to believe that Canada would be immune to the effects of a slowing global economy, Canada has the fortunate position of being a resource rich country with a wealth of commodities such as uranium, potash, natural gas and oil at a time where the global demand for these commodities is still greater than ever. This richness will continue to benefit Canada over the long term. In fact, Canada is the only G7 country that is a net exporter of oil. Canada’s oil reserves, mostly held in the oil sands of Alberta, are second only to Saudi Arabia. The careful investments of our largest banks and more conservative Canadian mortgage practices have helped shelter Canada to date from the underlying credit crisis. In fact, a recent Global Competitiveness Report from the World Economic Forum ranks Canadian Banks highest in terms of soundness, closely followed by Sweden, Luxembourg and Australia. However, in a move to ensure credit continues to flow, Finance Minister Jim Flaherty recently announced a plan to purchase up to $25 billion in insured mortgage pools through the Canadian Mortgage and Housing Corporation (CMHC). Given rapidly fluctuating global economic conditions today, the looming question is whether Canada’s foundation will remain solid. Using economic indicator data we will attempt to show how Canada is currently situated to ride out the storm and where, if any, the possible downside risks are to Canada’s longer term economic potential.

02


Table 1. Diversification and Value Offset Volume

Table 2. Crude Materials Grow While End Products Shrink

Distribution of Exports by Location and Total Value

Distribution of Exports by Sector

100%

$150

90%

$120

80%

$90

100%

Billions

75%

50%

25% 70%

$60 0%

60%

90

92

94

United States Japan

96

98

00

United Kingdom Other

02

04

06

Rest of Europe Total Value

08

00

01

02

Crude Material (Inedible) Fabricated Materials (Inedible) Special Transactions Live Animals

$30

03

04

05

06

07

08

End Products (Inedible) Food, Feed, Beverages, & Tabacco Other

Source: Statistics Canada

Source: Statistics Canada

Exports – Rising values and diversification It has been domestic demand, not export growth, bolstering the economy over the last while as net exports continue to weigh on the overall growth of the economy.

In 2000, crude products represented only 12.5% of Canada’s total exports. By mid 2008 that number had grown to 29.6%. Look for crude exports to continue to increase to the US, the world’s largest oil consumer, as the country strives to reduce its dependence on Middle East oil.

It would make sense that the Canadian economy would suffer a trickle down effect whenever the US faces economic hardship since for the last decade roughly 75% to 85% of Canada’s exports have flowed to the US, Canada’s largest trading partner. However, this is not entirely the case. While in the last five years the percentage of Canada’s total exports to the US has decreased from 82% to 76%, the actual dollar value of these exports has increased 18.7% driven by the stronger position of the Canadian dollar. At the same time, other countries are filling the void created by softer US demand. In fact, there has been a 99% increase in the dollar value of exports to the UK and a 107% increase in the dollar value of exports to all other countries excluding the US, Europe, and Japan. Canadian companies have increased exports from $97 billion to $125 billion in the same 5 year period. Even taking into account the rise of the Canadian dollar and demand for natural resources, it is important to note that Canada’s exports are seeing greater diversification enabling Canada to slowly spread its risk and reduce its liabilities with any one country. Despite the credit crunch and rising transportation costs Canada not only continues to flourish as a net exporter, but is also slowly decreasing its dependency on the US (Table 1). Recent free trade agreements with Peru and Colombia and the rapid growth of Brazil’s GDP (expected to surpass Canada in 2008) are just a few reasons why Canada’s exports to South America have been growing rapidly and will continue to do so. In addition to diversifying geographically, the types of exports leaving Canada are shifting to favour crude products such as petroleum, wood, and metal ore. The percentage of exports that are crude products has expanded quickly in the past 8 years (Table 2).

A Safe Habour in the Storm

Exports of end products (which includes motor vehicles, machinery, and other inedible consumer packaged goods) have fallen from 52.0% to 32.4% over the past 8 years while the percentage of fabricated materials (which includes plastic materials, precious metals, and basic wood and metal fabricated products) has remained relatively constant, increasing slightly from 26.2% to 28.8%. Although fabricated materials and end products still comprise 61.2% of Canada’s total exports, it is clear that the strong Canadian dollar and booming resource prices are rapidly shifting Canada’s distribution of exports. While there is no end in site for global demand of resource commodities of which Canada is rich in, the long term sustainable economic growth of Canada, particularly in the central and eastern provinces, will weigh heavily on the country’s ability to invest in the growth of other sectors. In November 2007 the Canadian dollar reached a high of $1.09 US and has since retreated below parity. This softening of the dollar should have a positive effect on Canada’s export volumes as Canadian products become more competitive again on a global scale. With transportation costs rising to historic highs, and increased congestion at existing port facilities, many companies may need to do a cost benefit analysis of offshore just-in-time delivery versus domestic manufacturing activity as well as sourcing the delivery of raw materials and finished goods. This has potential upside for industrial related demand for real estate in Canada.

03


Canada – Looking Forward

Employment and Savings – Paving the way for growth Canada’s unemployment rate hit a 33-year low in 2007 and with low unemployment comes upward pressure on wages translating into increased disposable income for Canadians (Table 3). It is interesting then to look at the overall employment picture and what Canadians are doing with their income. While Canada continues to experience job losses in manufacturing, this isn’t a new trend. The appreciation of the Canadian dollar and the offshoring of manufacturing activity to cheaper production centres have had an impact on Canada and the US for a number of years now. The recent slowing of the US and global economies has only helped to exacerbate the situation further. As previously noted in Table 1, the demand for end products from Canada has been on a gradual decline since 2000, directly affecting the job market in the manufacturing sector, particularly related to the struggling North American automotive sector. However, despite the manufacturing job losses, unemployment in Canada is persistently trending downward as job losses in agriculture and manufacturing have been offset by job creation in other sectors such as utilities, construction, transportation, and professional, scientific, and technical services, many of which are higher paying opportunities. This trade off between manufacturing jobs and other service sector related jobs is also evident by looking at the vacancy rates in the office and industrial space markets throughout Canada. While industrial vacancy rates in central Canada’s manufacturing heartland are softening, office vacancy throughout Canada has been trending downwards. Much of the job growth we have experienced over the past few years has been in office space related jobs, thereby driving the demand for office real estate across the country, which should bode well for the continued health of the nation’s office market. Since 2007 the US has been plagued by consistently weakening labour markets, most recently eight consecutive months of job losses and rising unemployment. Canada has only recently begun to experience this trend reversal in unemployment (Table 4). For the remainder of 2008 we can expect unemployment to fluctuate, partially due to global economic conditions but also due to the cyclical nature of Canada’s unemployment rate. Canada is positioned to continue generating jobs in the long run as the resource market remains strong and a slight recovery in the manufacturing sector follows a forecast weaker Canadian dollar. As the resilience of the Canadian economy becomes more apparent, also expect more foreign investment stimulating job growth in Canada.

Since 2002 the percentage of Canadians working has been growing rapidly, reaching record high levels of employment even through the beginning of the credit crunch (Table 5). Thus, although Canada’s employment statistics have weakened in recent months, Canada continues to experience record levels of unemployment and employment. Exposure for the Canadian economy will come further down the road as the population continues to age and low birth rates persist resulting in a shrinking of the overall labour force unless propped up by net immigration. Canada’s other exposure relates to its labour productivity levels which continue to lag those of the US.

Table 3. Earnings on the Rise Full Time and Part Time Median Weekly Wages $800

$225

$750

$200

$700

$175

$650

$150

$600

$125 00

01

02

03

Full Time Median

05

06

07

08

Part Time Median

Source: Conference Board

Table 4. Unemployment Rate Near Record Low Canada vs US Unemployment Rate 8%

7%

6%

5%

4%

3%

00

01

02

03

Source: Statistics Canada / US Census Board

Will We Remain a Safe Harbour in the Storm?

04

04

04

Canada

05

US

06

07

08


With an understanding of the overall employment picture in Canada, the next logical question is what are Canadians doing with their earnings and how will that help support Canada in difficult economic times? The US has been experiencing a negative personal savings rate since 2005, with savings fluctuating between 0 to -2% (Table 6). Although Canada’s personal savings rate is nothing to brag about, hovering around 2% for the last couple of years, the fact that it remains positive means Canadians are still saving and able to make more investments, which in turn helps drive the domestic economy and create jobs. A comparatively higher historical savings rate than the US is also a strong indicator that during more challenging economic times Canadians will have a greater nest egg from which to draw upon.

Table 5. Employment Rate Surpasses US Canada vs US Employment Rate 65%

More conservative lending practices on behalf of Canada’s banks have also protected most Canadians from the over-leveraged situation in residential housing compared to the US. Many US consumers were using their homes as ATM machines, extracting equity from their homes to finance consumption when interest rates were lower and house prices on the rise - ratcheting up high debt levels as a result. Canadian consumption has been supported more solidly by wage and employment gains rather than housing equity. According to CIBC World Markets, Canadians are carrying less debt per capita, less mortgage debt as a share of income, less consumer debt as a share of income and a higher net worth as a share of income compared to their US counterparts.

64%

63%

62%

61%

60%

00

01

02

03

04

Canada

05

06

US

07

08

Source: Statistics Canada / US Census Board

Table 6. Positive Savings Benefits Canada

Table 7. Down Economy or Housing Correction?

Canada vs US Savings Rate

Canada vs US Housing Resale Price Index (2000 = 100)

16%

200

12%

170

8% 140 4% 110 0% 80 -4%

90

93

96

99

Canada

US

02

05

00

08

Source: Conference Board / BEA

Source: CREA

Will We Remain a Safe Harbour in the Storm?

05

01

02

03

04 Canada

05 US

06

07

08


Canada – Looking Forward

Traditional housing market price activity can be explained by economic fundamentals such as employment, interest rates, inflation and other rational economic indicators. As Table 8 shows, speculation (or non fundamental drivers) has a large role to play in explaining the run up of house pricing in many markets around the globe. In countries such as the US, UK and Ireland 10% to 30% of price appreciation cannot be explained by fundamental drivers. In these markets, pricing corrections are taking place as house values return to their natural levels. Exposure to both subprime and pricing corrections is acting as a catalyst in stalling economic growth, as consumer spending and investments are put on hold with declining home equity. Fortunately, Canada has limited exposure to both and, in turn, the price appreciation in Canada’s housing market between 1997 and 2007 can be explained by economic fundamentals. As such, this lack of speculation bodes well for a more muted market correction. On the other hand the US and the UK are facing record high levels of unsold properties and, while the number of future foreclosures remains unpredictable, an end to the correction looks bleak as the glut of supply continues to increase.

Percentage Increase from ‘97 to ‘07 Not Explained by Fundamentals 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% Italy Spain Japan France Austria Finland Norway Belgium Sweden Canada Australia Denmark Germany Netherlands United States United Kingdom

Ireland

Source: IMF

Table 9. Consistent Housing Starts to Meet Demand Canada Population and Housing Starts 250

34 33

200

Thousand

33 150

32

Population 32

100

31 50

31 30

01

02

03 Single

Source: CMHC / Statistics Canada

Will We Remain a Safe Harbour in the Storm?

06

04 Multi

05 06 Population

07

0

Housing Starts

The first inclination when looking at Table 7 is that the worst is yet to come for Canada, as the market has only just begun to see signs of a housing correction that has been underway in the US and other markets for a while now. However, truth be told, Canada’s correction will neither be as dramatic nor span as long as the corrections being experienced in countries such as the UK or the US.

Table 8. Canadian Growth Justified by Fundamentals

Millions

Housing Prices - A Correction is not in order One of the greatest indicators of the strength of an economy is the fundamentals of its real estate market. While home values in the US peaked in late 2005 and have since fallen by 12%, home values in Canada have had a slightly divergent path, rising by 19% since 2000 to their peak in late 2007, and since falling off by only 6% (Table 7).


Housing Starts – Building only what the market can support A unique way to look at the economic health of the country is to look at the ratio of housing starts in relation to the annual population and household growth. If demand can support the supply, an increasing or stable ratio of housing starts to population growth can mean more investment, more disposable income, more employment generated through construction and trades, and more home ownership or a strong rental market. While both the US and Canada maintain a steady rate of population growth at approximately 1% per year, and rates of household growth at approximately 0.95% in the US and 1.3% in Canada, there has been a significant shift

Table 10. Too Much Inventory in the Market

Millions

US Population and Housing Starts 2,500

305

300

2,000

1,500 290 Population 1,000 285 500

280

275

01

02

Single

03

04 Multi

05

06 Population

07

0

Source: US Census Bureau

Housing Starts

295

in the ratio of housing starts to both population and household growth in the US. Prior to the bursting of the housing bubble in late 2005, the US had 2.1 million units in multi and single housing starts. During the same year Canada had approximately 225,000 housing starts. This means in 2005 for every unit built in Canada, 9.2 units were built in the US. By the end of 2007 this ratio was cut by 36%, with 5.9 units built in the US to every unit built in Canada. In turn, the Canadian market has experienced 6 consecutive years of over 200,000 housing starts. While expected to experience downward pressure this year, Canadian housing starts are still on track to surpass the 200,000 level (Table 9). In contrast, housing starts in the US have dropped off sharply with a build up of unsold inventory and diminishing demand. (Table 10).

In 2004, the US had a run up in the ratio of housing starts to population growth (Table 11), while during the same period Canada began to pull back and stabilize. Since 2005, the US has fallen from building 76% of a unit for every new member of the population to Thousands 47%. During the same period Canada has remained constant at 67%, another strong indicator that the Canadian housing market is in a much different place than the US. Further support for the long term strength of the Canadian economy is the value and quantity of building permits in Canada. Again in Table 12, you can see the rapid run up in residential building permit activity in the US followed by a rapid cool off as the housing bubble burst in late 2005. In contrast, although on a much smaller scale, you can see a steady and consistent climb in the value of housing permits for Canada with the quantity of permits remaining relatively constant. While most economists expect housing to ease in the coming months, they do not forecast the crisis that has been experienced in the US.

Table 11. Avoiding the Ups and Downs

Table 12. US Dips Below Year 2000 Levels

Canada vs US Ratio of Housing Starts to Population Growth

Can vs US Value and Quantity of Building Permits Index (2000 = 100)

0.8

500

400

400

0.7

300

0.6

200 200

100

100

0.5

0

0.4 of New Houses per Additional Member of Population Number 01 02 03 04 05 US Canada

US

Canada

300

06

07

00

01 02 03 United States (Value) United States (Quantity)

Source: US Census Bureau / Statistics Canada / CMHC

Source: CMHC / US Census Bureau

Will We Remain a Safe Harbour in the Storm?

07

04

05

06 07 Canada (Value) Canada (Quantity)

08

0


Disclaimer and confidentiality clause This report should not be relied upon as a basis for entering into transactions without seeking specific, qualified, professional advice. Whilst facts have been rigorously checked, DTZ Barnicke can take no responsibility for any damage or loss suffered as a result of any inadvertent inaccuracy within this report. Information contained herein should not, in whole or part, be published, reproduced or referred to without prior approval. Any such reproduction should be credited to DTZ Barnicke. © DTZ Barnicke Limted, Real Estate Brokerage 2008

Final Thoughts With all the news of foreclosures, layoffs, bankruptcies, bailouts, recession, subprime and credit crunch it is difficult to sort out the fear factor from reality. Should we be worried about the health of the Canadian economy or take comfort in the fact that most fundamentals remain intact? Is this the calm before the storm or are we a safe harbour from the turmoil occurring in the global economy? It is important to review the fundamental indices, before panicking at the newest release of employment, inflation statistics or stock market turmoil. Despite a pull back in consumer confidence, Canadian consumers have more to feel confident about than their US counterparts. Retail sales are still growing, the trade surplus is growing, and housing values and unemployment rates sit at near record levels. While the overall economic

Table 13. Canada Ahead of the Game G7 Total Government Budgetary Balance (National Account Basis) 2 1 0 -1 -2 Percent of GDP -3 -4 -5 G7 Average

Germany

Italy 2007 (Estimate)

France

United Kingdom

2008 (Projection)

Japan

United States

Canada

performance masks the regional differences seen between the resource rich provinces and the manufacturing heartland, the domestic side of the economy remains resilient and this will continue to drive economic activity. Although Canada’s economic potential may be facing some strong headwinds over the near term, these fluctuations are cyclical and if there’s one thing we need to remember it’s that run ups not supported by strong fundamentals often result in a correction – the higher you rise without merit the farther you have to fall! The divergence of the Canadian and US economies is resulting in a widening of the gap for three significant economic indicators – employment, domestic demand, and household credit quality. Theses factors have a tremendous impact on GDP as they play directly into the variables that make up GDP; consumption, gross investment, government spending, and net exports. Therefore as Canada’s economy diverges from that of the US, the GDP growth of Canada will follow suit. Canada’s financial sector has held up despite the volatility in recent weeks. While there has been a forced de-leveraging in equity markets as a result of the credit crisis, credit conditions in Canada are not nearly as tight as other markets. Whereas Canadian money market spreads have widened as of late, they are still significantly lower than that of the US or UK. According to the OECD, Canada is estimated to be running the greatest current account surplus and fiscal budget surplus of the G7 nations, and one of only two G7 nations expected to have a positive budgetary balance moving forward into 2009. While the G7 nations are continuing to show signs of slowing down further, non member countries such as Brazil and China are showing signs of more expansion and will be playing key roles in Canada’s ongoing economic growth. Growth in Canada will likely continue to slow down and perhaps recede in the short term as other large economies continue to pull back and events related to credit shortages continue to unfold. In fact, at the time of writing, all of the major Canadian banks had recently reduced their GDP forecasts for 2008 and 2009. However, while there are plenty of risks to the outlook over the longer term there are also some sound fundamentals to the Canadian economy. It is expected that any slowdown in Canada will be short lived with somewhat modest impact on residential and commercial real estate activity. In difficult times new opportunities are sought after and doors are opened. As emerging markets turn to Canada to supply their growth, international businesses expand their operations into economically sound countries like Canada, and Canada expands its global presence, job growth and the expansion of Canada’s real estate market will ensue. While it would be naïve in this climate not to batten down the hatches and prepare for a rough ride, all signs point to Canada remaining a safe harbour in the storm.

2009 (Projection)

Source: OECD Economic Outlook

Table 14. Total Government Financial Balance G7 Total Government Net Debt (National Account Basis) 100

80

60

40 Percent of GDP 20

0 G7 Average

United States

France 2007 (Estimate)

Source: OECD Economic Outlook

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United Kingdom

Germany

2008 (Projection)

Italy 2009 (Projection)

Japan

Canada

Contact Lesley Yule, M.Sc.Pl. National Director of Research Email: lesley.yule@dtzbarnicke.com

Jeff Cheong, MBA, LEED AP Research Analyst Email: jeff.cheong@dtzbarnicke.com


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