Housing improvement on the horizon
We believe the North American housing market has bottomed. This is not to say we forecast a massive near-term rebound, but if we are correct, it will support our long-standing view that a sharp recession is not a foregone conclusion, despite what a multitude of bears are saying these days. Also, it provides some interesting investment opportunities in the U.S. and Canada in the form of home renovation giants such as Home Depot, along with Canadian banks and multi-family REITs.
BMO’s Chief Economist, Doug Porter, puts it very well: “one could make the argument that if the big forecasting mistake almost everyone made in 2022 was to underestimate inflation… the big mistake 40% of the way into this year appears to be that almost everyone has underestimated the resiliency of the economy… the jobless rate is flagging precisely zero weakness, matching 70-year lows... for every sour note, a positive signal pops up somewhere else. The blow-out quarterly report from Nvidia, driven by AI demand, is but one example of pockets of real strength. Even the housing market is showing a pulse, with new home sales grinding higher from last summer’s lows.”
Specifically, home prices and building permits in Canada, and the all-important NAHB (National Association of Homebuilders) Index in the U.S. increase our conviction that the North American housing market has, in fact bottomed. Canadian housing in April saw 1) home sales, 2) new homebuilding, and 3) prices move in the right direction. Existing home sales jumped 11.3% in seasonally adjusted terms from the prior month. Aside from the snapback caused by the lockdowns in 2020, that's the largest monthly rise since 2009. Separately, CMHC (Canada Mortgage and Housing Corp.) reports that housing starts popped 22% in April to a solid 261,600 units. This marks the highest level of starts since last November. The Home Price Index rose 1.6% month-over-month, the second consecutive increase following a steep 11-month descent.
This is no doubt related to increased clarity on interest rates; the Bank of Canada (“BoC”) and the U.S. Federal Reserve (“Fed”) are most likely already on pause or will be very soon. This matters greatly since housing and all related activities constitutes over 15% of Canadian GDP (residential investment is 8% by itself).
South of the border, it was recently reported that U.S. builder confidence in the market for newly built single-family homes in May rose five points to 50, according to the NAHB/Wells Fargo Housing Market Index (“HMI”).1 This marks the fifth straight month that builder confidence has increased and is the first time that sentiment levels have reached the midpoint mark of 50 since July 2022.
Over the last 18 months, we have frequently stated our preference for Canadian over U.S. equities due to better recovery potential for some large sectors (i.e., Energy, Materials and Industrials) and cheaper valuations among others. Another argument in our favour – albeit a longer-term one – is demographics. Canada’s population growth is far higher than most industrialized countries and certainly the U.S.; a trend that is particularly supportive for Canada’s long-term housing market health.
Multi-family REITs: Interesting derivative play on housing recovery
While REIT revenues are driven by rental rates rather than single-family housing prices, they do benefit from a migration toward rental properties when prices rise too much or too quickly for condos and houses. Accordingly, we think that they will continue to have pricing power (i.e., benefit from outsized rent increases) for the foreseeable future.
Case in point, CAPREIT, the largest publicly traded multi-family REIT in Canada, just reported an average turnover spread (the price increase when new tenants move in) of +26.7% in the Canadian residential portfolio (vs. 10.2% in Q1/22 and 24.3% in Q4/22). Generally, BMO REIT’s analyst Mike Markidis considers CAPREIT “a core holding for investors seeking broad-based exposure to the multi-family residential market in Canada, which is experiencing strong population-growth driven demand and a chronic shortage of new supply”.
Technical analysis
The S&P/TSX Composite Index is currently reversing back to the upside from a successful test of a major support level (this time it is a rising long-term trendline) accompanied by new buy signals in daily momentum gauges. The set-up in short-term momentum gauges are similar to the October, December and March lows which resulted in 15.47%, 8.8%, and 8.4% rallies respectively, and there is no reason to think this time will be any different. In terms of upside potential, there really is not any significant price resistance until the February peak at 20,843. A breakout there would open an upside swing target that measures to 22,531 which is only slightly above the all-time high at 22,213.
Canadian banks - Despite the earnings misses in late May, the S&P/TSX Bank Index still looks like it is in the late stages of a basing/bottoming process (the transition phase between a bear market downtrend and a bull market uptrend). A close above resistance at 4,300 in the Index would signal the beginning of a new long-term uptrend with an initial upside target that is measurable to 5,014. New buy signals in short-term momentum gauges suggest the next major move here will be to the upper end of the base.
Rate hikes are back on the table!
After pricing rate cuts for 2023, the short-term rate market reverted back – again – to pricing further tightening of monetary policy in the near future. A similar pivot was also observed at the longer end the yield curve as the combination of surprisingly stronger economic data and slow progress on the inflation front took precedence over the U.S. banking sector and debt ceiling issues. In just four weeks, markets have come to realize that inflation will be slower to trend back toward 2%, slimming the odds of a policy pivot this year barring any major economic downturn. Gone are the expectations of a BoC rate cut, with the market now expecting one more rate hike in the coming months. Markets continue to expect the Fed could be forced to cut, but this is gradually being pushed into 2024, only after considering further tightening this year that could have a greater impact on the economy.
As much as we argued against rate cuts this year, we could also question whether the BoC and the Fed have done enough and if there is appetite to raise again. Considering the swift tightening pace and the usual lag for the impact, it may be too early to judge its success yet. This leaves the status quo as the base case scenario for the June meetings. We admit though, the case for hikes is building up again. Following the upside Canadian monthly and quarterly economic growth surprise, BMO’s economist, Doug Porter, concluded that “the run of sturdy data undoubtedly raises the odds that the Bank of Canada needs to go back to the well of rate hikes, and even puts some chance on a move as early as the next policy decision. However, given the uncertain backdrop and the possibility that inflation took a big step down in May, the BoC could opt to remain patient for a bit longer and signal that it's open to hiking in July if the strength persists.”
Similar results in the U.S. has led some Fed voters to become vocal about the potential need for higher interest rates and revived the odds of a hike. However, at the other end of this argument, is the fact that since the May hike, the real policy rate turned positive and is expected to rise gradually assuming the Consumer Price Index continues to trend lower. This has historically been an indication that the end of the cycle is near.
The most recent pullback in interest rates leaves markets better aligned with the resiliency of economies and the persistent inflation which supports a higher-for-longer narrative. More importantly, it removes the market exuberance in pricing an early policy shift which, barring a major economic downturn, was difficult to foresee. That leaves us with higher rates and attractive opportunities from an income perspective and again offers optionality for greater portfolio risk diversification. We admit the market volatility is daunting, but the good news is that the back-up in yields provides another opportunity for investors to take advantage of current conditions.
Looking forward, we believe bonds will continue to earn their yields, but the potential for capital gains may be more limited in the short term. We continue to recommend maintaining a better-quality bias when selecting corporate credit exposure as the risk for a recession remains. High-yielding short-term securities are definitively compelling with risk-free treasury bills flirting with 5% and GICs yielding above that level. However, considering the current inversion of the yield curve, we believe that a short-term allocation should be combined with a more long-term strategy. This will mitigate future reinvestment risks and should help lock in higher returns for longer.
Please contact your BMO Nesbitt Burns Investment Advisor if you have any questions or would like to discuss your investments.
1 The survey also asks builders to rate traffic of prospective buyers as “high to very high,” “average” or “low to very low.” Scores for each component are then used to calculate a seasonally adjusted index where any number over 50 indicates that more builders view conditions as good than poor.
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