The Bank of Canada has increased its key policy interest rate five times over the last year-and-a-half. This represents the largest sustained increase of the rate in almost 13 years. Over these 13 years, Canadians responded to the downward trend in rates by increasing their borrowing (rationally, some would say).
Mortgages, which account for 70% of all household debt, have been the biggest driver of Canadians’ increased indebtedness. That’s why a great deal of attention has been paid to the domestic housing market. But, historically, housing has taken time to respond to shocks. The next chart shows that during the early 1990s bear market in Toronto housing, home prices didn’t decline until 10 months after sales volumes declined, and mortgage delinquencies didn’t peak until three years after sales volumes declined.
Outside of housing-related purchases, automobiles are the most expensive item people typically go into debt to buy. The next chart shows the Bank of Canada estimates that, next to housing, vehicle purchases are the sector most sensitive to rate hikes. And as consumers tend to buy cars more frequently than they buy homes, vehicle sales can offer a timelier window into the habits of indebted consumers.
The following chart illustrates that Canadian drivers wasted no time in responding to the all-time-low interest rates that accompanied the recession in 2009. Over the ensuing eight years, new vehicle sales skyrocketed, surpassing the long-term growth trend in the population of drivers.
To buy more cars, half of Canadian purchasers in 2018 took on loans that amortized over seven years. To put in perspective just how incredibly long this is for a car loan, the Financial Consumer Agency of Canada estimates that an SUV purchased with an eight-year-term loan would have negative equity until the seventh year.
But who wants to wait seven whole years for a new car?!? Certainly not indebted Canadians! J.D. Power estimates that 30% of Canadians who trade in for a new car have negative equity on their old one. In other words, not only are these Canadians paying for a new car, but they’re also still paying for an old car that they can’t even drive anymore!
Trading in a car with negative equity may not be the most financially-prudent decision, but when interest rates are near zero it isn’t the most expensive proposition. Rising rates change this calculation. And to Canadian drivers’ credit, they seem to be realizing this is the case. The next chart shows that auto sales in November fell 9.4% year-over-year (“y/y”), the ninth-straight month of declines. The 9.4% fall in November represents the largest y/y decline since 2009. Things were even worse for the North American automakers, with sales at GM down 18.3% y/y, Ford down 10.7% y/y and Fiat-Chrysler down 35.1% y/y. Is it any wonder that GM decided to close five North American manufacturing plants in 2019, including the one in Oshawa.
Source: DesRosiers Automotive Consultants Inc., BMO Capital Markets Economics
So what does this mean for the Canadian economy? Are households finally starting a deleveraging process? Will this lead to a balance sheet recession? Will housing prices crash?
Fortunately for us, we don’t have to make any of those predictions. But that doesn’t mean we aren’t uninterested. We recently evaluated the equity of GM (GM-NYSE) as a potential investment for our portfolios. Its valuation metrics certainly looked cheap: 4.9x P/E ratio, 14% free cash flow yield, 2.5x EV/EBITDA multiple. But because of concerns similar to the ones raised above, we concluded that these metrics were all based on peak sales from the automotive industry. As a result, we decided not to buy the equity.
In the future we will be equally cautious about any company that derives a disproportionate percentage of sales from indebted Canadian consumers. Eventually, Canadians will have to pay the piper. We believe that day is drawing nearer.