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How Does The Economic Cycle Affect You?

How does the economic cycle affect you?

By Misael Lizarraga

Statistics Canada released its third-quarter report on national wealth at the end of last year, and it showed that Canada’s total GDP is currently at over $2 trillion, and the national wealth is valued at around $11.415 trillion. Of that total amount, real estate holdings make up $8.752 trillion, which is around 76% of the total national wealth

Because purchasing a home is the largest purchase that most people will ever make in their life, it really shouldn’t surprise us that it makes up such a large percentage of the total national wealth. And while 76% is not the highest nor lowest it’s ever been, it is still a very large number.

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Now that fewer homes are selling, inventory is rising, and Vancouver home price tags are falling, it’s not hard to see why many homeowners are beginning to sweat. Are we finally in the beginning of a recession? And if so, how much will real estate prices drop? If you’re a homeowner, should you cut your losses now, and potentially sell your property at a loss, or should you wait?

Before you make any major decisions, it’s a good idea to review how economic cycles work, and how its ups and downs affect your real estate holdings.

What is the economic cycle?

All modern economies experience significant fluctuations in economic activity, and the Canadian economy is no different. In some years we see that industries are booming, unemployment is low, and interest rates are low. In others we see companies closing, unemployment rising, and general pessimism dominates financial news. When the economy is doing well, we call it a period of expansion or boom, while a period of economic contraction is called a recession (and if it’s bad enough, a depression).

The stages that occur between a contraction and expansion and a contraction again is called an economic cycle (or a business cycle). A full economic cycle is generally divided into 4 stages in order to facilitate its study and make it easier to understand which stage we are currently in.

Stage 1: Expansion

During an expansion phase, consumer confidence is high, interest rates are low and credit is easy to obtain. New homebuyers have an easy time qualifying for mortgages, and home sellers have an easy time selling their properties. Investors are having the time of their life, since they can easily obtain capital and their current investments are steadily appreciating.

As demand for more products increase, business owners increase their production, and hire more workers.

Because of heightened demand, the cost of products goes up, and inflation goes up. A little bit of inflation isn’t bad, but if not controlled it can get out of hand.

Stage 2: Peak

During the peak stage, the economy is running at maximum capacity. Unemployment reaches historical lows, incomes are on the rise, and GDP is growing at a strong pace. On the other hand, prices continue to rise due to inflation. At this point, the central bank will need to change its economic policy in order to slow the economy down, and mitigate the effects of a recession.

During a peak, it’s easy to spot inflated assets. But because everyone involved in purchasing those inflated assets is making money, caution is thrown into the wind. Investors who fear missing out begin to take more and more risk, in an effort to outperform the market, and hopefully sell before the asset goes through a price correction.

Unwarranted optimism, commonly known as irrational exuberance, is prevalent during a peak. Some economists and speculators may even fool themselves into thinking that the market will keep growing forever, and the media may even claim that the current economic climate is the new normal. But reality catches up quickly.

Stage 3: Contraction

Several factors can trigger a contraction. The Bank of Canada could raise its interest rates too quickly , asset bubbles burst and cause a domino effect leading to a financial crisis (as happened in the US in 2008), or inflation gets out of control.

Whatever triggers a contraction, one thing is sure: runaway optimism is immediately replaced by caution and sometimes panic and despair. Investors change the game plan and often sell assets in order to put their money into more stable currencies, precious metals such as (especially) gold, or government bonds.

Because demand for products drop, companies cut their operations costs. A common way in which they do so is through layoffs. Unemployment goes up, and many homeowners who bought near the end of the cycle find themselves with mortgages worth more than the current value of their home. Some homeowners will default on their mortgages and lose their homes, though this is phenomenon is less prevalent in Canada than in other places, such as the United States.

During a contraction, people go into survival mode, save up their money and only buy necessities. At this point, the government will take measures to stimulate the economy, and the Bank of Canada lowers its interest rates to incentivize more spending.

Stage 4: Trough

We only know if the economy is in a trough after the fact, since a contraction can be followed by another contraction. Once the economy hits its lowest point, consumers won’t start spending unless confidence grows.

In order to incentivize spending, the government will use all its tools available to jump start the economy again. That could include building new infrastructure which carries lots of new jobs, tax cuts, and further drops in interest rates. Little by little confidence returns, the economy starts to grow, and the cycle repeats itself.

Where are we in the economic cycle?

According to Statistics Canada, we currently have the lowest level of unemployment we have ever had since it started tracking this data more than 40 years ago. At the beginning of the year, the government implemented mortgage stress tests, and the Bank of Canada has been steadily increasing its interest rates. The annual rate of inflation fell to 1.7% in November from 2.4% in the previous month; still positive, but slowing down.

All of this seems to indicate that we are either at the end of the expansion stage, or in the beginning of the peak stage.

Housing prices are dropping in Vancouver, should I sell my house before the market goes into a recession?

It’s easy to get nervous when you see prices drop, especially if your home managed to build quite a bit of equity since the last market downturn. It takes nerves of steel to not get caught up in the doom and gloom that happens every time we hit a recession. But let’s remember that you only realize a gain or loss on a home when you actually sell it. And even in the middle of the Great Recession of 2008, housing prices dipped, but quickly recovered any lost value in less than 12 months.

The average home owner should view their home as a long term investment which will be subject to the ups and downs of the market. Historical data clearly shows that home prices trend up in the long run.

If you’re already struggling to make your monthly mortgage payments, then maybe you should consider selling, especially if your mortgage term is coming up for a renewal. We have good reason to believe that the Bank of Canada will raise its overnight interest rates again in 2019, which will cause variable rate mortgage terms to increase. Some mortgage holders are looking to lock in their rates now, though that comes with an immediate increase in their monthly payments.

However, one of the few good things of an economic contraction is that interest rates are immediately dropped, making it easier to make monthly mortgage payments.

Whether you choose to sell your property now, or hold on to it for the long term, do not act on impulse or panic: make sure you do an honest assessment of your current economic situation and consult a trusted real estate professional.

 

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