May 26, 2022

Market Trends

RYPM

A “frothy” market exists when the price of an asset — housing, in this case — becomes detached from its underlying value as demand drives prices to unsustainable levels. Froth tends to precede a market bubble, which may eventually burst.

Robert Kavcic, Senior Economist at BMO Capital Markets, says froth is one of the driving factors behind Canada’s surging home prices.

In a May 20 publication, Kavcic writes that home prices have grown at about 3% per year since the early 1980s, “roughly reflecting” inflation, wage growth, and falling interest rates.

But even as inflation reaches a 30-year high, home prices have surged by more than a third in just two years, “clearly stretching” beyond the growth trend, he noted.

As of Q1 2022, when Kavcic believes the market peaked, home prices sat 38% above the trend, which is “the widest deviation in the past 40 years.”

In Toronto, home prices have risen 41.2% above trend. In the exurbs—one to two hours outside the city—they’ve risen by 76.3%. Cottage country has seen a similar surge at 63%.

“The most froth has accumulated in the suburbs and exurbs of Toronto,” he wrote.

“Other markets, such as Vancouver, Montreal, and Atlantic Canada are frothy, but not to the extent of Southern Ontario.”

However, as interest rates rise, Kavcic believes the froth could dissolve, bringing corrections to the housing market. The Bank of Canada has already hiked interest rates by 75 basis points in 2022 and Kavcic expects another increase of 125 basis points by year-end.

“Froth is coming out of home prices, just as it is across a number of other asset classes that were boosted by excessively stimulative policy,” Kavcic wrote.

“While a much cooler housing market will weigh on economic growth, we believe that this will be largely an asset-price phenomenon, with underlying fundamentals eventually setting a floor, and the financial system well protected.”

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