Wake up, have a coffee, read the news. The first article is about the U.S. handling of the pandemic, and it is terrible. Add to that political troubles, trade wars, record unemployment and the struggling economy.
Is it any wonder real estate and stock markets are crashing?
Wait a minute. Neither of the markets is crashing! Why not?
How the economy works is confusing, especially during a pandemic with governments testing the limits of monetary policy.
Making good financial decisions is predicated on a good understanding of the economy. In light of the worldwide economic troubles, what is the plan? What tools do the governments use to fix the problems we all face?
Central banks use monetary policy to stimulate the economy and set target inflation. In turn, stock markets and real estate respond.
1. Monetary Policy
Interest rate monetary policy
The Bank of Canada lowered interest rates to stimulate the economy as one of the first measures during the pandemic.
Interest rate monetary policy increases the value of investments, causes purchasing on credit to become more lucrative, and lowers the carrying cost of existing debt burden. Interest rate policy also inflates asset values and puts money in the hands of the wealthy, focused on incentivizing spending.
Unfortunately, there are limits. One, as we approach near zero-rates it becomes less effective.
And two, the wealthy might not spend the money and instead save or invest, which drives up the value of investments such as real estate.
As a result, we have seen an increase in real estate activity. The Toronto Regional Real Estate Board says existing home sales in the GTA in August 2020 jumped 40.3 per cent from August 2019.
Average home prices are also up. Real Estate Board of Greater Vancouver reports a 36.6 per cent jump over the same period. In part, interest rate policy is responsible for this.
Quantitative easing (“QE”) monetary policy
QE policy is for central banks to buy bonds and other financial instruments, giving investors cash in return. The Bank of Canada is continuing with large-scale purchases of at least $5 billion per week of Government of Canada bonds.
When the interest rates approach zero, the interest rate monetary policy becomes less effective. QE policy has the same effect at later stages. At some point the price for assets is too high and returns are too low to motivate spending.
Other than interest rate and QE, the Bank of Canada can do little to effectively motivate institutional buyers to spend.
“Helicopter money” monetary policy
“Helicopter money” is the idea to put money in the hands of those who need it most and will spend it. Think of the various stimulus packages we have seen for the individuals and businesses in Canada.
This policy can be incredibly effective, as people who receive such money are most in need and will spend it on living, thus increasing consumption and stimulating the economy.
We see governments “printing money” for QE and stimulus packages and theory teaches us that increasing money supply without increasing production will lead to inflation.
But it is not that simple. Inflation in the short term should not be a problem.
Ray Dalio explains in his book Big Debt Crises that spending is key.
Whether one spends money or uses credit, it does not matter. As credit decreases, additional money replaces lost credit and therefore does not cause inflation. Central banks simply make up for the disappearance of credit by increasing the amount of money.
Benjamin Tal, deputy chief economist CIBC Capital Markets, explains that additional money will go to replace lost money due to this pandemic. And the cost of carrying additional debt is further offset by lower interest rates. During recovery, we will be able to correct for additional debt with growth and inflation should not become a problem.
But of course, there is a limit to how much money is “printed” and if abused, inflation can become a problem.
3. Stock markets and real estate
Striking things happened with our neighbours. When the Fed announced zero interest rates and QE policy, the borrowed money became essentially free. Investing with borrowed money became easier and stock markets rallied. Many saw it as opportunity to buy low after an early pandemic market crash.
But the stock market recovery does not necessarily mean the economy is doing well.
When we think about stock markets, we think of indexes such as S&P 500. Indexes were driven up by technology titans like Google, Apple, Amazon and Facebook. At the same time, companies that relied on service or traditional retail suffered greatly.
Unfortunately, a stock rally without a strong economic output may be widening the wealth cap.
“When the rate of return on capital significantly exceeds growth rate of the economy, then it logically follows that inherent wealth grows faster than output and income.” (Thomas Piketty and Arthur Goldhammer, Capital in the Twenty-First Century). In short, the wealthy are getting wealthier.
In Canadian commercial real estate, investment volume and cap rates have seen some pressure.
Even with aggressive monetary policy, the CRE market has been negatively affected but we did not see a “crash.” This is in large part due to policies discussed above, and the Canadian government’s unprecedented fiscal spending on emergency economic measures.
In closing, the implementation of monetary policies has helped many of us stay employed and in business, but we are not out of the woods yet. There are many risk factors, including a second wave of COVID-19 and the impact of the health and political environment of our big neighbours.
We should take comfort that monetary policies seem to be working. With that, there is good reason to be cautiously optimistic about real estate markets and Canadian economic recovery.