Royal Bank warns on debt loads

The Royal Bank is issuing a cautionary alert about Canada's over-extended households and the hot housing market.

As Canadians are being saddled with unsustainable levels of debt, the economy is becoming increasingly exposed to foreign uncertainty, says the Royal Bank.

Canada's largest chartered bank said Monday it still expects the economy to muddle through 2012 pretty much like it did this year, buffeted by external headwinds like Europe's debt crisis, but keeping its head above water.

That is similar to the view held by the Desjardins Group economic team, which also warned of "waning" domestic demand in its newest forecast Monday.

Both cite Europe's fiscal debt crisis a key risk for the global and Canadian economies, but add tapped out domestic consumers complicate the matter.

"In this context, the labour market will be fairly calm in 2012, cooling consumer spending and residential construction," said Yves St-Maurice, deputy chief economist with Desjardins.

RBC notes that Canada's recovery from the 2008-09 has been based on a robust domestic sector, mostly consumer spending and the hot housing market, which added 3.9 percentage points on average to growth.

"However, this story is largely played out at this stage," the bank's economists say in a report released in conjunction with a teleconference of its economists. "Next year, the expected growth contribution from domestic demand should be cut by more than half to just 1.8 percentage points."

They note that even a 10 per cent correction in house prices — which would be considered a soft landing for the sector — would subtract one percentage point from growth.

Craig Wright, RBC's chief economist, said he fully expects domestic demand, including housing will cool, given that household credit debt reached an all-time high of 150.8 per cent in the third quarter. He points out that in the past year consumer household debt grew, but at the slowest pace since 2002.

"We're already seeing some signs that debt accumulation is moderating," he said, "and the housing sector will cool down as housing affordability becomes more of a challenge.

Wright said Finance Minister Jim Flaherty may need to take further steps to tighten mortgages requirements — by hiking the minimum downpayment or reducing the amortization period from 30 to 25 years — if the housing market does not cool.

But with the Bank of Canada expected to keep interest rates low for most of the year, Wright added a "cooling rather than collapsing" housing market is most likely.

U.S. financial firm Merrill Lynch also weighed in on Canada's housing market on Monday, saying it expects prices could fall as much as five per cent next year. The Merrill Lynch report said housing in Canada is overvalued by between 10 and 25 per cent, depending on how you factor in mortgage rates.

Taking up the consumer slack, the RBC expects exports to be a modest net contributor and the business investment will continue to be strong.

Overall, RBC economists see the world economy as a glass half full, rather than half empty. The U.S. will struggle with weak 1.7 per cent growth, and China will avoid a hard landing, they predict.

That leaves Canada growing at 2.5 per cent next year — more than half a point higher than the Bank of Canada's call — and the unemployment rate remaining steady at about the current 7.4 per cent level.

Desjardins economists see the economy only advancing 2.1 per cent next year, more in line with consensus.

However, both forecasting houses point out that there's a seldom-mentioned upside risk to the economic outlook, even if it is a long shot at this point.

"If the concerns about the eurozone manage to ebb, the likelihood is that investors will gradually abandon the bond market to look for riskier products, such as equity. The major U.S. and Canadian stock indexes could thus advance by nearly eight per cent for both 2012 and 2013," said the Desjardins Group.