The expectation is for the Bank of Canada to continue to tighten monetary policy with interest rate hikes throughout the rest of the year. These actions can further dampen consumer sentiment and place pressure on household balance sheets. With consumption being integral to the economy and representing 2/3rds of GDP, investors should look out for signs that suggest that mounting pressures are becoming too much for the consumer. Below are 6 themes that we track to assess the health of the consumer.

One) Consumer Balance Sheets: The pressure that higher payments may have on a household depends on the proportion of that household’s disposable income that is required to meet their debt obligations. Figures like 'Debt to Income' and 'Debt Service Ratio' provide insight into the ability of households to service their debt obligations. As shown in the table below, the 'debt to income' and 'debt service ratio' are in line with the two previous tightening cycles. That said, there is a chance that these figures could worsen given the size of debt is greater compared to the past. These higher debt level increase the potency and impact of hiking rates.

Two) Debt Profile: As the chart shows below, much of the impact from rate increases will be most felt by borrowers using lines of credit, which make up 25% of Canadian household debt. Important to note, a large portion of mortgages have fixed rates and were refinanced during the pandemic at lower rates. As such, these households are shielded from the current interest rate changes and will not face an immediate increase in their payments. As for variable rate debt, 70% currently have a fixed payment structure. Therefore, although higher rates will change the amortization schedule, borrowers continue to benefit from a predictable fixed payment schedule and should not cause any cash flow pressures.  Taken together, “only” 24% of all household debt ($650B), will be subject to increased interest payments from the recent rate hikes.

Three) Impact of Higher Rates on Disposable Income: In September, the Bank of Canada is expected to raise rates by 0.75%, which will put the overnight rate to 3.25%. Markets are also expecting another 0.25% to 0.5% increase before the end of the year. In dollar terms, this will result in $19 Billion in additional interest payments for households, which translates to 1% of household disposable income in 2022. Under that lens, some Canadian households may buckle under that pressure, but a majority should not break.

Four) Wage Growth: The tight labour market has resulted in higher wages, which helps offset some of the burden from rising interest rates. While, wage growth has fallen behind the recent surge in inflation, the average weekly wage growth has surpassed inflation (CPI growth) over the past 3 years. This is most evident with lower income earners who are seeing the greatest growth in wages. These earners are depicted in the chart below under column titled “1st quartile”.

Five) Delinquencies: When narrowing in on subprime borrowers (ie. poor credit), investors can see that delinquencies remain relatively low. As the chart below shows, the 30-day delinquency rates are well below the highs seen at the height of the pandemic. If unemployment rises, these delinquencies may increase, however a strong labor market with a low unemployment rate if 4.9% suggests that this is not an immediate concern.

Six) Savings Rate: Lastly, households have been able to maintain significant savings over the course of the pandemic. The numbers are staggering, with $300 Billion in savings available to be deployed. These savings will help consumers’ battle inflation while fulfilling the pent up demand that still remains. Should 10% of these savings be utilized, consumption could spike an additional 2.5% over the next year.

Although Canadians face a tightening cycle, the Canadian consumer appears to be in a stable position to combat inflationary pressures and higher interest rates.  Given the expectation that inflation peaked in June, the prospects for slower and smaller rate hikes in 2023 are reasonable. Both the US Fed and the Bank of Canada want inflation to normalize which can largely be done by cooling the economy. The hope from investors is that this economic slowdown can be done gradually and that any recession will be shallow and short in duration. We suggest that investors monitor labour market trends and employment indicators as the health of the consumer and the severity of any downturn will depend on whether the greater population can continue to bring home a paycheck.