Do you feel poorer? The reverse wealth effect could add to the sluggishness of Canadians’ spending

It is inevitable that if incomes fail to keep pace with a 6.8% inflation rate, more Canadian workers will be forced to skimp.

But economists who study financial behavior have found that even those who can afford to keep spending are also looking for ways to cut spending.

Anyone who got a salary increase of less than 1.8% this year actually suffered a salary cut of more than 5%. “real” or after inflation Income. This means that those with no savings, who spend what they earn, have no choice but to buy less – or go into debt.

And retailers have started to take notice. Earlier this month, shares of U.S. chains Target and Walmart, and Canadian Tire in Canada, fell sharply as lower sales showed up in net income, main markets down.

Want to save

But there are growing signs that it’s not just those with no savings who are looking for ways to spend less. Research on the so-called “wealth effect” has shown that the many Canadians who have savings invested in real estate, stocks, or cryptocurrency are not exempt from the urge to save.

“What we expect is that as wealth increases, consumption increases and as wealth decreases, we expect a decrease,” said Mark Kamstra, an economist who studies behavioral finance at the Schulich School of Business at York University in Toronto.

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Although originally based on economic ideas of how people should behave, the wealth effect actually happens in the real world, according to repeated studies.

While at first some economists insisted that the effect only applied to liquid investments, such as stocks or bonds where returns could be mined and spent, there is a growing body of research showing the theoretical value of your home – even if you have no intention of selling it. and extract value – can change your willingness to spend.

When house prices are rising 20% ​​a year, it’s hard for homeowners not to feel rich even if they have no intention of selling. (David Donnelly/CBC)

Those who have studied the wealth effect, including Bank of Canada Governor Tiff Macklem in 1994 when he was just a humble researcher at the central bank, concluded that the phenomenon is real. Nevertheless, there is still debate, and even conflicting studies, about exactly how it works. As Kamstra explained, while the theory offers a simple model with few variables, the real world is inevitably complicated and messy.

“There are well-known reasons for concern that steady or falling stock prices could aggravate a slowing economy by depressing household consumer spending,” the report from the US National Bureau of Economic Research said. .

rich house

The report’s conclusions, however, were that “the housing market appears to be more important than the stock market in influencing consumption in developed countries.”

Macklem, who studied overall national wealth rather than looking at individuals, suggested that the reason things like stocks and bonds had a lesser effect was because a smaller proportion of people owned them. By comparison, home ownership in Canada running at about 70%.

The classic anecdotal example of the wealth effect is certainly home and car sales, where when the price of relatively modest homes start to rise in a neighborhood, new and sometimes expensive cars start showing up in the driveways. .

WATCH | Home sales are slowing, and so are prices:

Canadian housing market sees signs of slowing as interest rates rise

Experts say rising interest rates are slowing Canada’s hot housing market, leading to lower sales and a slight drop in the average selling price in March.

The story is based on research from the Reserve Bank of Australia (RBA), the US equivalent of the Bank of Canada.

In 2015, as Australian property prices increased by around 10% per year, the RBA study found that “there is a robust cross-sectional relationship between changes in property wealth and new home registrations. vehicles”.

Not only that, but the authors put a number in there, showing that every percent increase in real estate wealth led to a 0.5% increase in new car purchases.

Wealth Psychology

The reason the housing example is particularly interesting is that, for the most part, the owners who bought the cars did not plan to sell their homes to realize the increase in value. This indicates a psychological effect.

“I mean, really, are you richer if you’re 50 and your house has doubled in value?” Kamstra asked rhetorically. ” What are you going to do ? You still have kids in high school. You’re not going to leave the neighborhood. You cannot downsize. What is this wealth? »

He cites another British study which, reasonably enough, shows the strength of the wealth effect depends on individual circumstances. For example, older homeowners who are considering downsizing give more consideration to the theoretical value of their home when making spending choices.

Do you feel rich enough to buy a Lamborghini? It’s not a myth, a study by the Australian central bank showed that people whose house prices rose bought more new cars. (Radio Canada)

Likewise, those who own securities such as stocks, or who have taken a stake in cryptocurrency, are feeling the effects of the rise and fall of these investments the most. A 2018 University of Ottawa study showed that “financial wealth and housing wealth have significant effects on Canadian consumption”, and that homeowners tend to use their homes only as the proverbial piggy bank when house prices are rising and interest rates are low.

This window may be closing.

As many commentators on home equity lines of credit, or HELOCS, have observed, Canadians may have gone too far to borrow up to 65% of the value of their home to invest in things like renovations. As interest rates rise and house prices fall, this type of borrowing and spending is likely to decline.

Buying Frenzy

And while holders of blue-chip portfolios may be willing to steer clear of a market downturn, the Investment Funds Institute of Canada reports that mutual fund holders have sold billions. dollars of their investments in March, a trend that could amplify if stocks fall further, locking in the declines. New market traders who entered during the GameStop Frenzy and the cryptocurrency boom probably felt rich when prices went up, but also probably feel poorer now, Kamstra said.

As conflicting studies have shown, even with access to historical data, it is not easy to disentangle the impact of the reverse wealth effect. Measuring it in real time is even harder, but according to pollster Nik Nanos, there are signs we may already be seeing its effect.

“Canadian consumer confidence continues to decline with negative pressure across all dimensions tracked, including job security, real estate values, personal finances and economic outlook,” Nanos said in a confidence data release. this week.

And whether you’re spending less because you’re actually poorer or just feeling it, pinching pennies when your future wealth seems uncertain can be a natural impulse that’s hard to resist.

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