Steep decline in net wealth will cut billions in household spending

Increasing interest rates and soaring prices leave Canadians feeling less confident about spending

Steep decline in net wealth will cut billions in household spending

Expect the negative wealth effect will be in full display until next year as the housing-based fortunes of many Canadians fade away in the face of rising rates, warns analysts from one of the Big Six banks.

In a new commentary, Nathan Janzen and Carrie Freestone from RBC Economics noted that Canadians are spending significantly less and are feeling less confident and rich.

Although the pandemic resulted in the creation of $3.9 trillion in additional net wealth, thanks to a booming property market and soaring stock markets, they said those gains are currently being reversed.

Net wealth was already down $900 billion (-5.4%) in the second quarter of 2022, the biggest decline ever, due to the slump in housing prices and weakened financial markets. More drops in home prices are expected as a result of the aggressive central bank interest rate hikes that have already occurred.

Read more: High inflation, falling real estate values wipe out wealth gains

By the end of this year, the total net worth is expected to decrease by more than $1.1 trillion from its peak pandemic levels (though this is still well above pre-pandemic levels). At a time when Canadians are already feeling the pinch from increasing inflation and rising interest rates, this decrease in household wealth will be particularly painful.

“This is particularly the case for Canadians at the lower end of the income scale, who spend a larger share of their earnings on ‘non-discretionary’ or essential purchases like gas, food, and shelter,” Janzen and Freestone said.

In contrast, higher-income households have kept spending on non-essentials like travel and hospitality services to satisfy pent-up demand following pandemic lockdowns. This increased the pressure on inflation while maintaining healthy overall spending.

In general, though, people are starting to feel the impact of the steep decrease in net wealth.

Because households finance their spending either from their current income or their net worth, a decline in household net wealth tends to result in reduced confidence in making purchases.

The "wealth effect" — which looks at how diminishing net worth affects household spending — has been the subject of numerous studies by economists throughout the years. Prior to the pandemic, a $1 decrease in home equity seems to have resulted in a 1.3 cent decrease in household consumption, according to Janzen and Freestone.

“That said, if net worth changes are large, even a small per-dollar wealth effect can take a major toll on consumer demand,” they said.

Read more: Inverse wealth effect could worsen Canadians' spending woes

The epidemic resulted in significant changes to net wealth, with home values alone increasing by 52% and the value of household equity in real estate rising by almost $2 trillion. Overall, net worth increased by $3.8 trillion between Q4 2019 and Q1 2022, which aided in boosting consumer spending as pandemic lockdowns started to loosen.

But with the declines in home prices and financial markets this year, Janzen and Freestone forecast a 41% ($1.6 trillion) reversal in those net worth gains, from peak to trough.

“While that still won’t retrace all of our pandemic gains, it will nevertheless create a negative ‘wealth effect’ that will drag on consumer spending, even as labour markets soften,” they said.

And while the pandemic spending boom was driven by discretionary or non-essential expenditure on things like house improvements and furniture, Canadians will prioritize essentials like debt, groceries, and gas as interest rates increase and price pressures continue.

According to RBC Cardholder data, Canadian spending hit a plateau in the summer after rising in the spring as a result of the lockdowns caused by Omicron.

Businesses will feel the effects of this decline as it worsens, especially those in the manufacturing industry, they said.