Posted by Houses and Holes in Australian Property, May 20th 2013:

MB contributor, Rumpletstatskin, wrote an interesting post on the Australia property cycle this morning. In it he mused that:

The crucial lesson in all this is that Australian nominal asset prices have been supported by fiscal policy during the financial crisis, ongoing monetary policy adjustments, and foreign investment (including in mining infrastructure), which all supported employment and incomes.

This support allowed a slow melt adjustment since the financial crisis. Home prices have fallen, mortgage rates are down, and rents have increased. This means that buying a home is more affordable compared to renting than it has been for 15 years.

My message, if it wasn’t clear, is that if you have been holding off purchasing a home because of the risk of capital losses, then these risks are probably lower now than at any time in the past decade. Maybe prices will be a couple of percent lower at the end of next year, but I have a hard time wrapping my mind around downward price movement more severe than a couple more years of the slow melt, or around 3% in nominal terms. The chances of price gains is also now much higher.

Unfortunately this coming 2 year period is also likely to be economically unstable, with low wage growth and a fragile labour market. That is the catch with trying to time the residential property cycle – it is a game for players with lots of capital.

Cameron argues his post well but I vigorously disagree with these conclusions.

Australian property prices are not affordable on any spectrum that looks beyond the current cycle. Indeed, they remain at nose-bleed levels on any historical comparison.

Yet, prices have held at these high levels for over a decade and there is no saying that they won’t continue to do so. Throughout the GFC and afterwards I argued that the time of reckoning for the Australian housing bubble was not yet at hand. This was based largely upon the assumption that the nation had lots of firepower left in monetary and fiscal policy that would protect the downside. And so it turned out to be.

But each successive challenge has sapped these supports and insurance policies. Monetary policy is at 2.75% and probably has, at best, 1% of cuts left before it is exhausted. Fiscal policy too has limits now that the Budget guarantees bank borrowings. Not to mention the political paralysis preventing spending. We will never see another post-GFC stimulus program.

Most importantly, these limitations are apparent as the Australian economy enters a very serious challenge in the form of declining mining investment. In its editorial this morning the AFR wrote:

If Professor Garnaut is right, Chinese steel use per capita – the great driver of Australia’s resources boom – may not grow much further. He believes Australian resource investment will slide from 8 per cent of gross domestic product to just 2 per cent, effectively taking out about two years’ worth of national economic growth. This is already showing up in a string of profit warnings from mining services companies and an emerging slump in profitability in coal.

Think about that a moment. 6% of Australian GDP disappearing over the next three years before we even start to grow. This is the same forecast currently projected by ANZ and Goldman Sachs. It must be taken very seriously.

If this comes to pass, then it will be very difficult for Australia to avoid a recession and property bust of some kind. There will be very big falls in the dollar and they will protect Australian property prices to an extent. The fall will trap Asian investors already in the market but it will also deter future investors as currency risk becomes the new reality.

But the fall in the dollar is also going to hit consumers, much more quickly than it is going to benefit tradable sectors. Consumers will see purchasing power eroded as high inflation in oil and all imported goods overwhelms income growth. This will keep confidence under the cosh.

More to the point, a 6% draw down in business investment will hit the labour market hard and potentially trigger forced selling in property markets. Perth and Darwin especially are going to be at risk of property busts as the many project labourers on our major mining projects flood back into town with nothing to do. Not to mention the trouble we’ll see in the many sundry industries that have benefited from the mining boom. Brisbane is at risk of this dynamic too but has already corrected sharply so has less downside.

These factors, along with a generalised stalling in income growth, have the potential to feed bad loans back into the banking system. The majors can absorb serious losses. But how serious? And how much credit rationing would it take to pop the grossly oversupplied Melbourne and Canberra property markets, the latter afflicted with big job losses from a new government as well? Sydney is strong but only so long as credit keeps flowing.

There are of course arguments about high immigration, underlying demand, under supply and rising rents to support the market. And they will play some part. But none of these will matter in the circumstances I’m describing. If there are not enough jobs then people will move in together. Shortage will turn to surplus.

Cameron’s argument that the property cycle could be approaching a turning point will hold if these turn out to be normal times. A moderate retrenchment in mining investment will allow time to rebalance the economy so long as the dollar falls. Even so, things will seem abnormal. Inflation be high and property prices may rise in nominal terms but not so much in real.

But that is far from certain, indeed, may not even be the base case.

I am not saying any of this will happen. But if the mining investment cliff turns out to be precipitous in the next two years then the risk of a property shakeout is higher than at any time I can remember.

Reproduced with kind permission from Macrobusiness Australia.