Concern about rising household debt and house prices prompted Australian regulators to crack down on bank lending, with APRA introducing limits on interest-only loans.
China is also making it more difficult for Chinese nationals to purchase real estate offshore. The combined result is a slow-down in Australian bank credit, with credit and broad money growth falling below 5% for the first time since the global financial crisis.
Currency in circulation may be more volatile but a sharp fall in currency growth over the last two years confirms tighter monetary conditions.
The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry recently kicked off with intense media coverage. Airing of banks’ dirty laundry in public is again likely to lead banks to further tighten lending standards. Falling housing prices as a result of fewer offshore purchases and restrictive lending practices will in turn fuel a more negative lending outlook, creating a negative feedback loop.
While a credit contraction can still be avoided, it may be difficult for the RBA and APRA to reverse course. Given that their objective is to avoid a full-blown banking crisis, caused by a collapse of the housing bubble, the current slow-down may appeal as the lesser of two evils.
Australian banks are breaking primary support levels. There are two major reasons for this. One is the precarious level of household debt as a result of the housing bubble. The first graph below shows how housing prices have more than doubled compared to disposable incomes (after tax but before interest payments) over the past 30 years. And how household debt has risen, not as a result of, but as the underlying cause of, the housing bubble. Without rising debt there would be no bubble.
Growth in Australian housing prices is now slowing, prompting fears of a correction.
The second reason is falling returns on equity. Banking regulators have increased pressure on major banks to improve lending standards and increase capital backing for their lending exposure. For decades banks were given free rein to increase lending without commensurate increases in capital, to the extent that the majors hold only $4 to $5 of common equity for every $100 of lending exposure. Low interest rates, increases in capital and slowing credit growth have all contributed to the decline in bank equity returns to the low teens.
Concerns about rising interest rates pounded financial markets Friday as investors started to take the threat of inflation more seriously, a sharp shift from the sentiment that has characterized most of the stock market’s nearly nine-year bull-market run.
Annual growth in average hourly earnings for the private sector jumped to 2.88%, close to the 3.0% expected to trigger a more hawkish stance from the Fed.
The market is skittish about higher interest rates, with the VIX jumping to the highest level since November last year.
The ASX 200 found strong support at 6000, rallying strongly to test resistance at the recent high of 6150.
The recovery was assisted by banks, with the ASX 300 Banks index rallying to test resistance at 8500. Shallow Trend Index troughs below zero reflect improved buyer sentiment (still bearish but only just).
Miners are correcting as iron ore continues to lose ground.
Sentiment has been buoyed in recent weeks by global bullishness towards equities. But Friday’s US reaction to rising wage rates warns that the market is growing increasingly anxious about high stock valuations. Expect strong resistance for the ASX 300 Banks Index at 8500 and the ASX 200 at 6150.
The ASX 200 broke through 6050 after respecting support at 5900 over the last few weeks. Expect retracement to test the new support level. Bearish divergence on Twiggs Money Flow remains a concern, warning of large numbers of sellers. Target for the primary advance is the 2007 high of 6800 but I remain wary because of selling pressure and banking sector weakness.
The ASX 300 Banks index found short-term support at 8300. Twiggs Trend Index continue to warn of moderate selling pressure. Breach of 8300 is likely and would warn of a test of primary support at 8000/8100.
GDP growth has lifted in 2017 and the labour market has tightened.
Our base case has these trends continuing over the next two years, but there are a number of downside risks.
The ability of monetary policy to support the economy in the event of a negative shock is more limited than in the past thereby exacerbating the potential impact that any negative shock may bring.
On some important metrics it’s been a reasonably good for year the Australian economy. The labour market has tightened courtesy of very strong employment growth and real GDP growth has lifted. At the same time, nominal GDP growth has been buoyant due to firmer commodity prices when compared to a year earlier. Wages growth, however, remains soft and real wages are barely in positive territory.
The house view is that the improvement in the labour market continues over the next two years and the unemployment rate should continue to grind lower. But there are plenty of risks that would change the outlook if they were to materialise.
This note discusses some of the key global and domestic risks to the Australian economy. It begins with an outline of CBA’s base case for the economy over the next two years before delving into some of the potential risks. This is not an exhaustive list, but rather it covers a few areas that the author considers to be the most acute risks to our central scenario. They are: (i) the capacity to respond to a negative shock with monetary policy (and to a lessor extent fiscal policy), (ii) a solid fall in commodity prices; (iii) a sharp correction in dwelling prices; (iv) a policy “mistake”; and (v) a fall in net migration via a policy change.
CBA’s central scenario
CBA’s base case for the economy over the next two years is a benign one. It is broadly similar to the RBA’s forecast profile for the economy which is also not dissimilar to the consensus view.
On the key components, we see output growth continuing to lift to a pace of around 3%pa in 2018 (chart 1). We put potential growth at 2¾% (population plus productivity growth) which means our forecast profile has a gradual decline in the unemployment rate as spare capacity recedes (chart 2). In 2018, most of the key components of the economy are expected to contribute to growth, with dwelling investment the exception.
The capacity of wages growth to slow further from here is also limited in the event of a commodity price shock. That is because wages growth is already at record lows and wages growth is sticky downwards. A fall in wages growth was able to cushion the most recent terms-of-trade shock (late-2011 to early 2016) because growth in wages slowed in line with the weakness in commodity prices. This helped to support the labour market and keep the unemployment rate from rising as much as it otherwise might have. But this time, a fall in wages growth will not be able to absorb the shock to the same extent given wages growth is already so low.
A sharp correction in dwelling prices
The single biggest risk to the domestic outlook looks to be a sharp correction in dwelling prices. In our view, this carries a greater risk to the real economy than it does to financial stability given the banking system is well capitalised.
There is a commonly held belief in Australia that the main trigger for a fall in dwelling prices is a rise in unemployment. This seems logical because rising unemployment would generally be associated with a lift in mortgage delinquencies which would put downward pressure on prices. But the data suggests that employment is more likely to lag changes in dwelling prices rather than lead (chart 12). The obvious question to then ask is why? We attribute the answer, in part, to the wealth effect and the recent track record of monetary policy in smoothing out the business cycle.
In periods when employment growth is slowing, the RBA is generally easing policy. When this is occurring, as long as the RBA can fend off a recession, falling interest rates tend to push up dwelling prices via cheaper credit which in turn encourages spending and supports employment growth. Of course, it’s a different story if employment growth falls too fast and unemployment rises sharply. But so far, at the national level, this hasn’t happened since the recession of the early 90s.
The risk of a material correction in dwelling prices looks higher now than it has been for a long time given: (i) the incredible lift in dwelling prices over the past five years; (ii) mortgage rates are probably unlikely to go lower and indeed can’t go much lower; (iii) household debt to income is at a record high; and (iv) dwelling supply is in the process of lifting quite significantly in some jurisdictions.
A soft correction in dwelling prices would probably have no material negative impact on the labour market. But there is a risk that a hard correction in prices (a fall of 20% or more) would lead the economy into a downturn via the wealth effect (i.e. the notion that changes in demand are influenced by changes in the value of assets). Since income to one person comes via the spending of another, there is a risk that falling home prices leads households to put the brakes on spending which ultimately drags consumption and employment growth lower.
A policy “mistake”
We consider a policy mistake by the central bank to be a risk to the economy given how much debt the household sector is carrying. Specifically, if the RBA hikes too early it could derail the improvement in the labour market that has been underway over the past two years. The record level of debt being carried by the household sector means that interest payments as a share of income will rise quickly if/when rates move higher (chart 13).
The construction sector in Australia, for example, is proportionately bigger than the construction sector in most other advanced economies because strong growth in people means that more needs to be built – dwellings, roads, schools, hospitals, ports etc. Finally, at the margin, a strong population growth rate at a time when there is labour market slack is likely to be putting downward pressure on wages as workers from offshore add competition to domestic labour.
At present, both major sides of politics (i.e. the Liberal-National Coalition and the Labor party) support maintaining a high permanent migrant intake every year. But there is a risk that one of the major parties opts for a different policy stance. The example here is to be found in New Zealand where there has been a change in immigration policy following the recent election outcome that means migration should drop substantially over the next few years. As a result, a change in immigration policy cannot and should not be ruled out in Australia.
A material reduction in net migration to Australia would increase the risk of a fall in dwelling prices as well as weigh on total output growth (not GDP per capita) and negatively impact the construction sector. But it would also likely put upward pressure on wages growth by reducing the pool of workers in many occupations. In that context, it’s not so much a downside risk, but rather one that would see a shift in the economic outlook that would have both winners and losers. From a policy perspective it’s about assessing whether there is a net societal benefit. But that’s a question for another day.
The world economy is enjoying a synchronised recovery. But it will prove unsustainable if investment does not pick up, especially in high-income economies. Debt mountains also threaten the recovery’s sustainability, as the OECD, the Paris-based group of mostly rich nations, argues in its latest Economic Outlook.
…..Low investment and high indebtedness are not the only constraints the world economy faces. Political risks are also high, as are threats to liberal trade. But raising investment and lowering debt are high priorities. As President John F Kennedy said in 1962, “the time to repair the roof is when the sun is shining”. It is essential to hack off the overhangs of unproductive private debt bequeathed by the crisis and its aftermath. The transformation will not happen overnight. But we should eliminate the incentives for such risky behaviour.
An excellent summary of the global economy’s strengths and weaknesses. I agree with Martin that low rates of capital investment (which leads to low productivity growth) and high levels of both private and public debt are the major threats to continued growth. And that the time to address it is now.
Is it even a good idea to enact tax cuts at this point in the economic cycle? After all, growth has picked up, unemployment is at a 17-year low and capacity utilization is high. It’s reasonable to wonder whether tax cuts spur inflation higher rather than boost economic growth. We agree that inflation is likely to move modestly higher next year (more so if tax rates are reduced), but lower tax rates will likely improve productivity and benefit the economy.
Tax cuts are unlikely to have a significant impact on inflation or productivity other than through indirect stimulation of new investment and job creation.
…..If the corporate tax rate is reduced from 35% to 20%, we estimate this would increase S&P 500 earnings-per-share between $12 and $15 annually. Companies could also see an additional boost in the form of earnings repatriation. It’s possible (and even likely) that some companies would use these earnings benefits to lower prices to increase market share, so some gains may be “competed away.” But we think an overall boost in profits and earnings is likely.
That would amount to an annual increase of between 10 and 13 percent in S&P 500 earnings per share (based on a forecast $114.45 EPS for calendar 2017). Companies that invest in building market share would expect a return on that investment by way of increased growth which would still benefit future earnings streams.
Furthermore, if U.S. companies finally bring their overseas earnings home in a tax-effective manner, it’s fair to wonder what they would do with their cash windfalls. Should this happen, we expect increases in balance sheet improvements, more hiring, a rise in capital expenditures, dividend increases, higher levels of share buybacks and an increase in merger and acquisition activity. All of these actions would be a positive for corporate health and equity prices.
I would expect a big increase in stock buybacks as that will boost stock prices and have a direct impact on executive bonuses. Mergers and acquisitions have less certain outcomes and are likely to be secondary, while new investment and job creation will most likely get the short straw.
The ASX 200 faces resistance at the key 6000 level. Money Flow is forming troughs above zero, indicating buying pressure. Recovery above 6000 would signal another advance. Failure of support at 5900 is less likely but would warn of a strong correction.
Iron ore prices are strengthening and likely to test the descending trendline at 70. Breakout above 80 would signal reversal to a primary up-trend but that still seems a long way off.
Miners responded with another rally, the ASX 300 Metals & Mining Index respecting support at 3300.
So why the hesitancy? Banks are the largest sector in the ASX 200, with Financials representing 37.2% of the broad index. The ASX 300 Banks index is retreating and expected to test the band of support between 8000 and 8100. Trend Index peaks below zero warn of long-term selling pressure.
The outlook for banks is not that rosy. Household debt is growing faster than disposable incomes, placing finances in an increasingly precarious position. Interest payments are still manageable at 8% of disposable income but that could change if interest rates rise.
The housing cycle appears to have peaked, with growth now falling. A function of tighter controls by APRA over investor lending and a Chinese crackdown on capital outflows.
Building approvals for detached houses remain steady but approvals for higher-density housing are falling.
A boom in construction of high-density housing has provided a strong tailwind to the economy over recent years, illustrated by the sharp spike in total residential construction compared to new houses in the chart below.
But the downturn in apartment prices and falling building approvals is likely to turn that tailwind into a headwind as apartment construction falls. This would affect not only the construction sector but the entire economy.
Political uncertainty over the continuation of favorable tax treatment for housing investors could also impact on new housing investment and strengthen the headwinds facing the economy.
Australia is headed for a period of political uncertainty, while tighter Chinese monetary policy and a crackdown on capital outflows will slow the local real estate boom. Employment is strong but low wage growth suggests under-employment.
Reliance on mining and real estate as the backbone of the economy is bound to disappoint. What the economy needs is a vibrant manufacturing and tech sector but this is shrinking rather than growing, with investment in machinery and equipment falling from 8% to almost 4% of GDP over the last decade.
Stocks are rising but we need to temper our enthusiasm with a hint of caution. The ASX 200 is testing medium-term support at 5900. The tall shadow on Friday’s candle indicates continued selling pressure. Breach of 5900 would warn of a strong correction to test primary support at 5650, while respect (indicated by recovery above 6000) would confirm an advance to 6250 (5950 + 300).
I remain wary of the banks because of their low capital base and high mortgage exposure. Reversal below the medium-term trendline warns of a correction to test the band of primary support between 8000 and 8100. Recovery above 8800 is less likely.
Miners are more bullish despite the low iron ore price. The ASX 300 Metals & Mining index is testing medium-term support at 3300. Respect is likely and would signal another advance.
Last week’s elections signal possible trouble for Republicans in 2018. We caution against reading too much into the results. But Democratic gains in Virginia and elsewhere confirm signals from national polling that suggest the GOP will struggle to hold the House next year.
We expect a tax bill to be passed in 2018, which should help the economy and equity markets. While there are significant differences between the two plans, the simple reality is that it would be political suicide for Republicans if they don’t pass tax reform before next year’s elections. Depending on the details of the final bill, we expect individual tax cuts to be a plus for consumption, while repatriation and corporate tax cuts should contribute to corporate revenues and earnings.
Despite some views to the contrary, we believe the global economy should continue to improve. Some argue the world is in a period of secular stagnation. After all, growth remains very slow despite years of low or even negative interest rates. In our view, the world economy is enjoying a period of reflation and should experience more synchronized growth in 2018.
Stronger global growth is benefiting multinational companies. These companies have reported stronger revenue and earnings results than domestically oriented companies this quarter.
The bull market in equities is aging but remains very much intact. The current bull market is closing in on nine years, which makes it natural to ask how much longer it can continue. In our experience, there are several reasons for a bull market to end, including advanced Federal Reserve tightening, the flattening of the yield curve, slower levels of money growth, widening credit spreads and rising inflation. We are watching these factors closely, and don’t see signals yet that would point to the end of the current run.
In a nutshell: the bull market will continue until the Fed tightens monetary policy in response to rising inflation. When this will happen, no one is sure.
Long-term Treasury yields continue to move sideways, building a base, with 10-year yields oscillating between 2.0% and 2.6%. Breakout above the 2014 high of 3.0% appears a long way off despite the Fed gradually raising short-term rates. Rising yields increase the opportunity cost of holding gold, reducing demand.
Higher interest rates would be likely to strengthen the Dollar. The bear rally on the Dollar Index has run into resistance at 95. Reversal below the rising trendline at 94 would warn of another test of primary support.
Leith van Onselen questions whether the RBA should target a flat growth rate of say 5% for nominal GDP rather than inflation:
I am not convinced that the RBA and RBNZ should necessarily set interest rates around nominal GDP. As shown in the below charts, setting interest rates in this manner would likely see the cash rate rise significantly from current levels which, given anaemic wages growth and high underemployment in both nations, would seem unwise:
Let’s look at the graph of GDP growth a bit closer. If we target 5% GDP growth:
From 2001 to 2007 rates were too low. That would have softened the sharp fall in 2008
Rates in 2008 were too high
Rates were not too low in 2009 to 2010 because of the growth undershoot in 2008
Rates were too high 2011 to 2016
Again, rates are not too low in 2017 because GDP has undershot its growth target for the last 6 years
I believe that targeting nominal GDP would help to stabilize growth with higher rates in the boom to prevent the need for lower rates in an ensuing bust.
Where I do agree with Leith is that banks need to re-focus from financing largely speculative (housing) assets to financing productive investment. In fact, not just the banks but the entire economy.
The CoreLogic home value index held flat in Oct taking annual growth to 7%yr, an abrupt slowdown from the 11.4%yr peak in May.
Policy measures continue to have a material impact. Although official rates remain near historic lows, regulators introduced a new round of ‘macro prudential’ tightening measures in late March. Meanwhile a range of other changes have also seen a progressive tightening of conditions facing foreign buyers.
….Sydney continues to record the sharpest turnaround in conditions, annual price growth slowing to 7.7%yr in Oct, essentially halving since Jul. Melbourne continues to see a much milder turn with price growth still tracking at 11%yr.
….The houses vs units breakdown shows a more pronounced slowdown for houses with annual price growth slowing to 7.2%yr from 12.4% in May. Our monthly seasonally adjusted estimates suggest prices have been declining at about a 2% annualised pace over the last 3mths. ….Notably, the detail suggests the pace of unit price declines in Brisbane and Perth is moderating while price growth in Melbourne units has shown essentially no slowing to date.
The slowdown is likely to carry through to year end. However, the next few months will be a critical gauge of whether markets are starting to stabilise. To date, the timeliest market measures – buyer sentiment, auction clearance rates and prices – are showing few signs of levelling out. However, some of the pressure from macro-prudential measures may ease off a little.
China’s crackdown on capital flight seems to be having an impact on housing prices in Australia. Whether this is sufficient to cause a collapse of the property bubble is doubtful unless there is a general decline in prices, causing mortgage lenders to tighten credit standards.
The banking sector remains my major concern. With CET1 leverage ratios between 4 and 5 percent, the sector could act as an accelerant rather than a buffer (Murray Inquiry) in an economic downturn.
A note on Leverage Ratios:
I use Tier 1 Common Equity (CET1) to calculate leverage rather than the more commonly used Common Equity which includes certain classes of bank hybrids — convertible to common equity in the event of a crisis — as part of capital. Inclusion of hybrids as capital is misleading as conversion of a single hybrid would be likely to panic the entire financial system (rather like a money market fund “breaking the buck”). In the recent banking crisis in Italy, regulators chose not to exercise the conversion option for fear of financial contagion. Instead the Italian government was called on to bail out the distressed banks. Same could happen here.
WASHINGTON—The White House has notified Federal Reserve governor Jerome Powell that President Donald Trump intends to nominate him as the next chairman of the central bank, according to a person familiar with the matter….
A global investment bank has called the end of Australia’s world record housing boom, saying the golden years are “officially” over after home prices fell in Sydney for the second month in a row.”
There is now a persistent and sharp slowdown unfolding”, ending 55 years of unprecedented growth that has seen home values soar by more than 6500 per cent, UBS economists wrote in a note to clients on Thursday.
….recent weakness in auction clearance rates and anaemic price growth over the past five months suggested “the cooling may be happening a bit more quickly than even we expected”, economists George Tharenou and Carlos Cacho wrote in their note, downgrading their growth forecast for 2017 to just 5 per cent.
Not quite a Minsky moment but something to watch closely if you hold bank stocks.
A Minsky moment is a sudden major collapse of asset values which is part of the credit cycle or business cycle. Such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money.
The spiraling debt incurred in financing speculative investments leads to cash flow problems for investors. The cash generated by their assets is no longer sufficient to pay off the debt they took on to acquire them.
Losses on such speculative assets prompt lenders to call in their loans. This is likely to lead to a collapse of asset values.
Meanwhile, the over-indebted investors are forced to sell even their less-speculative positions to make good on their loans. However, at this point no counterparty can be found to bid at the high asking prices previously quoted.
This starts a major sell-off, leading to a sudden and precipitous collapse in market-clearing asset prices, a sharp drop in market liquidity, and a severe demand for cash.
Great market summary from Bob Doll at Nuveen Asset Management:
Economic data remains strong and hurricane effects have been surprisingly muted. Real third quarter gross domestic product was reported to be 3.0%, with nominal growth hitting 5.2%. Both numbers came in higher than expected, with nominal growth reaching its strongest pace since 2006.
Home sales are increasing, demonstrating that economic growth remains broad. New home sales hit their highest level since 2007.
The Federal Reserve is on track to increase rates again in December. We expect the central bank will enact its third hike of the year, while continuing to reduce its balance sheet. Fed policy remains accommodative, but is clearly normalizing.
Corporate earnings are on track for another strong quarter. We are past the halfway point of reporting season, and the vast majority of companies have beaten expectations. On average, companies are ahead of earnings growth expectations by 4.9%.
Stock buybacks appear to have slowed, but companies are still deploying cash in shareholder-friendly ways. From our vantage point, we are seeing companies pour more resources into hiring and modest amounts of capital expenditures.
Tax reform prospects still appear uncertain, but we have seen progress on the regulatory front. While President Trump has struggled to enact his pro-growth legislative agenda, he has had success in rolling back regulatory enforcement. The financial and energy sectors in particular appear to be benefiting from less scrutiny.
It is possible that tax reform will focus on corporate rather than individual rates. The most controversial aspects of tax reform are focused on possible changes to individual tax rates (such as arguments over the deductibility of state and local taxes). In contrast, corporate tax reform appears less controversial, as Congress seems to have broad agreement on the need to reduce corporate taxes and solve the issue of overseas profits. While still a small probability, Republicans may choose to separate the two issues and proceed solely on a corporate tax bill.
Economic growth remains muted but earnings are exceeding expectations. High levels of stock buybacks in the last few years must be playing a part.
Rising home sales are a bullish sign.
The Fed remains accommodative for the present but I expect increasing inflationary pressure to temper this next year.
Slow rates of investment remain a cause for concern and could hamper future growth — buybacks are cosmetic and won’t solve the low growth problem in the long-term.
Corporate tax reform would be a smart move, creating a more level playing field, while avoiding the acrimony surrounding individual tax rates.