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.
Ambrose Evans-Pritchard reports on a statement by Zhou Xiaochuan, the governor of the People’s Bank (PBOC):
Mr Zhou told China Daily that asset speculation and property bubbles could pose a “systemic financial risk”, made worse by the plethora of wealth management products, trusts, and off-books lending.
He warned that corporate debt had reached disturbingly high levels and that local governments were using tricks to evade credit curbs.”If there is too much pro-cyclical stimulus in an economy, fluctuations will be hugely amplified. Too much exuberance when things are going well causes tensions to build up. That could lead to a sharp correction, and eventually lead to a so-called Minsky Moment. That’s what we must really guard against,” he said.
The function of the central bank is to remove the punch bowl just as the party really gets going (William McChesney Martin jr., Fed chair 1951 – 1970). It looks like the PBOC may have left it too late:
Non-financial debt has galloped up to 300 per cent of gross domestic product – uncharted territory for a big developing economy.
The International Monetary Fund says debts in the shadow banking system grew by 27 per cent last year.
Less widely known is that the “augmented” budget deficit – including local government spending and the deficits of quasi-state entities – has jumped to 13 per cent of GDP. This is an astonishing level of fiscal stimulus at this stage of the economic cycle. It was around 6 per cent in 2010….
What this means is that public and quasi-public debt in China is growing at the rate of 13% of GDP. China has achieved its growth targets but at what cost to economic stability? There are no free lunches, especially from the “perpetual leveraging doomsday debt machine”.
Bill Evans at Westpac sums up their outlook for the Australian economy:
….Constraints on growth next year are likely to centre on a lack lustre consumer who struggles under the weight of weak wages growth; high energy prices and excessive leverage. Conditions in housing markets, particularly in the eastern states, are likely to soften while the residential construction boom will turn down.
We are also less euphoric about growth prospects for our major trading partners than seems to be the current consensus. We expect China’s growth rate to slow from 6.7% to 6.2% as the authorities step up policies to slow its long running credit boom.
Yet the ASX 200 broke out of its line formed over the last 4 months, signaling a primary advance.
Miners are advancing, with the ASX 300 Metals & Mining Index breaking resistance at 3300.
The ASX 300 Banks Index is headed for a test of 8800. Upward breakout would complete a bullish outlook for the ASX 200.
Stephen Koukoulas says Australians have little to worry about high household debt:
….According to the latest data complied by the RBA, household assets are growing very strongly, aided by a building up in savings, unrelenting growth in superannuation holdings, growth in bank deposits and of course, from rising house prices.
While household debt is indeed just under 200 per cent of disposable income, household holdings of financial assets, which includes superannuation, direct share holdings and deposits, is now over 400 per cent of income…..
….The total value of housing in Australia is …. over 500 per cent of disposable income.
…. for every $1 of debt that the house sectors has, they have $5 of assets, which is a loan to value ratio of 20 per cent.
…..while the asset side of the household balance sheet remains healthy, the debt side will remain a non-problem.
That’s the problem with averages, they conceal a multitude of sins. Many Australians own houses without a mortgage. Probably the same group own most of Australia’s financial assets. They are financially secure, no doubt, and help to make the averages look reasonable.
But there are vast numbers of Australians in the mortgage belt with low financial assets and high loan-to-value ratios (LVRs) on their household mortgage. Any rise in interest rates would cause them financial stress and the impact of this would flow through the entire economy.
Almost 50,000 households are at risk of defaulting on their home loans in the next 12 months and nearly a third of homeowners are in mortgage stress, new figures show.
The latest mortgage stress and default modelling from Digital Finance Analytics for the month of September reveals more than 905,000 households are estimated to be in mortgage stress — 45,000 more than there were the month prior.
….Of those households, 18,000 are in severe stress, which means they are unable to meet home loan repayments with their current income.
By David Llewellyn-Smith (“Houses & Holes”)
Reproduced with kind permission from Macrobusiness:
Great stuff today from the always entertaining and cross-disciplinary Viktor Shvets at Macquarie:
Investors seem to be residing in a world without any notable perceived risks. It is an extraordinary and unprecedented situation, particularly given unresolved issues of over leveraging and associated over capacity as well as profound disruption of business and economic models, which are not just depressing inflation but also causing extreme political and electoral outcomes while feeding Maslowian-type disappointments across labour markets.
What can explain such lack of concern regarding potential risks?
In our view, the only answer is one of investors’ perception that, as we discussed in our preview of 2H’17, ‘slaves must remain slaves’ and hence, neither Central Banks nor other public institutions can afford to step aside but need to continue to guarantee asset price inflation. In its turn, this can only be achieved by ensuring that volatilities are contained (as they are the deadliest enemy of an ongoing leveraging) and liquidity is expanding at a sufficient pace to accommodate nominal demand.
The optimists would argue that the productivity slowdown that the world experienced over the last decade was primarily caused by the global financial crisis (GFC) and that we are starting to turn the corner. Hence, optimists argue that velocity of money is likely to improve, and this would allow Central Banks to gradually (and very carefully) withdraw liquidity and rate supports. While this is the ‘dream outcome’ from Central Banks’ perspective, we don’t see any convincing evidence that this is occurring.
We maintain that the best explanation for investors’ perception that risks are low is that a combination of Central Banks’ liquidity (still running at ~US$1.5-2.0 trillion per annum), an assumption that Central Banks would swiftly reverse their policies at the slightest sign of volatility reemerging, and China’s real estate and infrastructure investment, act as ‘risk buffers’. Investors seem to believe that liquidity cannot be withdrawn, volatility must be arrested and cost of capital cannot go up, and hence, financial assets are in many ways underwritten. While Central Banks would like to have a little bit more volatility and a little bit more price discovery, they would be highly averse to shocking what is the highly financialized and leveraged global economy.
While it is hard to back what is essentially a long-term ‘doomsday’ machine, nevertheless, the above describes our view. We remain constructive on financial assets (both equities and bonds), not because we expect a return to self-sustaining private sector led recovery and growth but because we believe that an ongoing financialization is the only politically and socially acceptable answer. In our view, therefore, the greatest risk is one of policy miscalculation.
We remain constructive on financial assets, not because we believe in a sustainable recovery, but because we back the perpetual leveraging ‘doomsday’ machine.
Shvets has been pushing the “long grinding cycle” narrative for a number years now:
Despite all these challenges, Shvets still recommends his clients to invest in certain types of stocks. “The outcomes of the next 10-15 years could be quite dramatic. How do you invest in that climate? There are only two ways of investing. The first is: Assume non-mean reversion. The private sector will never recover. The only thing left would be the public sector cycle.”
This means we can conveniently forget about corporate profits, or valuations like the price-earnings ratio of the S&P 500, as many investors already have done. The only thing that matters is public sector activity in the form of central bank intervention or government stimulus programs.
An extreme example of this cycle is perhaps Venezuela. While the country is going up in flames, people don’t have enough food, and the currency is dissolving itself in a vicious hyperinflation, the stock market actually went up 10 times since the beginning of 2012. Only recently has reality caught up with stocks and the market gave up 15 percent of its gains since the beginning of the year.
‘Buy quality sustainable growth, high returns on equity. Companies capable to generate a high return on equity through margins and without leverage. Don’t worry about the price to earnings ratio, there is no mean reversion,” says Shvets. And don’t own any financials. Good advice. The stock price of the likes of Deutsche Bank and Credit Suisse have been decimated this year.
The share prices of Deutsche Bank AG (DBK) and Credit Suisse AG (CSGN) have both lost almost 50 percent of their value this year (Source: Google Finance).
The other option is to invest along some pretty grim themes which benefit from the new trends identified by Shvets. “People are still going back to 20th-century thematics, it’s so old-fashioned.”
None of the new trends can be described as inspirational or uplifting, but the Macquarie portfolio reflecting the themes has bested the MSCI World Index by almost 30 percent since the beginning of 2015.
“The biggest theme is declining return on humans, the replacement of humans, biotech, augmentation of humans, opium for the people, like computer games and gambling,” Shvets said.
Then there are themes catering to geopolitical risk and potential regional war or civil uprisings, like detention and prison centers, weapons, and drones. Another theme supports the aging demography in the West, so companies holding hospitals, funeral operators, and psychiatric institutions should do well.
On the positives, Shvets notes technological disruptors like Amazon and Google. All those companies should be independent of the government and long-term structural shifts. “They go on no matter what.”
“If you think of gold, the only way gold loses is if normal business and private sector cycles come back. If that is the case, gold goes back $100 per ounce. The other outcomes: deflation, stagflation, hyperinflation are all good for gold.” As for a return to a gold standard, Shvets has more bad news: “Gold standards come back after the war, not before the war.”
In principle I agree therefore the MB Fund is long:
US stocks despite the valuations;
we are underweight Australian assets given interest rates will go to zero or the equivalent in a world of endless oversupply;
investment becomes a matter of discerning the most potent disruptors or the most embedded rent-seekers at the best prices.
Where I disagree is that the business cycle is entirely dead. To my mind, this is a process not a one-off shift, driven by successive crises that shunt de-globalisation and de-privatisation forward with each convulsion. After all, we have not yet had an earnings-destroying event in the US in this cycle so the lack of risk has been real.
Next year China is going to slow and the Fed tighten, at some point one two many times. Mean reversion will come but then so will our next round of socialisation.
Some interesting comments from economist Saul Eslake regarding the Australian housing bubble:
“Rising house prices are not of themselves a reason for the market to drop. About two thirds of Australia’s household debt is owned by the top 40 per cent of households, by income distribution. There hasn’t been a lot of lending to people on low incomes,” explains Eslake.
Lending to people on small salaries is one of the reasons housing markets in other countries, such as the US in the sub-prime crisis, have come under pressure in the past.
There has also been a decline in the home ownership rate in Australia that also reduced the chance of a housing bubble popping. According to the 2016 census, home ownership is the lowest it has been since the census of 1954…..
Australia also never experienced the same extent of low-doc lending as happened in the US prior to the financial crisis, where “ninja loans” – no income, no job, no assets – were commonplace.
Similarly, very high LVR lending, another problem in the US, did not occur to the same extent in this market.
“In the US people of surprisingly modest means could get loans valued in excess of 100 per cent of the value of the property. But in Australia it’s very difficult to get a mortgage at more than 80 per cent LVR without mortgage insurance,” says Eslake.
…..An excess supply of housing, which impacted the US and Irish markets, is also missing in Australia.
“In countries housing supply ran a long way ahead of underlying demand. Builders kept building in the expectation of future demand. When the cycle changed, forced sales and excess supply crashed the market,” says Eslake.
For the last 15 years Australia has had a housing shortage. While that’s changing given a record numbers of apartments have been built in the last few years, supply has not yet outstripped demand.
While he does mention risks attached to interest-only mortgages, Saul’s view is that “a correction in the domestic residential property market, at this point in the cycle it seems unlikely.”
I believe there are further assumptions that he has not mentioned:
That banks continue to provide credit at the same rate as they are at present. A slow-down in new credit, precipitated by rising interest rates or falling prices, could cause a contraction.
That the inflow of foreign investment into Australian residential housing continues at the same rate as at present. There are three possible headwinds:
Reluctance on the part of Australian banks to increase exposure to foreign investors.
Tighter monetary policy in China.
And a Chinese crackdown to restrict capital outflows.
That current low interest rates continue. Inflationary pressures are low, so this is not unreasonable at present, but circumstances can change. So can LVRs.
I would describe the situation as reasonably stable at present but increasingly precarious in the long-term as the ratio of household debt to disposable income continues to climb.
A quick snapshot of the Australian economy from the latest RBA chart pack.
Disposable income growth has declined to almost zero and consumption is likely to follow. Else Savings will be depleted.
Residential building approvals are slowing, most noticeably in apartments, reflecting an oversupply.
Housing loan approvals for owner-occupiers are rising, fueled no doubt by State first home-buyer incentives. States do not want the party, especially the flow from stamp duties, to end. But loan approvals for investors are topping after an APRA crackdown on investor mortgages, especially interest-only loans.
The ratio of household debt to disposable income is precarious, and growing worse with each passing year.
House price growth continues at close to 10% a year, fueled by rising debt. When we refer to the “housing bubble” it is really a debt bubble driving housing prices. If debt growth slows so will housing prices.
Declining business investment, as a percentage of GDP, warns of slowing economic growth in the years ahead. It is difficult, if not impossible, to achieve productivity growth without continuous new investment and technology improvement.
Yet declining corporate bond spreads show no sign of increased lending risk.
Declining disposable income and consumption growth mean that voters are unlikely to be happy come next election. With each party trying to ride the populist wave, responsible economic management has taken a back seat. Throw in a housing bubble and declining business investment and the glass looks more than half-empty.
Every great cause begins as a movement, becomes a business, and eventually degenerates into a racket.
Good to see Ambrose Evans-Pritchard weighing in on the (absence of) the next global financial crisis:
….If corporation tax drops to 25 per cent and incentives are offered to repatriate up to $US4 trillion of US corporate cash held offshore – tinder for stock buy-backs – you might see the sharemarket’s price earnings ratio breaking the all-time high of the dotcom boom.
Whether any of this stimulus is wise is another matter. The Bank for International Settlements chides central banks for making a Faustian Pact long ago, rescuing markets every time there is trouble but letting asset bubbles run unchecked in the good times.
They have created “intertemporal” imbalances that require ever lower real interest rates with each cycle. The deformity is worse today than before the Lehman crisis after eight years of emergency stimulus.
The global debt ratio is 40 percentage points higher at 327 per cent of GDP. Nobody knows what the sensitivity may be to even a modest degree of tightening.
Yet if the Sword of Damocles hangs ever over us, that does not mean it is about to fall. My humbling discovery after decades of amateur observation is that such episodes take longer to play out than you imagine.
I was convinced that the global financial system was spiralling into crisis at least 18 months before Fannie Mae, Freddie Mac, and Lehman Brothers collapsed over those terrifying weeks of late 2008.
That was a bad call. Even disasters have their proper sequencing.
WASHINGTON—The Trump administration proposed a wide-ranging rethink of the rules governing the U.S. financial sector in a report that makes scores of recommendations that have been on the banking industry’s wish list for years.
….If Mr. Trump’s regulatory appointees eventually implement them, the recommendations would neuter or pare back restrictions from the Obama administration, which argued the rules were necessary to guard against excessive risk taking and a repeat of the 2008 financial crisis.
Seems to me like the exact opposite of ‘draining the swamp’. The new administration proposes removing or limiting the rules intended to reduce risk-taking in the financial sector.
Falling wage rate growth suggests that we are headed for a period of low growth in employment and personal consumption.
The impact is already evident in the Retail sector.
The RBA would normally intervene to stimulate investment and employment but its hands are tied. Lowering interest rates would aggravate the housing bubble. Household debt is already precariously high in relation to disposable income.
Like Mister Micawber in David Copperfield, we are waiting in the hope that something turns up to rescue us from our predicament. It’s not a good situation to be in. If something bad turns up and the RBA is low on ammunition.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery. The blossom is blighted, the leaf is withered, the god of day goes down upon the dreary scene, and — and in short you are for ever floored….
~ Mr. Micawber in Charles Dickens’ David Copperfield
Raising interest rates would increase mortgage stress and threaten stability of the banking system.
Lowering interest rates would aggravate the housing bubble, creating a bigger threat in years to come.
The underlying problem is record high household debt to income levels. Housing affordability is merely a symptom.
There are only two possible solutions:
Raise incomes; or
Reduce debt levels.
Both have negative consequences.
Raising incomes would primarily take place through higher inflation. This would generate more demand for debt to buy inflation-hedge assets, so would have to be linked to strong macroprudential (e.g. lower maximum LVRs for housing) to prevent this. A positive offshoot would be a weaker Dollar, strengthening local industry. The big negative would be the restrictive monetary policy needed to slow inflation when the job is done, with a likely recession.
Shrinking debt levels without raising interest rates is difficult but macroprudential policies would help. Also policies that penalize banks for offshore borrowings. The big negative would be falling housing prices as investors try to liquidate some of their investments and the consequent threat to banking stability. The slow-down in new construction would also threaten an economy-wide down-turn.
Of the two, I would favor the former option as having less risk. But there is a third option: wait in the hope that something will turn up. That is the line of least resistance and therefore the most likely course government will take.
….China’s commodity futures markets are the ‘canary in the coalmine’ for hints that the markets may be in for an even wilder ride.
Most WMPs [wealth management products] have a maturity between 1-4 months and managers of these WMPs need their Chinese retail investors to roll over by buying new WMPs. If this stops or slows, (which is happening now – see Bloomberg) it will result in assets being force-sold by fund managers to pay back expiring WMPs. The liquid assets that have boomed in recent months such as iron ore futures, will be, and have been, the first to be sold. Next to be sold will be shares, international assets and local property and local corporate bonds if there is still a functioning market for them.
Extract from the latest Financial Stability Review by the RBA:
….In Australia, vulnerabilities related to household debt and the housing market more generally have increased, though the nature of the risks differs across the country. Household indebtedness has continued to rise and some riskier types of borrowing, such as interest-only lending, remain prevalent. Investor activity and housing price growth have picked up strongly in Sydney and Melbourne. A large pipeline of new supply is weighing on apartment prices and rents in Brisbane, while housing market conditions remain weak in Perth. Nonetheless, indicators of household financial stress currently remain contained and low interest rates are supporting households’ ability to service their debt and build repayment buffers.
The Council of Financial Regulators (CFR) has been monitoring and evaluating the risks to household balance sheets, focusing in particular on interest-only and high loan-to-valuation lending, investor credit growth and lending standards. In an environment of heightened risks, the Australian Prudential Regulation Authority (APRA) has recently taken additional supervisory measures to reinforce sound residential mortgage lending practices. The Australian Securities and Investments Commission has also announced further steps to ensure that interest-only loans are appropriate for borrowers’ circumstances and that remediation can be provided to borrowers who suffer financial distress as a consequence of past poor lending practices. The CFR will continue to monitor developments carefully and consider further measures if necessary.
Conditions in non-residential commercial property markets have continued to strengthen in Melbourne and Sydney, while in Brisbane and Perth high vacancy rates and declining rents remain a challenge. Vulnerabilities in other non-financial businesses generally appear low. Listed corporations’ profits are in line with their average of recent years and indicators of stress among businesses are well contained, with the exception of regions with large exposures to the mining sector. For many mining businesses conditions have improved as higher commodity prices have contributed to increased earnings, though the outlook for commodity prices remains uncertain.
Australian banks remain well placed to manage these various challenges. Profitability has moderated in recent years but remains high by international standards and asset performance is strong. Australian banks have continued to reduce exposures to low-return assets and are building more resilient liquidity structures, partly in response to regulatory requirements. Capital
ratios have risen substantially in recent years and are expected to increase further once APRA finalises its framework to ensure that banks are ‘unquestionably strong.’
Risks within the non-bank financial sector are manageable. At this stage, the shadow banking sector poses only limited risk to financial stability due to its small share of the financial system and minimal linkages with the regulated sector, though the regulators are monitoring this sector carefully. Similarly, financial stability risks stemming from the superannuation sector remain low.
While the insurance sector continues to face a range of challenges, profitability has increased of late and the sector remains well capitalised.
International regulatory efforts have continued to focus on core post-crisis reforms, such as addressing ‘too big to fail’, as well as new areas, such as the asset management industry and financial technology. While the goal of completing the Basel III reforms by end 2016 was not met, discussions are ongoing to try to finalise an agreement soon. Domestically, APRA is continuing its focus on the risk culture in prudentially regulated institutions and will review compensation policies and practices to ensure these are prudent.
Reading between the lines:
household debt is too high
apartments are in over-supply and prices are falling
we have to maintain record-low interest rates to support the housing bubble
APRA is “taking steps” to slow debt growth but also has to be careful not to upset the housing bubble
the Basel committee has been dragging its feet on new regulatory guidelines and we cannot afford to wait any longer
Growth of currency in circulation is also slowing. The fall below 5% warns of a contraction.
One piece of good news is that Chinese monetary policy seems to be easing. After a sharp contraction of M1 money stock growth in January, February shows a partial recovery. Collapse of the Chinese property bubble may be deferred a while longer.
Which is good news for iron ore exporters. At least in the short-term.
The balance sheets of Australian households with a mortgage are dangerously exposed to any fall in house prices.
It isn’t just that household debt relative to disposable incomes has reached a record high of 189 per cent, it’s that households’ ability to service that debt is potentially a ticking time bomb…..
A recent Digital Finance Analytics survey found that of the 3.1 million mortgaged households, an estimated 669,000 are now experiencing mortgage stress.
“This is a 1.5 per cent rise from the previous month and maintains the trends we have observed in the past 12 months,” it found. “The rise can be traced to continued static incomes, rising costs of living, and more underemployment; whilst mortgage interest rates have risen thanks to out-of-cycle adjustments by the banks and bigger mortgages thanks to rising home prices.”
I have been predicting the collapse of the Australian property bubble, so feel obliged to also present the opposite view. Nothing like confirmation bias to screw up a good investment strategy.
Here Jessica Irvine argues that the property bubble will not burst:
Believe me, no one is keener than me to see a property bubble burst.
But sadly – for would-be buyers, at least – I just don’t see it happening.
Sure, there are risks.
If it turns out that banks have been lending to people who really can’t afford it, then we have a problem when interest rates start to rise.
Experts have been calling the end of the property market for years. But banks insist they stress test customers for a 2-percentage-point rise in interest rates and require “interest-only” borrowers to prove they could afford to repay principal too, if required.
More worrying is the mortgage broking channel, where a recent ASIC investigation found most of the high loan-to-value loans are written. If there is a weakness in the housing market, it’ll be in this area of lending standards and so called “macroprudential” policies when interest rates start to rise. The recent clamping down on investor loans is welcome.
But ultimately, the defining thing about bubbles is that they inevitably must pop.
But where is the trigger for a widespread home price collapse?
In a world of low inflation and growth, the Reserve Bank is likely to raise interest rates very gently, cushioning households.
Widespread job losses would be a trigger, but there is no talk of that. With record low wages growth, labour is hardly expensive at the moment.
Bubble proponents point to very high household debt levels relative to incomes. But the structural lowering of interest rates in the late 1990s and again after the global financial crisis has increased the amount of debt households can afford to service from a given income.
Lower rates have also helped many households build significant “buffers” against future rate increases, in offset accounts and other forms of saving.
Bubbles form when asset prices disconnect completely with market fundamentals.
But there are very good reasons to expect housing to be so expensive.
Forget the Cayman Islands, housing – owner occupied and investment housing – offers the best tax shelter around, from negative gearing and the capital gains tax discount on investment housing to the complete exemption of the family home from capital gains tax AND from the pension asset test.
Meanwhile, rapid population growth has been met by sluggish increases in housing supply. Incompetent state governments have created a premium for inner-city housing, where buyers can avoid paying the indirect costs of long commutes.
In the aftermath of World War II, home ownership rates skyrocketed as governments focused on supply.
But since then, governments have instead implemented policies that boost only the demand side of the equation, with tax concessions and cash bonuses for buyers that only increase prices.
Absent any trigger for widespread forced property sales, home owners will always respond to sluggish market conditions by sitting on their properties for longer. Lower volumes provide a cushion against falling prices.
In such a market, the best a first-time buyer can hope for is that future price gains might come back into line with income growth.
Indeed, that’s exactly what happened after the early 2000s property boom when Sydney prices stagnated for almost a decade.
It’s less exciting, but more likely.
Jessica makes a good point about offset accounts which may cause real household debt to be overstated. This warrants further investigation.
But she seems too complacent about market fundamentals:
an oversupply of apartments;
negative gearing and capital gains tax advantages that could be removed by the stroke of a pen (or a tick on a ballot paper); and
prospective sharp cuts to immigration (again dictated by the ballot box)
Interest rate rises seem unlikely in the near future as inflationary pressures are fading. But I doubt that new homebuyers could afford a 2 percent rise in interest rates, that would amount to an almost 40% increase in monthly repayments for some. Even if they survive, repayments will take a big bite taken out of other household consumption and hurt the entire economy.
Also, the RBA may plan to increase rates gradually, to cushion the effect on homeowners, but Mr Market could have other ideas. And if you think central banks act autonomously from markets, think again.