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 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.
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.
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.
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.
Manufacturing is holding its head above water (50 on the PMI chart) and industrial production shows a small upturn but investment growth is falling, as in many global economies including the US and Australia. Retail sales growth has declined but remains healthy at 10% a year.
Electricity generation continues to climb but steel, cement and plate glass production all warn that real estate and infrastructure development are slowing.
Interest rates remain accommodative.
Real estate price growth is slowing but remains an unhealthy 10% a year. Real estate development investment rallied in response to lower interest rates but is clearly in a long-term decline.
There are no signs of an economy in immediate trouble but there are indications that the real estate and infrastructure boom may be ending. Through a combination of fiscal stimulus and accommodative monetary policy the Chinese have managed to stave off a capitalism-style correction. But failure to clear some of the excesses of the past decade will mean that the inevitable correction, when it does come, is likely to display familiar Asian severity (Japan 1992, Asian Crisis 1997).
Retail sales growth (excluding motor vehicles and parts) slowed to 2.4% over the 12 months to June 2017.
Source: St Louis Fed & US Bureau of the Census
Seasonally adjusted light vehicle sales are also slowing.
Source: St Louis Fed & BEA
Seasonally adjusted private housing starts and new building permits are starting to lose momentum.
Source: St Louis Fed & US Bureau of the Census
The good news is that Manufacturer’s Durable Goods Orders (seasonally adjusted and ex Defense & Aircraft) are recovering.
Source: St Louis Fed & US Bureau of the Census
Cement and concrete production continues to trend upwards.
Source: US Fed
And estimated weekly hours worked (total nonfarm payroll * average weekly hours) is growing steadily.
Source: St Louis Fed & BLS
All of which suggest that business confidence is growing and consumer confidence is likely to follow. Bellwether transport stock Fedex advanced to 220, signaling rising economic activity in the broader economy.
Target: 180 + ( 180 – 120 ) = 240
The S&P 500 broke resistance at 2450, making a new high. Narrow consolidations and shallow corrections all signal investor confidence typical of the latter stages of a bull market. The immediate target is 2500* but further gains are likely.
Target: 2400 + ( 2400 – 2300 ) = 2500
The stock market remains an exceptionally efficient mechanism for the transfer of wealth from the impatient to the patient.
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
Philip Parker – veteran fund manager decides to sell all shares in Altair’s Trusts to hand back cash and hands back mandates for SMA/IMA’s and also sells MDA family office mandates to cash from shares.
AUSTRALIAN EAST COAST PROPERTY MARKET BUBBLE AND THE IMPENDING CORRECTION
CHINA PROPERTY AND DEBT ISSUES LATER THIS YEAR
THE OVERVALUED AUSTRALIAN EQUITY MARKETS AND
OVERSIZED GEO-POLITICAL RISKS AND AN UNPREDICTABLE US POLITICAL ENVIRONMENT
The underlined above are some of the more obvious reasons to exit the riskier asset markets of shares and property – in my opinion.
As a result of the above and after 25 years as a fund manager and 30 years in this industry I am taking around 6 to 12 months off. The main reason is in my opinion that there are just too many risks at present, and I cannot justify charging our clients fees when there are so many early warning lead indicators of clear and present danger in property and equity markets now….
A dip in the latest consumer price index (CPI) growth figures brings the inflation measure back in line with the Fed target of 2.0%. Inflationary pressures appear contained, easing Fed motivation to implement restrictive monetary policy.
Personal consumption continues to grow at a modest pace. The down-turn in expenditure on services would be cause for concern — this normally precedes a recession — if not for a strong rise in expenditure on durables.
Manufacturers new orders for capital goods display a similar recovery.
The housing recovery continues at a modest pace.
Construction spending as a percentage of GDP remains soft, suggesting that the recovery still has plenty of room for improvement.
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.
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
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.”