THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA

Transcription

1 BANKWEST CURTIN ECONOMICS CENTRE THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA March 2018 Kelly Burns, Steven Rowley, George B. Tawadros and Ankita Mishra BCEC Research Report No. 10/18

2 About the Centre The Bankwest Curtin Economics Centre is an independent economic and social research organisation located within the Curtin Business School at Curtin University. The Centre was established in 2012 through the generous support of Bankwest, a division of the Commonwealth Bank of Australia. The Centre s core mission is to deliver high quality, accessible research that enhances our understanding of key economic and social issues that contribute to the wellbeing of West Australian families, businesses and communities. The Bankwest Curtin Economics Centre is the first research organisation of its kind in WA, and draws great strength and credibility from its partnership with Bankwest, Curtin University and the Western Australian government. The Centre brings a unique philosophy to research on the major economic issues facing the State. By bringing together experts from the research, policy and business communities at all stages of the process - from framing and conceptualising research questions, through the conduct of research, to the communication and implementation of research findings - we ensure that our research is relevant, fit for purpose, and makes a genuine difference to the lives of Australians, both in WA and nationally. The Centre is able to capitalise on Curtin University s reputation for excellence in economic modelling, forecasting, public policy research, trade and industrial economics and spatial sciences. Centre researchers have specific expertise in economic forecasting, quantitative modelling, micro-data analysis and economic and social policy evaluation. The Centre also derives great value from its close association with experts from the corporate, business, public and not-for-profit sectors.

3 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA Contents List of figures List of tables Executive summary Key findings Introduction The dynamic relationship between house and equity prices Patterns of house, equity and energy prices 2000 to 2014 Equity and energy prices National house prices National house rents Regional Western Australia The nexus between national house, equity and energy prices Data and methodology Key findings for equity prices Key findings for energy prices The nexus between capital city house, equity and energy prices Key findings for house prices and equity prices Key findings for house prices and energy prices Key findings for house rents and equity prices Key findings for house rents and energy prices The Nexus between WA regional house, equity and energy prices Key findings for house prices and equity prices Key findings for house prices and energy prices The magnitude of spill over effects between key regions of WA ii iii iv v vi vii Discussion and conclusion 45 Appendix Data sources Methodology References 53 i

4 List of figures Figure 1 Equity and energy prices, 2000 to Figure 2 Median house prices, Australia and capital cities, 2000 to Figure 3 Median house rents, Australia and capital cities, 2000 to Figure 4 Proportion of persons employed in Mining in selected capital cities, to 2014 Figure 5 Key regions of WA 9 Figure 6 Median house prices, WA regional areas, 2000 to Figure 7 Response of house prices and rents to shocks to equity prices (Australia) 18 Figure 8 Response of house prices and rents to shocks to energy prices (Australia) 20 Figure 9 Response of house prices to shocks to equity prices (Brisbane, Adelaide, Darwin) 24 Figure 10 Response of house prices to shocks to equity prices (Melbourne, Sydney, 25 Canberra, Perth) Figure 11 Response of house prices to shocks to energy prices (Melbourne, 28 Brisbane, Hobart) Figure 12 Response of house prices to shocks to energy prices (Sydney, Canberra, 29 Darwin, Adelaide) Figure 13 Response of house prices to shocks to energy prices (Perth) 29 Figure 14 Response of house rents to shocks to equity prices (Brisbane, Perth, 31 Darwin) Figure 15 Response of house rents to shocks to equity prices (Sydney) 32 Figure 16 Response of house rents to shocks to equity prices (Melbourne, Adelaide, 32 Canberra, Hobart) Figure 17 Response of house rents to shocks to energy prices (Adelaide, Perth, 34 Hobart) Figure 18 Response of house rents to shocks to energy prices (Sydney, Darwin) 34 Figure 19 Response of house rents to shocks to energy prices (Adelaide, Perth, Hobart) 34 Figure 20 Response of house prices to shocks to equity prices (WA regional) 38 Figure 21 Response of house prices to shocks to equity prices (South West) 38 Figure 22 Response of house prices to shocks to energy prices (WA regional) 40 Figure 23 Response of house prices to shocks to energy prices (Kimberley, South West) 40 Figure 24 Positive spill over effects from shocks to Pilbara house prices 41 Figure 25 Negative spill over effects from shocks to Pilbara house prices 41 Figure 26 Positive spill over effects from shocks to Kimberley house prices 42 Figure 27 Negative spill over effects from shocks to Kimberley house prices 42 Figure 28 Spill over effects from shocks to Perth house prices 43 ii

5 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA iii List of tables Table 1 Comparison of advantages and disadvantages of alternative investment options Table 2 Summary statistics, equity and energy prices, 2000 to Table 3 Summary statistics, house prices, Australia and capital cities, to 2014 Table 4 Correlation between house, equity and energy prices, 2000 to Table 5 Correlation between house, equity and energy prices, 2010 to Table 6 Summary statistics, house rents, Australia and capital cities, to 2014 Table 7 Correlation between house rents, and equity and energy prices, to 2014 Table 8 Correlation between house rents, and equity and energy prices, to 2014 Table 9 Summary statistics, house prices, WA regional areas, 2000 to Table 10 Correlation between house, equity and energy prices - WA regional areas, to 2014 Table 11 Correlation between house, equity and energy prices - WA regional areas, to 2014 Table 12 Estimation results - house prices, house rents and equity prices - 17 Australia Table 13 Estimation results - house prices, house rents and energy prices - 19 Australia Table 14 Estimation results - house and equity prices - capital cities 23 Table 15 Estimation results - house and energy prices - capital cities 27 Table 16 Estimation results - house rents and equity prices - capital cities 30 Table 17 Estimation results - house rents and energy prices - capital cities 33 Table 18 Estimation results - house and equity prices - WA regional 37 Table 19 Estimation results - house and energy prices - WA regional 39 vii iii

6 Executive summary This report examines the impact of equity and energy prices on house prices across Australian capital cities and regional Western Australia (WA), over the period 2000 to Energy prices, for the purposes of this study, refers to a broad range of consumable fuels (including oil, gas and coal). In recent times, there has been significant debate around, and research into, the drivers of Australian house prices. The role played by equity and energy prices, if any, has been raised but not explored in depth. The findings presented in this report shed light on the interrelationship between energy, equity and house prices to help inform policy debates. This research employs a dynamic model to investigate the short and long run impact of equity and energy prices, as well as shocks to these prices and spill over effects on house prices and rents. This is the first study to consider this dynamic relationship for key regional areas of WA, many of which are reliant on resource industry employment and investment, and therefore makes a significant contribution to the existing body of knowledge. As policy makers grapple with housing affordability issues across Australia, this report provides valuable insights into the impact of movements in equity and energy prices on house prices and rents. By conducting this research at the capital city and WA key regional area level, the report investigates how the impact of energy and equity prices varies according to the region s level of resource intensity. This is important from a policy perspective, particularly in constrained regional markets, permitting predictions of potential demand shocks which require a supply response. iv

7 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA v Key findings Patterns of housing, equity and energy prices 2000 to 2014 Trends in house, energy and equity prices varied dramatically pre and post the Global Financial Crisis. Energy prices grew at more than twice the rate of equity prices in the lead up to the Global Financial Crisis. Since then, growth in equity and energy prices has slowed markedly. House price growth slowed markedly across all Australian capital cities over the period House price growth has varied significantly across capital cities in the last 5 years. House prices are correlated with energy and equity prices, showing a strong and positive association from 2000 to House prices were more strongly correlated to energy prices from 2000 to 2007, and more closely related to equity prices from 2010 to House prices in Western Australia show the strongest correlation with energy prices, consistent with the state being the mining and resource hub of Australia. The nexus between national housing, equity and energy prices House prices in Australia are related to macroeconomic factors and equity prices over the long run. At a national level, shocks to equity prices can drive house prices down, and house rents up, over the longer term. Shocks to energy prices can drive house prices down over the longer term, but have little impact on house rents. The nexus between capital city housing, equity and energy prices Equity and energy prices, along with key macroeconomic indicators (income, inflation, interest rates) are useful leading indicators of house prices across many capital cities. The direction and magnitude of any impact that energy price shocks have on house prices and rents differs immensely depending on a region s level of resource intensity. Energy prices can have positive income effects on house prices in resource intensive regions, and negative income effects on house prices in non-resource intensive regions. Evidence suggests that equity prices have short-run effects on house rents for Sydney and Perth only; whereas energy prices have short-run effects on house rents in Perth and Hobart. The nexus between WA regional housing, equity and energy prices Energy prices are a leading indicator of changes in house prices over the shortrun in most regions of WA. Energy price shocks can have positive and immediate impacts on house prices across most WA regional areas. There is no evidence that equity prices impact house prices at the WA regional level in the short or long run. Shocks to house prices in one region of WA can spill over into other regional housing markets, with positive spill over effects occurring in those regions that are contiguous. v

8 Introduction Housing affordability is an increasingly important socio-economic issue that is attracting the attention of policymakers at all levels of government across Australia (see, for example, Cassells et al., 2014, Duncan et al 2016). Australia is widely considered to be experiencing a housing affordability crisis and Australian housing is considered by some, although the methodology is questionable, to be extremely unaffordable compared to other cities internationally (Angel, 2015). Declining housing affordability in Australia has led to significant debate about the underlying drivers of this trend. Although housing affordability is a broad term encompassing various factors (Leishman and Rowley, 2012), house prices and rents are traditionally the major focus when discussing affordability in Australia and are thus used as a proxy for affordability in this report. There are several well established drivers of housing markets: prices, population, income, inflation, consumer confidence, employment and interest rates. These factors directly impact the supply and demand of housing in Australia. Several other factors have been observed as possible drivers of Australia s housing market, including energy prices and equity prices. It has been widely suggested that the recent boom in commodity prices may have played a role in driving house prices and rents in Australia. There are a variety of transmission mechanisms through which equity prices can influence house prices. For instance, there is a direct transmission mechanism between house prices and equity prices influencing changes in consumption and investment decisions through income and wealth effects. The income effect occurs because rising equity prices increase investment income and provides opportunities to invest in other assets, such as housing. The wealth effect occurs because higher equity prices increase the value of an investment portfolio, and portfolio rebalancing often leads to greater investment in housing. House prices can also be affected indirectly by equity prices through changes in interest rates as a result of monetary policy intervention by the Reserve Bank of Australia to stimulate or restrain economic growth. Changes in the relative price of equities and housing can also give rise to a substitution effect towards the asset class offering higher returns, and thereby influence the level of housing demand. 1 On the consumption side, energy prices constitute expenditure for households and therefore any change in these prices will directly impact a current, or future, household s level of disposable income. Changes in disposable income impact housing investment decisions, for both owner occupiers and investors. Accordingly, a rise in energy prices is expected to have a negative impact on housing demand and therefore prices (ceteris paribus). On the investment side, households in resource intensive regions are likely to experience an increase in employment and income as a result of a booming local economy tied to the energy market. In this case, rising energy prices can in fact lead to a rise in income and thus have a positive impact on housing demand. Policy makers have been grappling with how to address rising house prices and rents across Australia, but lack an informed understanding of the complex interrelationship between house prices, equity prices, energy prices and resource intensity. Housing policy tends to be capital city focused ignoring the different drivers of rural and regional markets (Beer et al., 2011) many of which are particularly reliant on energy related industries. We therefore model the relationship between house prices against relevant macroeconomic variables as well as the equity price index and energy price index, for national, capital city and, importantly, WA regional areas. 1 In this study, we employ the energy price index to directly capture the impact of the strength of the energy sector on investment, employment and housing demand. This index is also used as a proxy for changes in household energy consumption costs by assuming there is a link between movements in these measures. Please refer to the Data and Methodology section for further information. vi

9 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA vii The dynamic relationship between house and equity prices Housing and equities are considered investment alternatives in financial economics. Indeed, both houses and equities tend to be important investments in people s portfolios. Many scholars and practitioners have argued that investment in housing leads to diversification benefits for investors because of its low correlation with several commonly used equity price indices. Table 1 summarises some of the advantages and disadvantages that can motivate a person to invest in housing and/ or equities. Table 1 Comparison of advantages and disadvantages of alternative investment options Capital gains Returns Tax benefits Capital gains Returns Tax benefits Investment house Yes Capital gain, Rental return Negative gearing; 50% capital gains tax discount High Management fees; maintenance costs Large Owner-occupied house Yes Capital gain No capital gains tax Low Maintenance costs; running costs Large Equities Yes Capital gain, dividends Negative gearing Medium Management / broker fees Small Piazzesi et al. (2007) and Kapopoulos and Siokis (2005) put forward several explanations to describe the dynamic relationship between house prices and equity prices. The first explanation is that of a wealth effect, which states that as equity prices rise, investors with unanticipated increases in wealth will increase their demand for housing. As such, the equity market will lead the housing market. This operates through two mechanisms because housing is both a consumption good and an investment asset. The first mechanism suggests that unanticipated increases in equity prices will lead to an increase in aggregate consumption. The second operates through portfolio adjustment. That is, as equity prices increase, households will rebalance their portfolios by selling equities and purchasing other assets, such as a house (Markowitz, 1952). Second, equity prices may have an effect on house prices through the income channel. For instance, Green (2002) highlights the fact that equity prices reflect the profitability of firms and profit-based remuneration of employees, such as wages and bonuses. In this instance, an increase in equity prices will lead to an increase in the demand for housing as both a consumption and an investment good, which will lead to higher house prices. The third explanation given to describe the dynamic relationship between house prices and equity prices is what is known as the credit-price effect. This effect suggests that because real estate serves as collateral, credit constrained firms are able to borrow more freely for investments. The credit-price effect postulates that the housing market will lead the equity market because firms holding commercial and residential properties will have large unrealised gains that will lead investors to bid up the equity value of the firm. However, because firms demand more commercial and vii

10 residential real estate to undertake more expanded investment projects, the price of commercial and residential properties will also increase, suggesting an increase in both property and equity prices, with persistent feedback effects. A fourth explanation given is that of composition risk, which relates changes in consumption expenditure to asset prices. The decisions made to consume and save depend not only on the size of future consumption, but also on the composition of that consumption and that between housing and other consumption. Since investors expect higher future consumption during expansionary periods, they sell equities during a recession in the current time period to increase current consumption, which drives current equity prices down. As such, this inter-temporal substitution drives the price of equities down during recessionary periods. Piazzesi et al. (2007) develop a model where the concern by investors about composition risk suggests that the size of this inter-temporal effect will depend on the share of housing in consumption. Their model suggests that recessionary periods will be more severe when the equity of housing consumption is low. Finally, the dynamic adjustment of housing prices to shocks in economic fundamentals is likely to create a series of lead and lag relationships between house price and equity price movements. Since house prices are slower than equity prices to adjust to shocks, the lead and lag relations identified by Granger causality can be attributed to the slow adjustment of the house market. Clayton (1996) and Himmelberg et al. (2005) show that while economic fundamentals are important factors that cause movements in house prices, house prices themselves tend to react slowly to shocks in the fundamentals. viii

11 Patterns of house, equity and energy prices 2000 to 2014

12 Equity and energy prices Over the last 15 years, house 2, equity and energy prices have exhibited some interesting trends and patterns. House prices have exhibited a range of similarities and differences across Australian capital cities. In this section, we shed light on recent trends in these markets, and how these trends varied prior to the Global Finance Crisis (GFC hereafter) and more recently from 2010 to As Figure 1 shows, up until 2004 equity and energy prices remained relatively stable with a slight steady upward trend. At this point, prices began to diverge from one another and growth in energy prices largely outstripped that of equity prices. Despite this divergence, they continue to exhibit some similarities. Overall, energy prices exhibit greater volatility than equity prices. Over the period 2000 to 2014, equity prices grew by 3.9 per cent per annum on average, whereas energy prices grew at well over twice the rate (10.3% per annum, as seen in Table 2). However, the largest growth in these prices occurred prior to the GFC where equity and energy prices grew by 8.8 and 21.5 per cent per annum on average, respectively. Both energy and equity prices exhibited greater volatility, and a sharp decline, following the onset of the 2007 GFC. This is reflected in the average annual growth rates over the past five years, which have markedly slowed to 1.4 and -3.8 per cent for equity and energy prices, respectively. Table 2 Summary statistics, equity and energy prices, 2000 to 2014 Average annual growth rate % Equity prices Energy prices Source: Standard & Poors; Author calculations. Figure 1 Equity and energy prices, 2000 to ,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, Q2 2002Q2 2004Q2 2006Q2 2008Q2 2010Q2 2012Q2 2014Q2 Equity Energy Source: Standard & Poors. 2 For the purposes of this report house refers to separate houses with the remaining dwelling types classified as other residential. Separate houses dominate dwelling types in Western Australia (80 per cent). For further details refer to page 13. 2

13 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA 3 National house prices House prices grew on average by 7.2 per cent per annum across Australia from 2000 to 2014, as seen in Table 3. The largest growth in house prices occurred in Perth (8.7% per annum), Adelaide (8.2% per annum) and Brisbane (8.0% per annum). Median house prices more than tripled in these capital cities over the 15 year period. Darwin and Perth also exhibited the highest volatility in house prices over this period. Sydney maintained the highest median house price ($562,456), followed by Melbourne ($442,386). These are the only capital cities to exceed the national average median house price of $437,239. Overall, house prices in most capital cities grew at a similar rate from 2000 to 2014 (ranging from 6.8 per cent in Melbourne to 8.7 per cent in Perth per annum, on average). However, there were marked differences in the lead up to the GFC (2000 to 2007) where house price growth ranged from 6.7 per cent in Melbourne to 16.8 per cent in Perth. Growth in house prices in Perth eclipsed all other capital cities from 2000 to 2014, especially during 2000 to 2007, although the trend has been downward since As Figure 2 shows, real house prices exhibited some convergence in late 2008 and early 2009, at the same time the GFC was coming to an end. Significant growth occurred prior to the GFC ( ), and growth rates have declined across all capital cities since this time (Table 3). From 2010 to 2014, the average annual rate of growth of median house prices fell in every capital city and across Australia (except for Sydney). Growth in house prices across capital cities has shown a degree of convergence in the last 5 years, now ranging from -1.1 in Hobart to 7.7 in Sydney. Table 3 Summary statistics, house prices, Australia and capital cities, 2000 to 2014 Average annual growth rate % Average Australia $437, Sydney $562, Melbourne $442, Brisbane $347, Adelaide $306, Perth $371, Canberra $399, Hobart $281, Darwin $395, Source: REIA, Author calculations. 3

14 Figure 2 Median house prices, Australia and capital cities, 2000 to ,0000, , , , ,000 $ 500, , , , , Q2 2002Q2 2004Q2 2006Q2 2008Q2 2010Q2 2012Q2 2014Q2 Australia Sydney Melbourne Brisbane Adelaide Perth Canberra Hobart Darwin Source: REIA. Correlation is a measure of the strength and direction of the association between two variables. The strength of the association is indicated by the value of the correlation coefficient (ranging between 0 and 1) and the sign of the correlation coefficient indicates whether the two variables move in the same (positive) or opposite (negative) direction. Correlation does not necessarily imply causality. Table 4 shows the correlation between house prices, energy prices and equity prices (both adjusted for inflation) over the period 2000 to As can be seen in Table 4, energy prices have a positive correlation with house prices across all capital cities. The strength of this relationship is highest in Perth and lowest in Sydney, consistent with the city s level of resource intensity and proximity to resource intensive regions. Interestingly, house prices exhibit a stronger association with energy rather than equity prices across all capital cities (excluding Sydney). Despite this, house prices across most capital cities (except for Melbourne and Sydney) similarly exhibit a positive correlation with equity prices. In the case of Sydney, and to a lesser extent Melbourne, higher equity prices are associated with lower house prices (and vice versa). Traditionally, it has been assumed housing has a weak relationship with equity prices hence the role of both in a balanced investment portfolio. However, the story looks vastly difference when we consider the more recent period 2010 to 2014 (Table 5). Over this period, house prices were more closely tied to equity prices, as opposed to energy prices, across all capital cities. While equity prices continue to exhibit a positive correlation to house prices across Australian capital cities, the correlation to energy prices has changed markedly. We now find a much weaker - but still positive - association between energy prices and house prices in Adelaide, Hobart, Canberra, Brisbane and Melbourne. In contrast, this period is characterised by a negative and relatively weaker correlation between energy and house prices at the national level as well as in Perth, Darwin and Sydney. Overall, these results show that there is a relationship between house, energy and equity prices, and that this relationship has undergone some interesting changes in recent times and across different regions of Australia. 4

15 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA 5 Table 4 Correlation between house, equity and energy prices, 2000 to 2014 Energy Equities Australia Perth Adelaide Hobart Brisbane Darwin Canberra Melbourne 0.50 Sydney Table 5 Correlation between house, equity and energy prices, 2010 to 2014 Energy Equities Australia Adelaide Hobart Canberra Brisbane Melbourne Perth Darwin Sydney

16 National house rents House rents grew by 5.1 per cent per annum on average across Australia from 2000 to House rents were highest in Darwin, followed by Canberra and Sydney. Perth and Darwin exhibited the strongest growth in house rents over this period, increasing by 7.1 and 6.7 per cent per annum on average, respectively. Growth in rents was higher prior to the GFC in all capital cities, most notably in Hobart (8.0%), Perth (7.7%) and Canberra (7.7%). More recently, in the period 2010 to 2014, growth in house rents has slowed across all Australian capital cities (with the exception of Sydney). In fact, house rents in Canberra have showed no growth over this period whatsoever. Sydney and Perth reported the highest growth in house rents over this period at 3.4 per cent growth per annum on average. Table 6 Summary statistics, house rents, Australia and capital cities, 2000 to 2014 Average annual growth rate % Average $ p/wk Australia Sydney Melbourne Brisbane Adelaide Perth Canberra Hobart Darwin Source: REIA, ABS; Author calculations. Overall, house rents have been relatively stable compared to house prices. The main exception is Darwin, where house rents spiked upwards and continue to outstrip all other capital cities since the onset of the GFC. As is the case with house prices, median rents were most volatile in Darwin and Perth over this period. Figure 3 Median house rents, Australia and capital cities, 2000 to Q2 2002Q2 2004Q2 2006Q2 2008Q2 2010Q2 2012Q2 2014Q2 Australia Sydney Melbourne Brisbane Adelaide Perth Canberra Hobart Darwin Source: REIA; ABS; Author calculations. 6

17 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA 7 As Table 7 and Table 8 show, energy prices have consistently exhibited a strong and positive correlation with house rents across all Australian capital cities over the 2000 to 2014 period, even after the GFC. Interestingly, house rents in several capital cities (Sydney, Melbourne, Canberra and Darwin) - as well as the national average - had a weak but negative association with equity prices over the period 2000 to However, in the past five years (2010 to 2014), house rents have become increasingly related to equity prices in all capital cities. In addition, house rents now show a positive correlation with equity prices across Australian capital cities (except for Canberra). Table 7 Correlation between house rents, and equity and energy prices, 2000 to 2014 Energy Equities Australia Hobart Brisbane Adelaide Perth Canberra Darwin 0.70 Melbourne Sydney Table 8 Correlation between house rents, and equity and energy prices, 2010 to 2014 Energy Equities Australia Brisbane Hobart Adelaide Canberra Perth Darwin Melbourne Sydney

18 The impact of a region s level of resource intensity on house prices and rents is further illuminated in Figure 4, showing the proportion of person employed in the mining industry across selected capital cities. As alluded to earlier, the impact of energy prices on house prices and rents is likely to be vastly different depending on the regions level of resource intensity. One way to measure the importance of resources to the local economy is the proportion of persons employed in the mining industry. As would be expected, Perth maintains the highest proportion of persons employed in mining, with an average of 6 per cent of all persons employed over the study period. The proportion of people employed in Perth s mining sector reached as high as one in ten in early The Northern Territory reported the second highest proportion of persons employed in the mining industry over this period. Figure 4 Proportion of persons employed in Mining in selected capital cities, 2001 to Per cent Sydney Melbourne Brisbane Adelaide Perth Northern Territory Source: ABS; Author calculations. 8

19 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA 9 Regional Western Australia In this report, we analyse house prices across key regions of WA, as depicted in Figure 5. Figure 5 Key regions of WA Source: Government of Western Australia. As Figure 6 shows, house prices across regional WA and Perth were relatively similar up until This is the same point in time when house prices and rents began to diverge across capital cities, consistent with the commodity price boom and then the onset of the GFC. At this point, energy prices soared and house prices in the Pilbara and Kimberley (and to a lesser extent, Perth) outstripped all other regions. These regions continued to record the highest house prices across WA until the 2013 downturn in prices commenced in the Pilbara. House prices in the Pilbara, Kimberley and Perth regions exhibited the most volatility over this period. 9

20 Figure 6 Median house prices, WA regional areas, 2000 to ,0000, , , , , , , , , , Q2 2002Q2 2004Q2 2006Q2 2008Q2 2010Q2 2012Q2 2014Q2 Perth Gascoyne Goldfields Great Southern Kimberley Mid West Peel Pilbara South West Wheatbelt Source: REIWA; REIA. Interestingly, from 2000 to 2014, house prices grew the most in the Mid West and Gascoyne regions, with average annual growth rates of 9.6 and 9.0 per cent, per annum, respectively. Growth in median house prices across all regions of WA outstripped that of all other capital cities across Australia, indicating that an important driver of house prices during the GFC and commodity price boom is a region s level of resource intensity. Constrained market size in these regions is also likely to have played an important role. Limited land supply, with a number of legal and physical impediments, in a geographically constrained market means prices and rents react very quickly, and strongly, to demand shifts (McKenzie and Rowley 2015). House price growth across WA soared up until the onset of the GFC, and reached as high as 20.5 and 19.2 per cent per annum on average in the Peel and Gascoyne regions, respectively. In the last five years, however, house price growth has been negative in six of the ten WA regional areas. The largest decline in house prices occurred in the Pilbara, with an average fall of 7.2 per cent per annum from 2010 to 2014, and these falls have continued. This reversal in house price growth across WA in recent times corresponds with the decline in commodity prices, contraction of the mining sector and improved housing supply. 10

21 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA 11 Table 9 Summary statistics, house prices, WA regional areas, 2000 to 2014 Average annual growth rate % WA regions Average Perth $371, Gascoyne $303, Goldfields $238, Great Southern $273, Kimberley $440, Mid West $258, Peel $317, Pilbara $482, South West $302, Wheatbelt $160, Source: REIWIA, ABS; Author calculations. As Table 10 identifies, the correlation between energy prices and house prices across all WA regional areas was strong and positive over the period 2000 to The strength of this association is also higher than for any other capital city across Australia, again providing some evidence that the level of a region s resource intensity plays a role in driving house price growth. Consistent with the capital city level results, we continue to find a positive association between house and equity prices across all WA regional areas over this period. Table 11 shows that the strength of the association between house and energy prices has weakened across all WA regional areas in recent times consistent with the fall in commodity prices. In addition, the direction of this association has reversed in the Pilbara, Perth and Gascoyne regions. In fact, house prices across WA regional areas now have a stronger association to equity, as opposed to energy, prices. All WA regional areas continue to show a positive correlation between equity and house prices, except the Pilbara and Kimberley regions where prices have fallen significantly. Table 10 Correlation between house, equity and energy prices WA regional areas, 2000 to 2014 Energy Equities Perth Great Southern South West Mid West Kimberley Wheatbelt Gascoyne Peel Goldfields Pilbara

22 Table 11 Correlation between house, equity and energy prices WA regional areas, 2010 to 2014 Energy Equities Perth Great Southern Mid West Goldfields Peel Kimberley Wheatbelt South West Gascoyne 0.02 Pilbara

23 The nexus between national house, equity and energy prices

24 Data and methodology This study examines the short and long run dynamics between house prices, equity prices and energy prices within the confines of the structure of the Australian economy. House prices are determined by two key macroeconomic variables (real income and the inflation rate), as well as two financial variables (nominal interest rate and real equity prices or real energy prices). Real income is always included in any house equation, as its importance in determining the level of housing demand and supply in the economy is well established. The price level is included to address the assertion that investment in real property can hedge against inflation. Interest rates are included to capture mortgage costs. The interest rate also captures the substitution between investing in interest earning assets and housing. Data are sourced from the Australian Bureau of Statistics (ABS), Real Estate Institute of Australia (REIA), Real Estate Institute of Western Australia (REIWA) and Thomson Reuters DataStream. Further details about the data sources and methodology are provided in the Appendix. There are several studies documenting the dynamic relationship between equity prices and house prices. These studies demonstrate that equity prices can have both short and long run impacts on house prices, and that there can be direct or indirect transmission mechanisms through which these impacts can occur. Accordingly, we estimate a Vector Error Correction Model (VECM) for each housing market of interest (Australia, capital cities and WA regional areas). This approach enables us to examine the relationship between house, equity and energy prices in the short as well as in the long run. Another benefit of this approach is that we are able to examine the impact of shocks to equity and energy prices on house prices directly at the national, capital city and WA regional level. 3 A limitation to the macroeconomic approach adopted in this report is that we are unable to distinguish between investors and owner occupiers, and how credit, income, wealth and substitution effects differ between these cohorts. This report serves as an excellent platform for future investigations into these issues. It should also be noted that the focus of this report is on house prices and rents, rather than other dwellings. There are several reasons for this approach. First, the findings of this investigation provide less conclusive results for other dwelling prices and rents. This is most likely attributable to differences in the motivations of owner occupiers and investors. Second, by focusing on house prices rather than other dwelling prices, the investigation is comparable with international literature. Third, the data for houses is the only constant definition available from the various data-sets employed in this research. There are also some important caveats to the findings presented in this report. First, the measure of energy prices, as used here, is S&P/ASX 200 Energy Price index. This index consists of stock prices of all the companies out of 200 companies listed on Australian Securities Exchange, whose business is in the energy sector. 4 3 While the use of a VECM is a popular approach in the literature, there are a number of other empirical approaches that can also be employed. For instance, Chen (2001), Green (2002), Sutton (2002), Kakes and Ven Den End (2004), and Sim and Chang (2006), use vector autoregression (VAR) modeling and the concept of Granger causality to analyse the causal interactions between house prices and stock prices. Ibrahim (2010) and Lean and Smyth (2012) use the VECM approach, while Fry et al. (2010) use a structural vector autoregression (SVAR) to assess whether Australian house prices have been overvalued for the period Finally, Yuksel (2016) employs a threshold cointegration technique that allows for threshold adjustment in the short run between house prices and its determinants, while maintaining linearity in the long run. 4 Business in the energy sector is defined by either of the following activities: the construction or provision of oil rigs, drilling equipment and other energy related service and equipment, including seismic data collection; or, companies engaged in the exploration, production, marketing, refining and/or transportation of oil and gas products, coal and other consumable fuels. 14

25 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA 15 The potential limitation of using this index is that this index is constituted from the stock prices of the energy companies rather than the retail price of energy. We do acknowledge that housing consumers looking to buy or rent houses are more affected by the running costs of housing, which includes the price of energy, rather than the stock prices of energy companies. However, there is a strong link between retail price of energy and energy stock prices. Second, the impulse response functions trace the temporal responses of one variable to a one unit shock in another variable, holding all other variables constant. While it is well known that the impulse response functions are sensitive to the ordering of variables under a Cholesky decomposition, we use what are known as generalised impulse response functions. Generalized impulse response functions fully incorporate the historical patterns of correlations among different shocks, making the impulse response functions unique, and therefore invariant to the ordering of the variables. Thus, given the likelihood that the money market and the stock market are contemporaneously correlated, generalised impulse response functions are used in this study. Third, the estimation results should be interpreted with care. An estimated coefficient indicates how the dependant variable (house prices) varies when that explanatory variable changes by one unit, holding all other variables in the model constant. However, there are a range of immeasurable factors that impact house prices that simply cannot be included in the model (such as consumer tastes and preferences) and therefore cannot be held constant by the model, and this may impact the results. In addition, it is important to remember that alternative sample periods, model specifications and estimation methodologies may generate a different set of results. Fourth, due to the dynamic nature of the Australian housing market, a change in one variable is unlikely to occur without a simultaneous change in another explanatory variable(s). While some of these factors push prices in one direction, there are always other factors at work influencing house prices in the same or opposite. In reality, one could not expect to observe the exact change estimated by the model because other variables that influence house prices are also changing simultaneously. The estimation results should not be used to predict how a change in one variable will cause housing prices to change. Rather, they should be used to shed light on what variables can influence house prices and the nature of any relationship (strength, direction and temporal characteristics). 15

26 Key findings for equity prices At the national level, the results of this study find that house prices are influenced by key macroeconomic variables and equity prices. In terms of short-run effects, the results shown in Table 12 show that changes in Australia s inflation rate are a leading indicator of house prices across Australia. Lagged real income also affects Australia s median house prices. Similarly, the rate of interest prevailing in the previous first and second quarters also has an impact on Australia s median house prices. However, equity prices have no impact in the short-run. In the long run, we find a relationship between equity prices and other macroeconomics determinants that helps explain house prices in Australia. Table 12 also reports the results for house rents. Unlike the results for house prices, these results show that there is no long-run relationship between house rents, equity prices and other macroeconomic variables. In Australia, house rents are influenced by real incomes and interest rates in the short-run, however, equity prices have no impact. 16

27 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA 17 Table 12 Estimation results - house prices,house rents and equity prices - Australia Prices Rents Dependant variable ΔHPt 1 1 ΔHPt 2 Intercept 0.04** ΔHP i t ** ΔHP i t ΔHP i t ΔHP i t (0.12) ΔCPI t ** (0.72) ΔCPI t 2 (0.68) ΔCPI t (0.75) ΔCPI t (0.59) ΔGDP t *** (0.45) ΔGDP t ** (0.40) ΔGDP t ** (0.35) ΔGDP t (0.32) ΔINT t ** ΔINT t * ΔINT t 3 ΔINT t ΔSPI t 1 ΔSPI t ΔSPI t ΔSPI t ECT t *** (0.06) 0.08 (0.14) 0.34** (0.13) 0.02 (0.13) 0.35 (0.46) (0.46) (0.35) 0.39*** (0.14) 0.26** (0.12) (0.08) () ** ** Note: Standard errors are reported in parenthesis. An *, **, and ***, represents statistical significance at the 10, 5 and 1% levels, respectively. Please note that i takes the values of 1 and 2 for prices and rents, respectively. 17

28 The Impulse Response Function (IRF) based on the estimated error correction models are shown in Figure 7. The IRF shows the impact of a positive shock from one variable on another variable over a period of time (holding all other variables constant). From these functions, we are able to assess the direction, magnitude and persistence of the response of housing prices to the stock and energy price index. In this case, we examine the impact of a shock to equity prices on house prices and rents over a period of 3 years (i.e. 12 quarters). As Figure 7 shows, Australian house prices initially have a positive response to shocks emanating from the equity market, but that effect dampens out quickly. After a period of one year, we find an inverse association between equity and house prices. The reason is that higher equity prices motivate people to invest in equities rather than housing, reducing demand for housing and therefore prices. On the other hand, house rents alternate between being positive and negative in their response to shocks from the equity market for the first eight quarters, after which they become consistently positive. This result lends support to suggestions that shocks to equity prices drives a switch in consumption from ownership to renting and, driven by investors, a fall in the supply of rental housing. The combination causes an increase in rents over the longer term. These results again support the hypothesis that people elect to rent rather than invest in, or consume, housing when returns from the equity market increase. The inverse response of house prices and rents to shocks from the equity market clearly demonstrates how movements in the equity market can incentivise people to switch between the two asset classes. Figure 7 Response of house prices and rents to shocks to equity prices (Australia) 4 2 Percentage change Quarters Prices Rents 18

29 THE NEXUS BETWEEN EQUITY MARKETS & HOUSING PRICES IN AUSTRALIA 19 Key findings for energy prices Table 13 presents the estimation results for energy prices and other macroeconomics determinants to help explain house prices and rents in Australia. The results show there is no long-run relationship between house prices and energy prices at the national level. In the short-run, we find evidence that house prices are impacted by interest rates. For the equation describing house rents, we find that lagged real income, interest rates and inflation all have an effect in determining house rents. Changes in these macroeconomic variables therefore provide an indication of future changes in house prices and rents. We find no evidence of long run effects running from energy prices to house rents. Table 13 Estimation results - house prices, house rents and energy prices Australia Prices Rents Dependant variable ΔHPt 1 1 ΔHPt 2 Intercept 0.03 ΔHPt 1 i 0.49*** ΔHPt 2 i 0.16 (0.19) ΔHPt 3 i 0.02 ΔHPt 4 i 0.07 (0.13) ΔCPI t (0.97) ΔCPI t 2 - (0.95) ΔCPI t (0.95) ΔCPI t (0.86) ΔGDP t (0.33) ΔGDP t (0.35) ΔGDP t (0.36) ΔGDP t (0.39) ΔINT t *** ΔINT t * ΔINT t 3 - ΔINT t 4 ΔEPI t 1 - ΔEPI t ΔEPI t ΔEPI t ECT t (0.14) 0.34** (0.14) 0.02 (0.13) 0.46** (0.48) (0.47) (0.36) 0.36 (0.14) 0.23* (0.12) (0.08) () -0.02** *** Note: Standard errors are reported in parenthesis. An *, **, and ***, represents statistical significance at the 10, 5 and 1% levels, respectively. Please note that i takes the values of 1 and 2 for prices and rents, respectively. 19