MARKET INSIGHTS Market Bulletin May 5, 2017 Australian Housing: What s new in macro-pru In brief The acceleration in house prices, compared to the more modest growth in the broader economy, has ratcheted up concerns on financial stability and household leverage in the face of possible higher interest rates in the future. The use of macro-prudential rules is not new and further rules may be introduced to cool down the housing market. The Reserve Bank of Australia (RBA) prefers to keep broader interest rates on hold until clear signs of economic momentum emerge. The cooling of the housing market could dampen economic activity, impinging on earnings of domestically-focused companies, and is another reason that investors should be exploring the upside in international equity markets. The Australian housing market has so far defied the rest of the economy as prices have continued to accelerate against a more modest economic backdrop. The housing market looks out of balance on many metrics and the East coast markets look particularly frothy. The real concern surrounds the impact of household leverage and the affordability of debt as mortgage holders confront the prospect of higher interest rates. The RBA and other regulators are becoming increasingly focused on ensuring financial stability and using a broader suite of tools to maintain it. In this note, we consider the macro-prudential rules established by these authorities and their impact on the housing market, as well as what that implies for the broader economy and interest rates. Kerry Craig Global Market Strategist
THE MARKET THAT NEVER DE-LEVERED To paraphrase a Clarke and Dawe sketch on debt, John Clarke jokes the issue is not about being able to afford what you want to buy, but being able to afford the cost of the debt to buy it. Like most comedy, it contains an element of truth. Households have been able to increase their debt burden as the cost of servicing that debt has fallen (Exhibit 1). Unlike other developed economies, Australia managed to avoid a recession post the global financial crisis, as such households never had to de-lever or reduce their debt levels, leaving them with some of the highest debt-to-income ratios in the developed world. Low rates have enabled increasing amounts of leverage EXHIBIT 1: HOUSEHOLD DEBT SERVICE RATIO AND DEBT-TO-DISPOSABLE INCOME PERCENT OF ANNUALISED HOUSEHOLD DISPOSABLE INCOME 20 18 16 14 12 Household debt to disposable income (left) 10 Debt servicing ratio (right) 8 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 Source: Australian Bureau of Statistics, FactSet, RBA, J.P. Morgan Asset Management. Data are as of May 1, 2017. 14% 12% 1 Borrowers could soon find themselves in trouble as rising yields will raise the cost of debt. The broadening out of economic growth around the world and commensurate rise in expectations for inflation and longer-dated bond yields will eventually lead to higher mortgage costs for households. As foreign bond yields rise, the funding costs for Australian banks increase, which are quickly passed on to the consumer. The out-of-cycle rate hikes by the big retail banks in response to higher yields are evidence of this. Meanwhile, the fading headwinds to Australian growth (we have likely passed the bottom in the unwind of resource sector investment, commodity prices are no longer in freefall and the terms of trade are once again rising) means that the RBA itself is likely to be considering if the next official policy rate move will be higher rather than lower. 8% 6% 4% AND IS OUT OF SYNC The challenges facing the Australian economy as a whole over the past couple of years have barely touched the housing market. The rise in house prices has consistently outpaced income growth, raising the debt burden for many homeowners. Most recently, house prices increased 11% yearover-year in April according to CoreLogic data, a slower rate of appreciation than in March. However, most policy changes have had little impact other than a brief slowdown in the second half of 2016. The introduction of macro-prudential rules in late 2015 and an average increase in investor lending rates of 23 basis points since August 2016 failed to cool things off. The 50 basis points reduction in interest rates by the RBA in 2016 worked against these factors. However, it has been investors, rather than owner-occupiers, that have kept the housing market buoyant. As Exhibit 2 shows, the 1 threshold in growth imposed on investor lending in 2015 led to a sharp drop in lending to investors, and a reclassification of mortgages to owner-occupiers. However, the clear acceleration in investor mortgage growth during 2016 suggests that the investors have not been perturbed by rising prices or the tightening in credit standards. Applying the brakes to investor lending EXHIBIT 2: GROWTH RATE IN INVESTORS AND OWNER-OCCUPIED MORTGAGES ANNUALISED, 3-MONTH MOVING AVERAGE 12% 1 8% 6% 4% Investor 2% Owner-Occupier APRA threshold '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 Source: APRA, RBA, FactSet, J.P. Morgan Asset Management. Data are as of May 1, 2017. 2 AUSTRALIAN HOUSING: WHAT S NEW IN MACRO-PRU
ARE POLICY OPTIONS RESTRICTED? In the good old days, central banks had a clear remit. In the RBA s case, that was to keep inflation in check and running somewhere between 2-3% over the medium term. This level of inflation suggests that the economy is humming along nicely, avoids inflation (or deflation) risks and offers markets some reassurance about how the central bank may react to the economic cycle their reaction function. Today things are decidedly more complicated and there is an increasing focus on areas outside of simply targeting a band for inflation. This means central banks have had to develop a new box of tools. Many, including the RBA, have turned to macro-prudential rules, which allow for a level of greater precision than the blunt instrument of interest rate changes. The macro-prudential rules are designed to target the rise in riskier lending more specifically higher loan-to-value ratios and interest-only loans in an attempt to reduce future stress on the financial system, should interest rates rise. The new target to reduce interest-only mortgage lending to 3 of total new residential lending (currently 39%) should reinforce the 1 speed limit on investor lending growth, leading to a reduction in lending growth overall. The RBA is caught between record-high levels of household leverage and accelerating property prices on one side, and an uncertain labour market and record low wage growth on the other. The new macro-prudential rules provide some breathing room between these two conditions. Hiking interest rates to cool the housing market may only act to dampen the domestic recovery, while cutting rates to spur corporate expansion and hiring would add fuel to the housing market. Macro-prudential rules are likely to reduce activity in the housing market as loan demand falls and lead to a cooling of house prices. Given the close relationship between financing and building approval, building activity is also likely to decline in the year ahead (see Exhibit 4 in next section). However, the tightening in lending rules is probably not enough to offset the persistent demand for housing both by domestic and foreign buyers. Auction clearance rates have remained elevated and suggest that sturdy house prices will continue, at least in the near term (Exhibit 3). As such, a cooling of the housing market rather than a crash is our base case. Persistent demand is likely to prevent sudden crash in house prices EXHIBIT 3: AUCTION CLEARANCE RATES AND DWELLING PRICES 3MMA YEAR-OVER-YEAR CHANGE 85% 75% 65% 55% 45% Source: ABS, RPD CoreLogic, FactSet, J.P. Morgan Asset Management. Data are as of May 1, 2017. The RBA may not be satisfied with just two rounds of macroprudential tightening. It is impossible to rule out an interest rate hike should house prices continue to accelerate. However, the April Financial Stability Review signalled that rules could be tightened more if the existing measures do not cool lending to riskier borrows fast enough. Further restrictions on lending overall, such as restricting loan growth on specific loan-to-value ratios, imposing potentially higher capital ratios or increased risk weightings against investor lending for banks, could also be implemented. THERE IS A RISK TO BROADER ECONOMIC GROWTH The challenge the RBA faces is that a slowdown in housing activity could weaken the economic outlook through both building activity and household consumption. As Exhibit 5 (next page) shows, the year-over-year decline in building approvals could create a drag on growth via reduced building activity in the coming quarters. Tighter housing finance should slow building activity EXHIBIT 4: PRIVATE SECTOR BUILDING APPROVALS AND HOUSE FINANCING YEAR-OVER-YEAR CHANGE, 3-MONTH MOVING AVERAGE 6 4 2-2 Auction clearance rates 3mma (adv. 5 months, lhs) Dwelling prices y/y (rhs) 35% '09 '10 '11 '12 '13 '14 '15 '16 Private sector building approvals Total ex refinancing (adv. 5 months) 6 4 2 2 15% 1 5% -5% -1-2 -4-4 '06 '08 '10 '12 '14 '16 Source: ABS, FactSet, J.P. Morgan Asset Management. Data are as of May 1, 2017. J.P. MORGAN ASSET MANAGEMENT 3
Curbing lending growth may limit building activity and growth EXHIBIT 5: HOUSING CONTRIBUTION TO GDP AND BUILDING APPROVALS PPTS YEAR-OVER-YEAR CHANGE 2.5% 2. 1.5% 1. 0.5% 0. -0.5% -1. -1.5% -2. -2.5% Private dwellings contribution to GDP (lhs) Building approvals (y/y) 1q fwd (rhs) '86'88'90'92 '94'96'98'00'02'04'06'08 '10 '12 '14 '16 75% 6 45% 3 15% -15% -3-45% -6-75% Source: ABS, FactSet, J.P. Morgan Asset Management. Data are as of May 1, 2017. The increase in housing investment acted to offset the decline in mining investment over the past few years. Now the RBA will be looking for a pick up in non-mining business investment and in hiring to support wage growth and higher levels of consumption in the economy, as well as offsetting the decline in disposable household income as mortgage costs rise. INVESTMENT IMPLICATIONS The outlook for the Australian economy has improved thanks to fading headwinds that have constrained domestic growth in the last few years. Meanwhile, the more synchronised global economy means strong economic activity in Australia s trading partners. Any slowdown in the housing market will be a hindrance to domestic activity and the earnings outlook for those companies and sectors more reliant on the domestic economy for earnings growth. As such, investors should consider increasing their allocations to international equities, particularly those outside of the U.S., where valuation metrics look more attractive and analyst expectations for earnings growth continue to rise. The ASX 200 at 15.8x forward priceto-earnings is 12% above its long-run average. Compare this to European equities, which are currently trading in line with their long-run average, or even to emerging markets, which are currently trading well below long-run averages on a priceto-book ratio. 4 AUSTRALIAN HOUSING: WHAT S NEW IN MACRO-PRU
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