MB Member’s Report: Australian property’s greatest test

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Three of Australia’s four main housing data providers – the Australian Bureau of Statistics (ABS), RP Data-Rismark, and Residex – have provided their capital city house price indices results for the December quarter of 2013, with Australian Property Monitors due to report their results later this month.

With the bulk of the data in, and strong capital growth recorded over the 2013 calendar year, it is an opportune time to examine the state-of-play of the Australian housing market and to provide some pointers about the future. Individual capital city reports will be released throughout the year focusing on the current position and outlooks for each major market.

The current state-of-play:

At the national capital city level, house price growth accelerated over the second half of 2013, with the ABS (3.2% 1H; 6.1% 2H), RP Data (3.0% 1H; 6.7% 2H), and Residex (3.0% 1H; 5.1% 2H) all reporting a marked pick-up in growth (see next chart).

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It was a similar case for units, with the ABS (+2.6% 1H; +5.3% 2H), RP Data (+0.5% 1H; 6.0% 2H), and Residex (+1.9% 1H; +3.4% 2H) all experiencing a sharp acceleration in unit price growth over the second half of the year (see next chart).

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The strong momentum looks set to continue into 2014.

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While RP Data has registered a slowing of price growth in the first two months of the year (i.e. 1.2% growth over January and February), auction clearance rates recently hit an all time high on heavy volumes, suggesting buyer interest remains intense.

Moreover, arguably the single best short-term indicator for house price growth – housing finance commitments – continues to grow strongly which, given past strong correlations, suggests that prices nationally will continue to increase throughout the year (see next chart).

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But valuations are stretched:

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The release earlier this month of the ABS’ labour price index revealed that wages growth has slumped to the lowest level on record, with wages nationally rising by just 2.5% in the December calendar year, which was also slightly below the rate of inflation (see next chart).

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With house prices nationally growing at around 10% in 2013, Australia now finds itself in the precarious position whereby housing values are growing at roughly four times the pace of wages – a situation that can only ever be maintained for a short period of time.

In fact, when adjusted for inflation, Australian housing values are fast approaching their mid-2010 peak – a level that could be surpassed this year in the likely event that the strong price momentum continues (see next chart).

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A similar picture is painted when the value of Australia’s housing stock is compared against the nation’s GDP. As shown in the next chart, housing values are only 5% below their all-time highs, also suggesting that Australian housing could hit peak valuation sometime this year (see next chart).

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And growth is increasingly unbalanced:

One unusual feature of this housing boom is the extent to which it is being driven by investors. As shown in the next chart, investor’s share of housing finance commitments (excluding refinancings) hit 45% in the December calendar year, just below the all-time peak of 46% in mid-2003, with Sydney once again driving the lion’s share of investor demand (see next chart).

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Arguably, the current make-up of Australian mortgage demand is not conducive to sustainable house price growth. Investors, whose decision to purchase property are based on weighing-up alternative investment returns, are more likely to be fickle and cut-and-run as soon as conditions change, or more profitable opportunities are presented elsewhere. This places Australian housing on a more fragile footing than if demand was driven primarily by owner-occupiers, who tend to buy into housing for the longer-term.

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But we’ve been here before, right?

A common argument used to support Australia’s high housing values is that they have hovered around this level for around a decade, with similar levels of investor speculation in existence back then.

While a superficial examination of the above two charts supports this contention, the fact is Australia’s economy is on a very different trajectory than was the case a decade ago, with the economy facing multiple challenges.

A decade ago, Australia’s economy was about to embark on the biggest commodity price and mining investment boom in the nation’s history – a boom that would significantly boost Australian incomes and employment.

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Indeed, an examination of the next chart suggests the Australian housing market was spared from experiencing a correction in 2004 by the sharp rise in commodity prices and the terms-of-trade. The extra disposable income generated from the commodity boom arrived just as the growth of mortgage debt was beginning to wane, enabling home prices to remain elevated. While rising housing debt was the key driver of Australian home prices up until 2004, strongly rising incomes from the commodity boom played the greater role since, with rising debt reasserting itself only recently.

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The flipside is that falling commodity prices and the terms-of-trade could be expected to weigh on house prices going forward. As commodity prices fall, national income is reduced, pulling down wages growth, company profits, and Budget revenues.

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The terms-of-trade’s impact on household income is illustrated clearly in the next chart, which plots the annual growth rates in per capita household incomes and the average growth rates for each decade:

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As you can see, the terms-of-trade induced surge in household incomes over the 2000s was remarkable, with real per capita income growth averaging an extraordinary 2.8% over the decade, well above the 0.7% average growth rate experienced over the 1980s or the 1.2% average growth rate experienced over the 1990s. By contrast, between 2010 and 2013, real per capita household income growth has averaged just 1.0%, despite the terms-of-trade index still sitting above where it was at the beginning of this decade.

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Indeed, late last year, the Australian Treasury forecast that average per capita income growth would halve over the next decade to the lowest rate of growth experienced in 50 years, weighed down by the falling terms-of-trade (see next chart).

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To the extent that commodity prices and the terms-of-trade continue to retrace back towards their longer-term average levels, it will detract from household income growth. And with it, much of the income gains enjoyed over the 2000s will be unwound, weighing on asset valuations, including housing.

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The deteriorating employment outlook is another fundamental difference between the Australian economy today compared with a decade ago.

Earlier this month, the ABS released its labour force figures for January, which revealed that for the first time in more than a decade, Australia’s unemployment rate was 6%. In fact, the last time Australia’s unemployment rate had a six in front of it was back in July 2003.

However, what is clear when looking at the past is that in July 2003, the trajectory of the unemployment rate was going down, whereas today unemployment is rising (see next chart).

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The difference is even more stark when one looks at the growth in employment and the labour force:

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In July 2003, employment was growing at 2.1% per annum, compared with the meager 0.3% in the year to January 2014. Further, despite the high unemployment rate, the period prior to July 2003 had seen employment grow by more than the overall labour force in 16 out of the previous 21 months. By contrast, January 2014 marked the 14th consecutive month where employment grew by less than the size of the labour force. So for more than a year not enough jobs have been created to absorb the new entrants into the labour force – a far cry from the situation a decade ago.

To add insult to injury, full-time employment has been hardest hit by the recent labour market weakness, with the number of full-time jobs contracting by 0.9% in the year to January 2014, compared to 1.5% growth in the year to July 2003 (see next chart).

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Clearly, while the housing market was just as inflated a decade ago, values were at least supported by strong employment growth and falling unemployment, followed by strongly rising incomes. However, the situation today is the polar opposite, with the labour market deteriorating and anaemic income growth. These headwinds will obviously make it harder for house price growth to be maintained, while at the same time raising the real prospect that prices could correct in the event that unemployment rises significantly from current levels.

The economic outlook is deteriorating:

The medium-term outlook for the economy is also worrying. The once-in-a-century mining investment boom, represented below by “engineering construction”, is set to decline sharply over the next few years as large mining projects, such as the three liquified natural gas projects in Gladstone (valued at over $60 billion), are completed.

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While the exact timing of the unwind is uncertain, the below forecasts from Deloitte Access Economics are as good as any and highlight the expected trajectory of the decline:

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According to Reserve Bank of Australia (RBA) estimates, the mining sector accounts for nearly 10% of Australian employment, with most of these jobs in areas directly related to mining capital investment, such as construction workers, engineers, and other mining services. As mining projects are completed, much of the labour utilised during the construction phase will no longer be required, leading to a material increase in unemployment unless other areas of the economy can expand sufficiently to fill the void.

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One area the RBA has targeted to pick-up the employment slack is dwelling construction. However, as shown above, dwelling construction is relatively small when compared to engineering construction (which is mostly mining investment), leaving it poorly placed to fill the mining investment void. For example, for every 10% decline in engineering construction, dwelling construction would need to increase by around 25% just to keep overall construction levels constant- a highly improbable proposition.

The latest capital expenditures (capex) intentions survey, released by the ABS, also does not inspire confidence in the outlook. Capex intentions for 2014-15 came in far worse than expected (-17%), signalling a sharp contraction over the next year. To add insult to injury, the non-mining economy is not expected to pick-up the slack as mining investment declines, due to ongoing weakness in the manufacturing sector, where capex intentions have slumped to lows not seen since the early-1990s recession (worse when adjusted for inflation).

Arguably, a perfect storm is developing for the labour market, with the planned closure of the Australian automotive assembly industry by 2017, which is expected to lead to the loss of up to 50,000 jobs, coinciding with the collapse of mining capex and the loss of tens-of-thousands of mining-related jobs.

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Adding to these pressures, the downturn in employment caused by the unwinding of the mining boom will be met by a longer-term decline in the participation rate and working aged population as the baby boomer generation retires, resulting in a falling share of workers in the economy.

Already, these two factors – lower labour force participation and a falling employment-to-population ratio – have begun to manifest in the official labour force statistics, with both measures trending down sharply since late-2010 (see next chart).

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Population ageing will see a continued contraction in the share of workers in the economy, creating headwinds for the economy and asset valuations into the future.

Bottom-line:

While Australian housing is likely to be well supported in the short-term, propelled along by positive sentiment and intense investor activity, it appears to be accelerating into trouble.

Given current momentum, Australian housing valuations are likely to hit their highest level on record later this year just as the economy enters its biggest adjustment since the early-1990s recession. Unemployment is destined to rise materially over the next few years as large scale mining projects are completed and the Australian automotive industry shutters. Meanwhile, income growth is likely to remain anaemic as the unwinding of the biggest commodity price boom in the nation’s history continues to drag on national incomes.

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Australia’s authorities do have some ammunition left in the chamber in the form of further interest rate cuts and stimulus, such as the reintroduction of first home buyer grants, which should help to support housing values. Equally, however, immigration could fall significantly as the economy deteriorates – as generally occurs during economic downturns – taking some of the steam out of housing demand.

More broadly, the point of this report is that while nobody knows how the deteriorating economy will play out for the housing market, the unfolding structural adjustment makes gearing-up into property a risky proposition despite some favourable cyclical signals. The risk of correction sometime in the near future is arguably greater now than at any other time in living memory.

About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.