CS: RBA wrong on construction crash

So say the excellent Damien Boey at Credit Suisse:

RBA Deputy Governor Debelle has just delivered a “glass half-empty” speech about the housing construction cycle. Key points were as follows:

  1. 2020 shapes up as being the low year for residential construction, but the Bank can see through the trough to the other side.
  2. Long lead times on higher-density construction, and tight lending conditions for developers may elongate the downturn.
  3. The house price cycle has turned, but in the opposite way to the construction cycle, with different profiles across states.
  4. Falling house prices have exerted a negative wealth effect on consumption. The Bank has estimated that every 10% fall in house prices tends to cause a 1.5% fall in consumption over time.
  5. Falling house prices have negative impacted state stamp duty receipts … but this has not resulted in state governments changing their expenditure plans materially, so there has not been a pro-cyclical impact. Noting that state governments are funding constrained, unlike Federal governments, Debelle is making a veiled reference to the fact that many state governments have presumed upon Federal/RBA funding to finance future infrastructure spending, without fleshing out the details of how.

We totally understand where Debelle is coming from. Building approvals are tracking at much lower levels than completions at present, with the lead-lag between approvals and completions lengthening in recent years. So it makes sense that the Bank is bracing itself for the worst of the downturn to come. We also think that supply cuts are a key part of the equilibrating mechanism to support house prices, given that demand has been restrained for some time.

All of this said, we think that the RBA is overestimating the supply recovery time. In our view, 2020 will not just mark the low point for residential construction – but the inflection point. History tells us that rising (real) house prices tend to go hand in hand with a positive spread between dwelling approvals and completions. In other words, developers tend to plan for supply increases when they see house prices rising, because rising house prices are a sign that demand is strengthening. House prices have started rising robustly since the Federal election. Therefore, we would expect approvals to be outstripping completions. But they are not – at least, not yet. Therefore, the risk is that completions fall quite sharply in the near-term, consistent with rather weak 3Q and possibly 4Q real GDP growth. The risk is also that approvals start to stabilize, if not rise.

Now one could argue that there is circularity in this argument. If supply starts to rise, does this not cut short the house price recovery? Possibly yes. But we struggle to explain the recent recovery in house prices by reference to housing turnover levels alone. Housing turnover has risen to be sure – but not sufficiently to cause house prices to rise at the pace they are rising at. Remember that just as not all dwellings are created equally, so not all buyers are created equally as well. Some buyers are net new buyers, such as foreigners, investors and first homebuyers. In contrast, people moving houses do not add or detract from the housing demand-to-supply balance, because they give up a home to buy a new one. The key issue therefore is to isolate what net new buying activity is doing. Given that housing turnover has only increased moderately (and still remains at low levels historically), and given that first home-buying and investor participation have only increased moderately, the only logical conclusion is that foreign participation has increased too. This makes sense given that net permanent arrivals are accelerating. It also makes sense given developments in Hong Kong …

If indeed strong migration, and rich migration is supporting the housing demand cycle, along with credit easing and rate cuts, we can see a case for house prices rising, independently of what happens with supply. Indeed, room is created for supply to bottom out much sooner than many, including the RBA, think.

What is the risk to all of this? Strong foreign buying is often a sign of something going wrong somewhere else in the world. A temporary pick up in foreign participation can be a very welcome, albeit unsystematic, surprise in the short-term – but longer-term, the problems elsewhere in the world driving the exodus/influx of capital, can weigh on global growth, and eventually, the local housing market. Indeed, historically, Hong Kong capital inflows (rather than outflows) have correlated with rising house prices abroad. Moreover, when the next crisis hits, the RBA has pretty much told us that there will not be much left in rates to cut.

Our view is that the short-term picture for housing is better than what the RBA is suggesting, while the long-term picture is much worse. We also think that funding constraints for state government infrastructure spending from the housing downturn will be dealt with effectively. Our contrarian position supports a tactically positive view of cheap domestic cyclicals within the equity market.

Meh. This is no ordinary cycle. Mass immigration has killed income growth and apartment build quality. The banks are not lending into this mess. It’s not yet a financial dislocation of scale but it’s not about to turn on a dime, either.

We see any looming housing shortage triggering demand side retrenchment rather than supply side expansion, as more folks live together, and living standards fall.

As for Hong Kong, there’s no evidence of any material influx into property. I can just as easily discuss falling migrant quality as it shifts to the Indian sub-continent away from rich Chinese. They are much less property-intensive.

As well, the unfolding terms of trade accident is going to make it all worse.

Both the RBA and Treasury will have to put the pedal to the metal just to keep the Aussie economy above water in the next eighteen months and that’s before any external shocks appears.

David Llewellyn-Smith
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