The AUD jumped on the news that Malcolm Turnbull replaced Tony Abbott as PM
The jump in our currency was more likely a response to the uncertainty ending; markets hate uncertainty. It is likely to be a short-term reprieve for the AUD. Little has changed with the real economic outlook for Australia nor the ability of a federal government to meaningfully alter this outlook. Right now we are facing headwinds on all fronts, with only the housing sector providing material support.
But, as we have highlighted in our recent Smart Income seminars and webinars, a correction in Australian housing prices is becoming one of the biggest risks facing Australian investors. Without a significant external shock, housing prices could slowly normalise without a major impact on the economy. However the risk of an external shock to the Australian economy, namely a rapid slowdown in the Chinese economy, is rising, and coinciding with housing prices at record highs and rental yields at recent lows.
Firstly, the logic behind this statement - following the mining investment boom, Australia’s economy needed to replace that activity. Construction has provided a replacement, but the problem is that the current pace of construction is well in excess of sustainable construction levels. Australia had a shortfall of housing in Brisbane, Sydney and Melbourne which was pushing up housing prices steeply. That shortfall has now been reduced to zero in both Brisbane and Melbourne, and at the current pace of construction in Sydney, the shortfall will be filled there by 2017/18. That means that construction activity will slow over the next few years regardless of any steep correction in prices. BIS Shrapnel, arguably the best forecasters of Australian housing activity, expect dwelling commencements (construction activity for housing) to be 5% lower in 2016 compared to 2015, with only NSW still growing (just).
However, if there is some external shock to the housing market and confidence or even prices fall sooner than expected, construction will slow very quickly. So a housing market correction of any description is a risk for all investors in the Australian economy. Investors in shares or property are particularly at risk, but term deposit and other fixed income investors will also receive lower interest in such a scenario as the RBA is very likely to push rates lower in response.
That shock can come from a number of areas, or a combination of these:
- Oversupply pushes down rental income to the lowest annual growth in 20 years Oversupply is growing as the largest risk to the Australian housing market. As undersupply of housing shifts to oversupply, rental yields will drop. Signs of this have already started, rental prices in August were lower in every city except for Sydney. Lower rental prices naturally lead to lower investor interest.
- Chinese sharemarket crash hits foreign investor demand Chinese investors in Australian property are the same people that invest in China’s sharemarket, i.e. the upper middle class. There has been a lot of commentary about the Chinese sharemarket crash ’only’ impacting 50 million Chinese, but these are the same people that are investing in Australian property, so there will be some impact on their confidence and willingness to invest offshore. That sharemarket crash is too recent to have seen any noticeable impacts yet, but if there is to be an impact, it will hit the clearance rates in Sydney, Melbourne, Brisbane and Perth over the next 1 to 2 months.
- Investor lending cuts by regulators Both APRA and the RBA have given banks the message that they need to cut the level of investor lending from their current record levels. Media headlines suggest that this has started, but investor loans still grew at 16.5% in the year ended 30 July. So there is a lot more that can be done to cut lending if the regulators choose to do so. A sudden drop in investor loan approvals will impact prices when clearance rates drop, lowering confidence.
- Apartment market deposit defaults Investors buying ‘off the plan’ might not have to settle for up to 12-24 months later and typically have an indicative approval from their bank but not guaranteed approval. With lending to investors being tightened, these investors may find themselves struggling to secure the investor loan they need, and this typically leads to buyers defaulting on their purchase. This in turn leads to forced sellers and downward pressure on prices, particularly in inner city markets.
On the other hand, as we expect interest rates to remain low, investors will accept lower cash yields as they will find term deposits, shares and bonds also offer lower yields. So there is a gentle decline scenario for Australian housing in which there is a slow deflating of the investor market which leads to prices remaining flat while rental yields catch up. If the impact of any of the above shocks remains small, this is the likely scenario. If one or more of these cause a confidence crisis and prices drop sharply, the Australian economy as a whole will suffer.
In summary, any signs of a decline in the housing market will prompt the RBA to favour easing interest rates. This means that a slowing housing market is good news for long duration bond investors and investors in foreign currencies (as the AUD will likely fall if rates drop).