Tuesday 04 September 2018 by Warren Hogan Opinion

Housing the major risk to the economy

Consumers are still spending, reducing savings to maintain lifestyles despite weak wages growth. Warren Hogan sets the scene for a declining housing market and an RBA rate cut

Housing the major risk to the economy

The ongoing weakness in Australian wages, despite strong employment growth over the last 18 months, raises the very real risk that consumers could cut back spending. Falling house prices, global tensions and domestic political dysfunction are not helping.

Thus far consumers are hanging in there, reducing saving rates to maintain a modest pace of consumption growth. But further headwinds could knock the consumer off balance, resulting in a meaningful slowdown in consumer spending and with it, economic activity over the year ahead.

Housing the major risk

The most prominent risk right now is the housing market. Households typically put small, short term price falls into a long term context. But a bigger and more sustained fall could chip away at wealth perceptions. In the context of weak real income growth, it could force a reassessment of saving and consumption decisions.

The next few months could prove pivotal for the Australian economy if the housing market continues to weaken and wages fail to pick up. If these risks come to pass, the immediate policy response from the RBA could be to cut rates, particularly if more banks join Westpac, Suncorp and Adelaide in hiking mortgage rates in response to rising funding costs.

We are now inextricably tied to the cost of credit in international markets. The Fed’s tightening is our tightening, even if our domestic economy is slowing.

For real estate agents with a long list of properties for sale this spring the news of higher mortgage rates has just made their lives that much more difficult. To say it is a buyers’ market is an understatement. There is genuine concern among buyers about the state of the market. Higher mortgage rates are the last thing a nervous market needs ahead of the busiest period of the year.

Housing on a knife edge

So far, the downturn in the residential property markets has been orderly with both supply and demand falling in the major markets given tighter credit conditions and a reduction in investor activity. Price declines have been small. Turnover has fallen substantially, by as much as half in some markets. 

The mortgage market is in a state of flux and assessing supply of housing finance is difficult given unique conditions that have formed in recent years. The decision to manage stability risks in the banking system with macro prudential policy tools has caused a sharp reduction in the supply of new mortgages to investors. High loan to value ratio (LVR) mortgages are harder to get, while interest only loans are also more difficult and expensive, to acquire.

These macro prudential tools have successfully removed marginal players and speculators from the market and appear, until now, to have been the main contributor to slowing residential property sales.

More recently, the major banks have responded to the Bank Royal Commission’s scrutiny by tightening lending criteria under the guise of responsible lending practises. Banks are asking for much more information about income and expenses when approving mortgages. Feedback I have had in the market suggests a sharper focus on lending criteria has cut the loan size many people can take out by as much as 20% compared to a year ago.

Ironically, banks are fighting harder than ever for high quality borrowers. Some banks are offering bigger discounts to new borrowers with strong income positions and lower sub 80% LVRs.

These conditions have made for a quiet winter property market with auction clearances rates hovering between 50% and 60% in most markets. This is broadly consistent with stable property prices. But as we move out of winter and into the busiest time of the year for property sales, the market is on a knife edge.

New listings are down but properties on the market are well up. This is because it is taking longer to sell than in recent years. This suggests the market isn’t clearing at current price levels and further price falls are required. If new listings rise through the spring selling season, then this downward price pressure will intensify.

Critically important to the property market, having kept the downturn ‘orderly’ is a favourable macro backdrop. The economy is growing at a healthy rate of about 3%, enough to keep modest downward pressure on the unemployment rate. Employment boomed in 2017, the strongest year for job creation ever. So far this year, it is still growing but at a slower pace.

Equally, interest rates remain steady. For the past two years, the RBA cash rate has stayed at multigenerational lows of 1.5%. However, market interest rates on longer term maturities have been contained by low inflation and low global bond yields.

Consumer attitudes to housing have deteriorated

Many young Australian’s doubt they will ever own a house and property speculation has increasingly become a primary avenue to wealth creation for Australians. The property boom has been propped up on the view that our economy is strong and high rates of immigration will maintain property demand for years to come. 

Despite rental yields falling to levels equivalent to government bond yields and interest only loans becoming a major source of housing finance, most people are comforted that they will always be able to sell the property to someone. Let’s hope so, because if any of these assumptions proves incorrect our property markets could be in real trouble over the next few years.

Since the mid 1970s, the Melbourne Institute has asked people the wisest place for their extra savings, offering several different options including bank deposits, spend it and pay off debt.

One option is real estate, likely meaning residential property for most people. In response one in four Australians on averaged said property was the wisest place for savings. While the responses can move around with the property market and economic cycle, this average has been reasonably stable over the past 40 years.

Australian’s attitudes to real estate
Australian's attitudes to real estate
Source: Westpac-Melbourne Institute
Figure 1

The highest reading was just under 50% as Australia emerged from the early 1990s recession. The lowest reading was 10% a year ago. The number of Australians who favour property has plunged in the past year to unseen levels. At the moment only about one in eight Australian’s see property as a smart bet, a 40 year low.

Market momentum is weak as we enter the spring selling season. Credit has tightened and funding costs are rising. With consumer attitudes towards property at record low levels it looks like a very difficult period ahead. There is a real risk that the orderly adjustment seen in the past year will become a full blown bear market.

Falling house prices and weak wages growth could threaten consumption

Over the past 20 years the household saving rate has displayed a strong relationship with consumer attitudes to debt and liquidity. In Figure 2, I have constructed a consumer attitude to debt indicator from the Westpac Melbourne Institute Survey of Consumer Sentiment. I show this plotted, over time, against the statistician’s estimate of the household saving ratio.

Historically, the saving rate seems to be heavily influenced by consumer attitudes to holding liquid assets and paying off debt. This was most evident throughout the GFC. The relationship appeared robust until recently. Over the last three years, consumers cut back on savings despite maintaining a high degree of caution around debt and liquidity.

Consumer attitude to debt and the household saving rate
Consumer attitude to debt and household saving rate
Source: Westpac-Melbourne Institute
Figure 2

Consumers aren’t saving as much in recent years because income growth is weak rather than because confidence in the future is strong. This indicator suggests consumer attitudes to debt remains cautious, essentially unchanged since the GFC. Over the last two years however, the saving rate has fallen back to levels last seen prior to the GFC, when consumers exhibited much less caution about debt and liquidity.

The big question is how sustainable this is. Persistently weak income growth will eventually result in consumers reassessing this saving/consumption mix. A downward adjustment to spending would weaken domestic demand and undermine economic momentum, potentially damaging employment and business investment in 2019.

We are getting some hints of this starting to play out with data released this week. House prices continued to fall in the major markets in August with Sydney prices now down by over 5% since this time last year. Melbourne prices are also falling with only the smaller markets such as Hobart and Canberra showing any growth.

Retail sales were flat in July and are growing by less than 3% in annual terms. While this follows some good results in the second quarter, retail sales will respond to house price declines with a lag. Within retail sales it is the discretionary spending components that are weakest, again consistent with this view that Australian consumers are re-assessing their spending plans.

If weaker consumer spending starts to produce negative feedback loops back into housing and equity markets, the onus will be on policymakers to act as a circuit breaker, through a combination of monetary and fiscal stimulus. For the RBA the half full glass could start to look increasingly empty.

In this environment, particularly if it combined with a weakening inflation trend, the RBA would likely do an about-face and cut the cash rate.