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Tuesday, September 28, 2010

House prices do not inexorably increase

If the RBA’s ‘central case’ comes to pass, which would involve a surge in resources investment on the back of China and India’s industrialisation notwithstanding weak US and European growth, we can expect to see it raise the target cash rate at least four times to 5.5 per cent with an upper bound of six per cent. Note that this is exclusive of any additional ‘top-ups’ delivered via the banks.

Subject to the speed with which the RBA lifts rates, which is an important variable, this may generate modest month-to-month dwelling price depreciation across Australia, although the city-by-city outcomes will vary markedly. While dwelling prices may track sideways or correct somewhat, we expect that total gross returns (ie, capital growth plus direct or imputed rents) to remain in positive territory, just as they did during the GFC.

When Glenn Stevens cautioned households earlier in the year that house prices do not perpetually increase, he probably had this hawkish eventuality in mind. Of course, it beggars belief that any reasonable person would think that asset prices always rise.

Based on RP Data-Rismark’s Hedonic Index, we can identify at least five occasions since 1993 when national dwelling values have fallen. All of these corrections, which share a common characteristic that I will discuss later, were small in magnitude with the largest on record being the 3.8 per cent peak-to-trough decline experienced during the GFC.

Compare this with, for example, the Australian sharemarket, which has frequently suffered losses of five per cent or more on individual days, and fell by an extraordinary 50.5 per cent between September 2007 and January 2009.

Having successfully picked the 2-3 per cent calendar year price falls in 2008, and the robust recovery in 2009, we had been projecting a soft-landing in the national housing market since the end of last year. The zero capital growth registered in the June quarter accorded with our forecasts.

More recently, we have stated that we did not anticipate much, if any, capital growth in the second half of 2010 given that dwelling prices had already accreted by 4-5 per cent, which was in line with consensus estimates for calendar year disposable household income growth. (Recall that there is a close correlation between changes in dwelling prices and disposable incomes.)

At the time, our modal case was predicated on a measured tightening of monetary policy despite the futures market suggesting otherwise (at one point it was pricing in rate cuts through to end 2011). In the last month expectations have, however, shifted discernibly.

Perhaps the most important revelation was the projection released by the newly appointed Chief Economist of HSBC and 12 year RBA veteran, Paul Bloxham. While nobody can purport to accurately forecast the future, Bloxham is intimately appraised with the RBA’s response function subject to a range of possible employment, growth and inflation outcomes. If the RBA’s optimistic projections materialise, Bloxham is probably the best current guide to the trajectory of rates over time. And he is forecasting five hikes. This more hawkish contingency materially boosts the probability of a downward adjustment in dwelling values as buyers, who tend to discount the future rather heavily, modify their growth expectations. Think of this as similar to the impact of analysts downgrading their earnings forecasts.

Market intelligence indicates that if the RBA does go in October, which we believe is likely, the majors will add-on 15-20 basis points extra to recover funding cost leakages. This would, therefore, be tantamount to the best part of two hikes in relatively short order.

If the third quarter inflation print is on the high side, which would be a core measure of greater than 0.7 per cent, and unemployment trends down for the remainder of the year towards the 4.75 per cent level that is associated with ‘full employment’, the RBA will start thinking seriously about one further hike prior to Christmas. This would be motivated by the need to both cauterise burgeoning price pressures and to ensure that the household sector, which accounts for the bulk of economic activity, does not shed its conservative cloak and revert back to the saving and spending patterns that existed prior to the crisis.

Given that around nine out of every ten mortgagors in Australia have variable rate home loans, sharp rate hikes have a proven track-record of crushing dwelling price inflation. Using the RP Data-Rismark Hedonic Index, we can identify at least five episodes since 1993 when the RBA has jacked up rates with an immediate impact on observed dwelling price growth: mid 1994 to 1995; late 1999 to end 2000; late 2003; mid 2007 to mid 2008; and late 2009 to the current day. In each case, the increase in the cost of capital resulted in capital city dwelling price growth shuddering to a halt, or declining for a period thereafter (see the chart below). We have no reason to believe that 2010-11 will be different.

Borrowers applying for loans today should be prepared to service rates that are 150 basis points higher than what they are currently paying. They can, however, take succour from the fact that the peak rate is unlikely to endure for too long, and the ‘through-the-cycle’ headline mortgage rate should average between seven and eight per cent (ie, before any discounts).

To the extent that default rates and distressed sales tick-up a bit during this period, attractive investments may present themselves to patient buyers. But investors should not budget for long-term capital gains in excess of disposable household income growth.