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Friday, November 26, 2010

Housing heading towards dead-zone

Last weekend Australia’s housing market declared it had arrived in the dead-zone, with RP Data’s national weighted auction clearance rate slipping below the crucial 50 per cent threshold for the first time since 2008 (there was actually a one-weekend blip below this benchmark in February 2009). Consistent with our long-held projections, there has been a monotonic decline in the national clearance rate following its 75.5 per cent apogee in March this year (see chart).

Australia’s housing market looked to have stabilised after a soft patch over June, July and August. Dwelling prices were flat-lining and credit growth had begun building momentum. I expect this to be reflected in our October house price index results, which will be published next week.

Yet the surprise decision by the RBA to lift rates in November having resolved not to do so in October, combined with the major banks’ hefty top-ups, was akin to a surgical ‘double-tap’ from a Special Air Service Regiment operator’s Browning 9mm. It has suffocated any nascent recovery and stopped the market dead in its tracks. As the next chart below shows, sustained rate rises have a habit of doing that.

Recall also that around 95 per cent of all new Australian home loans are variable rate products, which means that the RBA-triggered increase in the cost of capital has, for the time being, killed off any improvement in demand.

The headline variable mortgage rate, which sits at 7.80 per cent today, has now moved beyond its recent historical average of 7.40 per cent (ie, since the advent of the RBA’s inflation targeting regime) into genuinely restrictive territory for the first time since November 2008. Household interest repayments as a share of disposable income are similarly creeping back towards the mid 2008 highs when the headline variable mortgage rate hit a gut-punching 9.6 per cent.

And all of the ‘partial’ indicators that RP Data and Rismark carefully track in real-time, including the stock of unsold homes available for sale (supply), the average time between listing and sale, the amount by which vendors have to discount their homes below the list price in order to effect a sale, and auction clearance rates imply that more soggy price conditions lie in wait (see charts).

The two principal bulwarks of support girding the national market, Sydney and Melbourne, are also starting to buckle under the weight of a rising interest rate burden and economic weakness outside of the resources sector.

In this respect, it is interesting to note that the third quarter GDP numbers, which are released next week, are likely to come in well below Q2’s above-trend 1.2 per cent pace. In fact, it is possible that Australia’s economy experienced little-to-no growth in the three months to September.

This does not, however, mean a great deal. The RBA’s objective has always been to put households and other interest rate sensitive areas of the economy into the central banker’s half-nelson in order to make room for the unprecedented investment stimulated by our once-in-a-century terms of trade boom.

One sneaky dividend yielded by this strategy is that the RBA also gets to engineer a gradual deleveraging of household balance-sheets as the incentive to save increases while the higher cost of gearing dissuades credit growth. Here I was wrong to question earlier in the year the RBA’s ‘cautious consumer’ thesis. I should have realised that the Bank was telling us that this was not a matter of choice: if households did not play-ball and pull their horns in, the Bank would force them to do so via its interest rate whip.

For those that would question the sanctity of the RBA’s high-growth ‘central case’, consider that the domestic investment that has already commenced but which has not yet been completed (ie, projects currently underway) represents an extraordinary 20 per cent of GDP. And this will be further amplified by the stunning pipeline of planned projects that have not begun.

To my mind, the third quarter was always going to be an economic air-pocket. We had the unusual conjunction of a European sovereign debt crisis, scaremongering by US deflationistas, an election in which the RSPT/MRRT tax was on the line, a hung parliament, and uncertainty about the integrity of the Chinese and Indian growth stories.

With Australia’s economy so heavily reliant on one sector (given the RBA’s commitment to crueling everything else), we will experience more volatility than in days past, as the RBA itself has repeatedly warned. But with a lot of this turbulence ostensibly behind us, I am expecting the fourth quarter and 2011 data flows to start once again providing positive surprises (with the exception of those deriving from the interest rate sensitive sectors).

The RBA believes that the fundamentals underlying Australia’s housing market are exceedingly firm. On the demand-side, household incomes will benefit from the income shock delivered by the terms of trade boom, which will help mitigate higher interest rates. The unemployment rate will also slowly drift back towards its 4.5 to 5.0 per cent full-employment threshold while population growth will remain healthy to staunch our enduring labour shortages.

In contrast, every credible economist agrees that housing supply in Australia is a serious policy problem with new starts running well below the rate of household formation. Public and private sector estimates of the theoretical housing shortage tend to range from 150,000 to 250,000 homes and growing at circa 40-50k per annum.

For the time being, these structural drivers are being thwarted by restrictive monetary policy settings, which, perversely, will only serve to reinforce the severity of the underlying shortage by further disincenting new housing investment.

To be clear, this is not what the RBA wants: at a recent event the RBA was asked by an analyst whether it would like to see less housing investment across the economy. The RBA responded that, on the contrary, it is now convinced that Australia suffers from a very substantial housing investment deficiency, and that policymakers should work to foster much higher levels of supply-side production (this was not the RBA’s position back in 2003-04 when it underestimated the extent of the inherent supply-side rigidities that were increasingly constraining the market’s ability to seamlessly accommodate new demand). Yet with dwelling prices tapering and interest rates escalating, no developer is going to be brave enough to ramp up their activities in the near-term.

Once the RBA’s current tightening cycle ends, these fundamentals will rapidly reassert themselves via an unprecedented housing construction boom underpinned by solid, through-the-cycle capital gains.

We are nevertheless forecasting weakness over the next 12 months if the RBA fulfils the consensus economist’s expectation of 3-4 cash rate hikes. This would likely lead to nominal and real dwelling price declines, which is no bad thing and would help eviscerate the myth that asset prices always rise. We also think that Rismark’s June quarter national dwelling-price-to-income ratio estimate of 4.6 times will compress somewhat over the third and fourth quarters, which will assuage valuation concerns.

Rismark has a team of four full-time PhDs dedicated to analytics and forecasting. We got 2008 right by projecting only trivial national nominal dwelling price declines. According to our market-leading hedonic index, the actual peak-to-trough correction was slightly less than four per cent. In late 2008 we stated that we thought the 2009 recovery would surprise on the upside, as it did. And we got a little ahead of the curve with our projected 2010 soft-landing, which we thought would come near the start of 2010 rather than in the second quarter.

Since the beginning of the year we’ve argued that we were not expecting national dwelling price growth of more than 4-5 per cent, which is why we have been bearish on the second half outcomes. Looking ahead, we think 2011 will afford astute investors some attractive buying opportunities as stress levels rise.

Some bears like to typecast us as very bullish because of our efforts to dispel the many myths peddled by doomsayers during the GFC. But as a matter of record, we have never publicly projected dwelling price growth beyond that realised by disposable household incomes. And in contrast to those who are genetically negative, we have been able to consistently pick cyclical changes.