By Alan Oster, Group Chief Economist, National Australia Bank Limited
Perhaps the biggest challenge facing the Australian economy right now continues to be the dramatic retreat of hard commodity prices from the generational highs back in 2011. This has far-reaching consequences for the economy and our customers via falls in mining investment (accounting for around half of all business investment in Australia) and lower incomes, employment demand and negative confidence effects, along with pressure on government revenues, just to name a few. In this environment, we are continually looking for cues from the global economy as to when a “lift off” in growth is likely to occur. It was hoped that large falls in oil prices would help to trigger a recovery in the global economy, but with prices somewhat stabilising more recently, the anticipated windfalls are not unfolding quite as expected.
So far in 2015, we have yet to see any clear evidence of an imminent lift in global growth momentum, at least nothing that is broad-based. If we look at the headline numbers, weak GDP results for Q1 in the US, UK and Canada have outweighed a pick-up in Japan and the Eurozone, while similarly mixed trends among the big emerging economies saw China slowing, India picking up and Brazil still very weak. Some of the more timely indicators are also suggesting that global growth is yet to pick up to around its long-run trend, as was expected. Monthly data on world production and trade flows suggests that growth in manufacturing output has lost momentum, while the volume of trade actually shrank in early 2015. Preliminary data for April shows global manufacturing output growing by around 2 percent year over year, less than half its long-run trend rate. There was a modest rise in business confidence in advanced economy manufacturing, but it is too early (and the data is sufficiently volatile) to read much into it. The limited information available on service-sector activity does not point to an upturn either (with the possible exception of Japan, where the economy is gradually recovering from last year’s tax rise).
Putting aside the mixed trends across the major advanced economies, it is China that is still very much the major driving force behind the economic fortunes of the Asian region, including Australia. China has been easing its policy stance for a number of months now, but the lack of any hard-hitting stimulus has meant that the gradual track of moderating growth has generally continued. While this will potentially be for the betterment of the economy’s stability in the long-term—switching to a more sustainable growth model—the short-term pain is playing out via subdued demand, particularly in commodity markets. The latest batch of economic partials suggested some minor improvements in May, but growth in industrial production is still close to recent six-year lows. Consequently, in June the People’s Bank of China (PBOC) cut its economic growth forecast for 2015 from 7.1 percent to 7.0 percent—consistent with the official growth target. For now, our economic forecasts remain unchanged (7.1 percent in 2015, 6.9 percent in 2016), but a growing risk is manifesting in the Chinese equity market, which has staged a remarkable rally this year (market cap more than doubled in 12 months), driven by record margin lending and novice investor participation. There was a sharp correction in late June—exacerbated by forced liquidation of stocks due to margin calls—prompting an additional 25-basis-point cut to benchmark lending rates (down to 4.85 percent, the lowest rate since at least 1989). The potential for a more destabilising collapse in equity prices is a major concern, with a loss in household wealth likely to constrain consumption, slowing the transition of China’s economy towards consumption-based growth.
Part of the increased investment in equity markets also relates to a substitution away from residential property, which is experiencing a downturn, given the generally limited selection of alternative investments available. Prices for Chinese real estate have essentially been in decline since around mid-2014, following a period of quite strong growth, and are having flow-on effects for investment activity in the sector; this has naturally been a significant event for commodity markets. Although prices for existing real estate appear to be stabilising, this is unlikely to provide support for new construction. Over the first five months of the year, residential construction starts fell by -17.6 percent YOY—although the rate of decline slowed a little in May.
Implications for the Australian economy
The completion of major mining investments means that growth in Australian export volumes has remained strong, supporting headline GDP growth. However, falls in commodity prices mean that the benefit to domestic incomes has been severely reduced—at a time when demand for labour in the industry is also dropping. Outside of the mining sector, the trends we are seeing in the global economy are not particularly conducive to stronger export demand, even in light of AUD depreciation. The RBA (Reserve Bank of Australia) continues to declare that an even lower AUD is needed to assist in “rebalancing” the economy away from mining, but the subdued global economic environment is likely to act as a significant roadblock regardless—although more positive trends have started to emerge in industries such as tourism.
Until global growth improves, we are looking inward for other drivers of growth in the Australian economy. But unfortunately, even with record low interest rates, domestic demand continues to disappoint. The Q1 National Accounts again highlighted that the domestic economy is struggling to offset the impact of sharply lower mining investment. Of particular concern is the fact that non-mining capital expenditure expectations for the coming year (as reported by the Australian Bureau of Statistics) have weakened even further—pointing to a fall in investment spending in 2015-16. Although, other capital-expenditure (capex) indicators, like those in our NAB Business Survey, suggest a slightly more upbeat outlook for non-mining investment.
On a brighter note, labour-market statistics have shown some improvement, although they have proven to be somewhat unreliable of late. Elsewhere, the recent Federal Budget and interest rate cut did appear to have a positive impact on business confidence in our NAB Business Survey, which moved up significantly in May to its highest level since August 2014. The pick-up in confidence is also a reflection of improved business conditions, which further cemented the upward trend seen over recent months. Encouragingly, leading indicators from the survey such as forward orders improved, as did capacity utilisation and capex spending. If these trends are maintained, it could signify a turning point in the economy. Only time will tell, and we remain nervous given the weak income backdrop. In the meantime, it continues to be the residential property market (at least in some areas) that is the major bright spark for the economy.
Is Australia facing a housing bubble?
Given the low interest-rate environment, demand for residential property—particularly by investors—has been incredibly strong. Residential property prices in Australia have increased 12½ percent over the past 18 months, which has been a boon for household wealth and has prompted added spending on certain items, such as household goods. However, the gains have been relatively confined, largely to the major eastern cities, with prices in Sydney and Melbourne rising 20 percent and 12½ percent respectively over the same period. Considering that wage growth has been very subdued—flat in real terms—the rise in price- (and mortgage debt) to-income ratios has peaked concerns that the market may be facing a bubble with a potentially severe market correction on the horizon.
Our view is that these concerns have been largely over-hyped. Firstly, even though price growth has been particularly strong in Sydney, and to a lesser extent Melbourne, markets in other capital cities have generally been much more subdued. Indeed, buyers who purchased an average property in Brisbane, Gold Coast, Hobart or Darwin at the peak of the previous market cycle would still be in the red, while buyers in Canberra, Perth and Adelaide have received only extremely low rates of return on their investments. Therefore, concerns of a price bubble are largely concentrated within specific markets, and conditions can even vary considerably across suburbs within any one city as well.
Looking through the variations, however, we are reasonably comfortable with the market fundamentals given sustainable rates of mortgage growth, an undersupply of housing in some markets, a lower mortgage-debt servicing burden (largely due to low interest rates) and no sign of a deterioration in banks’ mortgage assets. In fact, the most recent Financial Stability Review from the RBA highlights that mortgages with loan-to-value ratios greater than 90 percent have actually been in decline, while mortgagees are reportedly more than two years ahead of the scheduled repayments at current interest rates. Banks have been reasonably prudent in maintaining “interest rate buffers” in serviceability assessments, while indicators of non-performing loans have actually been improving. Trends in mining-exposed towns are probably the notable exception, but these account for a relatively low share of the housing stock, and lending standards have generally been tightened by banks for these towns in any case. In this environment, it seems that it would require a much more momentous deterioration in the labour market than we are expecting, and/or sharply higher interest rates, to trigger a destabilising market correction—a scenario that seems highly unlikely.
Nevertheless, the dramatic rise in investor demand for housing is being watched particularly closely by the Australian banking regulator, Australian Prudential Regulation Authority, especially in Sydney. Investor credit has increased around 20 percent over the past two years, while in New South Wales investor loan approvals now account for almost half of all mortgage loans, up from just a third in 2011. While this may have some implications for the affordability of housing, namely for low-income earners and first-home buyers, we do not see this having significant negative implications for the stability of house prices or the financial system in general. If anything, investors tend to be better positioned financially to service their loans, and past experience tells us they are more inclined to hold on to their investment properties during a market downturn, given the tax benefits involved. Despite these factors, APRA has responded—albeit with a “macroprudential light” approach—outlining prudential expectations regarding lending behaviour. These are not hard limits (e.g., investor credit growth below 10 percent) but could trigger more intense supervisory action.
It is also worth noting the role of foreign investment in the housing market. Although reliable data is hard to come by, feedback from our Quarterly Residential Property Survey suggests that foreign buyers are not an insignificant force in the market—at least in cities that have shown the most capital growth to date. The ramifications for the stability of the market are by no means clear, but again the potential impact on affordability (particularly for low-income and first-home buyers) is being vigorously debated. In response, the government has been vocal about tightening restrictions on foreign investment, at least in established property, but the results remain to be seen.
Overall, our assessment is that the possibility of a sharp correction in the Australian housing market is reasonably remote and would require a notable deterioration in the labour market and higher interest rates. However, the supply response to higher prices to date has been quite pronounced (particularly in apartments), which along with prudential measures by APRA and a persistently elevated unemployment rate (forecast to remain above 6 percent until mid-2017) will work to cap price gains going forward—although demand will remain robust while interest rates stay at record lows.