Australian housing prices have fallen for 15 consecutive months. The nationwide all-dwelling price index was down 2.0% year-on-year in August, with Sydney prices down 5.6%. This was Australia’s first nationwide housing price decline in six years. To be sure, prices remain 40% higher than levels in 2012, when abundant credit supply and strong foreign demand began powering the market. But these factors seem set to reverse over the cyclical horizon.
Falling house prices and rising debt-servicing costs lower discretionary income and generate negative wealth effects which may constrain household consumption and therefore prevent the Reserve Bank of Australia (RBA) from hiking its cash rate from 1.5% for some time. This is the basis for our more conservative view of a lower neutral rate and a benign environment for Australian bond yields. We also expect Australian banks to be negatively affected, given their large exposures to the housing sector directly and indirectly. The probability of an agency rating downgrade has risen.
Housing price declines tied to tighter credit availability and weaker foreign demand
Mortgage availability has tightened due to property-cooling measures and closer bank scrutiny. Over the past few years, the Australian Prudential Regulation Authority (APRA), the country’s banking regulator, has introduced various macroprudential measures to cool down the housing market. Notably, in late 2014 APRA required that banks cap the annual growth rate of loans to individual real estate investors to 10% from close to 20%. In early 2017, it required that banks limit interest-only loans as a share of mortgage underwriting flow to 30%, down from about 40%.
In addition, last December the Australian government established the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry to investigate financial sector misconduct. Under close regulatory scrutiny, banks have raised their underwriting standards. For example, they have incorporated more rigorous living-expense assumptions when assessing mortgage eligibility.
Weaker overseas investment demand is another important reason for the housing price declines. Foreign demand, mostly from China, grew rapidly between 2013 and 2016 and absorbed an estimated 15%-25% of new housing supply in Sydney and Melbourne, the country’s largest cities. To curb demand, governments in Victoria and New South Wales, the most populous states, raised their property stamp duty rate applicable to foreign investors. Victoria hiked its rate to 7% from 3% in 2016, while New South Wales raised its rate to 8% from 4%. Land tax surcharges for foreign and absentee homeowners also increased. Foreign investments in residential property plummeted by 66% during the fiscal year ended 30 June 2017, compared with the year before.
Mortgage serviceability will deteriorate further, putting downward pressure on housing prices
It is not news that Australian housing affordability is stretched. The country’s total housing debt stands at 140% of gross disposable income and mortgage payments are 38% of median pre tax income. We expect mortgage serviceability will deteriorate further due to rising mortgage rates as well as the policy-induced switch from interest-only to principal-and-interest loans.
Mortgage rates are poised to rise because bank funding costs are heading higher. The standard variable lending rate for owner occupier loans was 5.20% as of August 2018, according to the RBA, although various discounts may apply. Australian banks depend on external funding due to Australia’s structurally low savings rate, so funding costs can increase due to higher onshore or offshore interest rates, wider credit spreads for Australian banks, or a combination of these factors. We believe U.S. dollar liquidity will continue to tighten globally and investors may start demanding higher credit premiums from Australian banks, especially if investors grow more concerned about downside risks to Australian housing. As a result, the probability of out-of-cycle mortgage rate hikes in Australia has gone up. In fact, three of the country’s four major banks have recently raised their benchmark mortgage rates by about 15 basis points (bps) even though the RBA has held its policy rate constant.
We estimate that a 200 bps increase in Australian mortgage rates, a commonly adopted stress-test assumption at mortgage origination, could increase mortgage payments from 38% of pre tax income to close to 48%. This would bring the affordability gauge near its worst level over the past two decades, similar to that during the global financial crisis.
In addition, in line with new macroprudential measures since mid-2017, Australian banks have started to differentiate mortgage pricing in favor of principal-and-interest structures (See Figure 1). For example, the interest rate differential between owner-occupier principal-and-interest loans and investor interest-only ones widened from about 20 bps in mid-2017 to about 80 bps in early 2018. Banks are also less likely to issue or refinance interest-only loans. A typical owner-occupier switching from an interest-only (IO) to a principal-and-interest (P&I) structure will see their monthly mortgage payment jump by about 40%, which has a similar effect on serviceability as a 200 bps mortgage rate increase. The incremental debt service burden is significant because it can result in higher mortgage arrears and potentially weigh on housing prices further.
Estimating the downside for housing prices
We expect housing prices to continue to fall moderately by about 10% over the next couple of years. Already, the clearance rate of auctions – the most common way Australians buy and sell homes – has been falling since 2017. This signals reduced liquidity in the physical market, which often foreshadows further price declines.
However, we do not envision a housing market crash in Australia that is severe enough to threaten broad financial stability. The long-term health of the housing market is anchored by a relative balance in physical supply and demand (see Figure 2). Nationwide run-rate housing supply has come down from two years ago and is now roughly on par with run-rate housing demand. Moreover, the surplus supply of the past few years can be offset by the deficit accumulated over the decade since the global financial crisis. Over the secular horizon, Australian housing demand is supported by healthy population growth of about 1.25% annually, with approximately equal contributions from natural growth and net overseas migration.
An international comparison also suggests that Australia lacks the preconditions for a housing market crash. Key drivers of the U.S. housing crisis a decade ago – such as rapid accumulation of significant oversupply, compromised (sometimes fraudulent) underwriting practices and elevated leverage related to home equity and second lien loans – are absent. Australian mortgages are also full recourse with a strong social stigma attached to defaults. So far, the housing price correction appears purposely induced by proactive macroprudential policies, which suggests that regulators maintain decent control over the severity of the decline and have room to soften their stance if necessary. Finally, the domestic labor market remains healthy, which ultimately supports household debt repayment capabilities.
In our view, the tightening of credit conditions, a slowing housing market and deteriorating mortgage serviceability metrics will continue to curb household consumption. Furthermore, out-of-cycle mortgage rate increases by banks will keep the RBA on hold for longer. This underpins our view that the new neutral rate in Australia is low, around 3%, compared with the RBA’s estimate of 3.5%.
We expect that Australian bond yields will remain range-bound whilst still providing strong diversification, income and defensive characteristics for investors’ overall portfolios. We therefore remain neutral on Australian duration with a curve steepening bias. In our view, the likelihood of further funding pressure on the banking system will keep an asymmetric bias to the downside for the Australian dollar.
In addition, we have grown more cautious with the external credits of Australian banks. Mortgages represent two-thirds of bank lending in the country so changes in the housing market directly affect the credit profile of banks. The probability of a market-moving agency downgrade that causes major banks to lose their AA- rating for the first time in history is now higher than before. A downgrade can be triggered by weaker perceived institutional strength of the country’s banking sector, reduced sovereign support or deteriorating loan performance in a more-severe-than-expected housing downturn scenario.
Potential market dislocations of this sort can create value opportunities for active investors such as PIMCO with deep knowledge of the market.