Australian Market Strategist, Saxo Bank Group
Summary: Recession-free since the early 1990s, Australia has long been the exemplar of economic nirvana. But now, with a cooling labour market and tighter lending standards, cracks are beginning to emerge.
The elementary driver of the exponential boom in home prices and bank balance sheets in Australia is the accumulation of debt as interest rates have collapsed to a record low over the past 30 years. Australia now has one of the highest debt to income ratios in the developed world at 189%. But now the tables are turning as home prices have become unaffordable for the average person, supply is rife, foreign demand is dwindling and perhaps most importantly, banks have tightened the screws on lending standards, cutting off the supply of credit to a nation of people who have gorged themselves on debt with Australian households being some of the most leveraged in the world.
National home prices fell 0.7% over the month of November and in Sydney this slide was double the national average. According to CoreLogic this is the worst month on month slide since the Global Financial Crisis.
The epicentre of this downturn is focussed in Sydney where the 10% drop in prices since the peak in July last year is outpacing the declines seen in the late 1980s during the last recession.
Looking forward into 2019 it is likely that the East Coast housing market will continue to slide as credit conditions keep tightening with the banks self-regulating, weighing on the growth outlook for the year ahead. Despite this, panic has not yet set in among both homeowners and the central bank. For homeowners in Sydney the pullback has taken prices back to September 2016 levels as Deputy Governor of the Reserve Bank, Guy Debelle pointed out.
At present the Australian economy is in reasonable health, growing at a steady place with benign levels of inflation consistently below the RBA’s target band. According to Debelle we are in “unchartered territory” as house prices are falling whilst the labour market is strengthening, and unemployment is also falling, now sitting at its lowest level since 2012. The RBA is banking that a strengthening labour market will offset the potential hit to consumption off the back of declining house prices.
That said, the RBA is becoming anxious that lending standards have tightened significantly, and that continued credit constriction may add fuel to fire. The Australian newspaper has reported that “Reserve Bank governor Philip Lowe is understood to have met with the big bank chiefs in recent weeks to caution them against an overzealous tightening of credit supply in response to lending rules and the Hayne royal commission”.
The RBA is treading a fine line here given the decades of bad behaviour of the banks exposed in the banking royal commission which has led to tighter lending standards and the epic build-up of debt on household balance sheets from the property binge threatens long term financial stability. But it is important to remember the hit to households and the economy from a housing market crash would be dire. Though, it could be argued the unwind of credit excesses is eventually necessary to press reset on the economy and fix the problems with real change rather than keep inflating asset price bubbles in a bid to “extend-and-pretend” as our Chief Economist, Steen Jakobsen notes.
In fact, just recently, in a bid to extend-and-pretend blowing bubbles Australia’s prudential regulator announced it is removing the 30% limit on interest only lending along with the 10% growth cap on lending to property investors, confirming the financial regulators are concerned about the credit downturn and accelerating falls in property prices. The Australian Prudential Regulation Authority said the restriction had “served its purpose” as the proportion of new interest-only loans has halved since the cap was introduced last year.
The Q3 lending data shows that interest only loans made up 16% of new lending, in 2015 this figure was almost 50%. Following the introduction of the cap, rates for these loans repriced higher, correspondingly the removal should reduce rates. Interest only loans are typically used by investors utilising negative gearing concessions and whilst house prices continue to slide investor demand is weaker and is likely to remain so even if rates on interest only loans come down a touch. However, the move is unlikely to cause a meaningful increase in credit supply as banks will continue to tighten credit standards and serviceability measures in the wake of the banking royal commission.
Tougher credit checks and verification of borrower income and expenses are in full swing, as the Australian Financial Review reports “no application is spared a forensic look at discretionary spending.” The royal commission final report is due to be submitted to the Governor-General by 1 February 2019 and it is highly unlikely credit standards are loosened in the run up to this event.
What would it take for the RBA to get worried?
The risks to the downside would become more severe if unemployment were to rise in the midst of hit to economic growth or in the wake of the Royal Commission banks further tighten lending standards resulting in lower loan supply and higher loan costs. A self-perpetuating feedback loop could then ensue as prices fall further and loan supply is still tight, mortgage stress rises, defaults rise particularly for those with less equity in their homes, vulnerable mortgagees can then no longer afford their mortgages and are forced to sell their homes. As unemployment increases this further perpetuates that vicious circle as those with loss of unemployment are forced to sell sending prices spiralling further down. If this scenario were to unfold the RBA would have no choice but to cut the cash rate and depending on the severity of the slowdown implement quantitative easing as a policy response, another scenario outlined by Debelle in his December speech.
How is the economy holding up?
All eyes are on the household indicators with house prices continuing to fall and consumption accounting for around two-thirds of the economy. As we previously noted, household spending stumbled in the Q3 GDP, weighing on growth. The effect of a sustained fall in the housing market is a key risk to the RBA forecasts and not to be underestimated. The household savings ratio fell to 2.4%, the lowest level since the financial crisis, but this drawdown is failing to support strengthened household consumption. Household spending growth slowed from 0.9% in Q2 to 0.3% against a declining household savings ratio. The risks arise whereby as house prices fall, households may feel less comfortable with running down their savings especially if wages are stagnant, eventually consumption takes a hit. The combination of soft household consumption and negative household income growth per capita is cause for concern against the backdrop of a cooling housing market, tighter lending standards and a slowdown in global growth predicted for next year.
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