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Saturday 5 January 2019

Housing market hits the buffers

Yield spreads compressed

Please note that this free blog is a collection of opinions and hopefully interesting observations rather than financial advice - an obvious point, I know, but one that needs to be reinforced from time to time!

With that aside out of the way, a point I raised yesterday - the remarkable weakness in inflation - sparked off a bit of online discussion which is worth exploring a bit further.

With thanks to the social media contributors, including highly respected economists Dr. Alex Joiner of IFM Investors, Jordan Eliseo of ABC Bullion until very recently, Justin Fabo of Macquarie Bank, and of course those other economists that prefer to maintain online anonymity!

I've drawn on some of their thoughts below. 

This chart is all the more interesting when you look at what has contributed to the little inflation there is.

Take smokes, for example, which have apparently been mandated to keep increasing in price by 12½ per cent per annum above average earnings growth from now until the end of time (OK, more accurately, this legislation was extended out from 2013 until at least the year 2020). 

The biggest contributor to headline inflation for quite some time, therefore, has been tobacco, contributing a thumping 0.6 per cent over the 2018 financial year!

Bad news for smokers, but take tobacco out of the equation and inflation is considerably weaker still.

Consumer pushback time

We're now 18 months beyond the end of a multi-year cycle wherein a positive wealth effect likely saw some consumers blindly accepting consumer price increases.

But this period of modest pricing power is now over, with new housing market entrants and recent upgraders far less likely to spend freely with Sydney and Melbourne housing prices declining quite sharply in 2018 (joining Perth and Darwin, which have already experienced a downturn). 

Instead these consumers will be pushing back hard against consumer price increases for non-discretionary items, and seeking out alternative consumption choices while the price of their biggest asset is experiencing deflation (options that are increasingly available through outlets such as Amazon Australia, Aldi, and others).

We may well see a fall in the rate of administered price inflation, while market goods and services inflation ex-volatile items has already been floundering at about 1 per cent seemingly for ages, which an uptick in wages isn't going to change in a hurry. 

The economy just hasn't been strong enough to generate inflation. 

In fact underlying inflation increasingly looks more likely to fall to 1½ per cent than hit the Reserve Bank's optimistic forecasts. 

Conservative buffers

The Reserve Bank has held firm on interest rates, happy to wait until things pick up, but time, tide, and the next global downturn are apparently waiting for no man, and their patience may prove to be self-defeating in the midst a tightening credit cycle.

The way the housing market deteriorated in the latter half of 2018, the sharp fall in money growth - and soon housing starts - will at some point put pressure on the Reserve Bank to reduce rates further. 

The prudential practice guide APG 223 on residential mortgage lending discussed ADI serviceability policies to incorporate a sensible interest rate buffer of at least two percentage points, while a prudent ADI would use a buffer above this level, say 2½ per cent.  

In 2018 it was further required that mortgage assessments incorporate interest rate floors "comfortably above 7 per cent", which is arguably now too conservative given that the next move in interest rates is increasingly likely to be down according to financial markets (at the very least, there are no imminent hikes). 

Financial markets appear to believe that domestic risks are steadily building, and that the tightening cycle in the US is almost cooked.

The Aussie mortgage market landscape has changed significantly over a period of some years, with higher risk lending reduced sharply, high LVR lending at the lowest level on record, and interest-only lending curbed dramatically.

Meanwhile, there are risks building: Chinese investors have been clubbed out of the market, several hundred billion dollars of interest-only loans are falling due to be reset, apartment projects are floundering, and prices are falling. 

With the hot air long since sucked out of the housing market and home loans available from around 4 per cent, prospective homebuyers should theoretically be presented with an opportunity to get into the market.

But this may prove to be too difficult if they are stress-tested for a 7¼ per cent mortgage rate scenario which appears to be increasingly remote.