Welcome to the Property Imperative weekly to 25th August 2018, our digest of the latest finance and property news with a distinctively Australian flavour. And what a week it was…
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Scott Morrison, the new PM must carry much of the burden for our current economic situation, which to my mind is sliding by the day. Booming debt and flat wages have combined to drag way too high home prices lower, as the number of SME’s feeling the pressure continue to rise. Sprooking high jobs growth (measured on a simplistic basis which does not report underemployment, accurately) and in an environment where the cpi for real households is much higher than the quoted number means the GDP is likely to flag, as the Aussie continues to slide against the US. The bears are it seems out in force now. You can watch my discussion with John Adams, recorded before the spill “Is Parliament Fiddling While Rome Burns” for the political context.
We expect some unnatural acts from the new man, perhaps with first time buyers offered the chance to tap into super to “buy now” and probably overt attempts to trim migration ahead of the election ahead. Remember Morrison spent time at the Property Council, so he is so to speak, pro-property, and pro-property investment – thus the debt bubble may grow further and investors enticed back, at least to some extent. This means a harder fall if or when Labor sweeps to power as the property market turns to custard, what a nice incoming present.
And analysts seem to agree the bears are out. For example, Damien Boey at Credit Suisse says that in the year-to-2017, the Australian population grew by 388,056 people to 24,782,303 residents. According to the 2016 Census, the average number of people per household is 2.57894. Assuming this number remained steady throughout 2017 (an optimistic assumption), household formation was about 150,471 (388,056 divided by 2.57894). Now it is possible for replacement housing demand to rise as high as 25,000 per annum. Therefore, an optimistic estimate of underlying housing demand is around 175,000 per annum. This is below the current level of dwelling completions of around 210,000 per annum. In other words, Australia is in a situation of marginal housing oversupply to the tune of 35,000 per annum. Consistent with this state, house prices are falling moderately. However, it is now possible that marginal oversupply could become worse, due to changes in the political climate. For example, former Prime Minister Abbott, representing the shadow conservative wing of the ruling Liberal Party, has advocated in the past that he would like to cut immigration by up to 80,000 per annum. If the immigration intake is cut by 80,000 per annum, household formation would fall to 119,451 per annum, and underlying housing demand would fall to 144,450 per annum. At the current level of dwelling completions, this would increase marginal housing oversupply to 65,549 per annum, consistent with much faster house price declines. A 40,000 per annum cut to the immigration intake result in a 50,039 per annum housing glut. On top of all of this, we need to consider the risk that if the Liberal Party loses the next election, and the Labour government wins a majority, the new government would attempt to grandfather out negative gearing provisions for investment properties.
Boey does not include the tighter credit environment and high debt which is, as we discussed in this week’s live stream event, crimping households’ ability to borrow. In fact, this is the strongest negative impact on home prices, which is why we revised down our four economic scenarios, such that we think there is only a 5% probability of the RBA’s forecast for the economy playing out. All our other scenarios are more bearish. You can watch the full event on YouTube, including the chat during the session, we had more than 300 watch live on Tuesday. Our next event will be on the 18th September at 20:00 Sydney, and its already scheduled on the channel if you want to set a reminder.
We expect the next RBA rate move to be down, not up, whilst both Barclays and RBS this week pushed out their expectation of a potential cash rate rise from the RBA, due to weaker economic conditions to late 2019 or 2020.
Home prices continue to run lower, as the latest data from CoreLogic shows, with year to date falls of 3.44% in Sydney, and 3.29% in Melbourne, plus a fall of 1.95% in Perth. But also of note is that prices are now falling faster in Melbourne, down 0.59% this month so far, compared with 0.23% in Sydney. And auction clearance rates continue to languish, as more properties remain on the books for sale.
Of course, values are still up 35.3% since the 2010 peak at the 5-city level, driven overwhelmingly by exceptionally strong gains in Sydney at 58.5% and Melbourne 40.4%. But there has been little movement elsewhere (and in fact down in inflation-adjusted terms). And remember the CoreLogic index is driven by settlement data which is weeks behind transactions themselves.
CoreLogic also showed that as well as fewer seven-figure sales occurring now as values decline, the volume of more affordable homes selling is also falling. Their analysis shows that the share of sales under $400,000 homes has continued to decline over the past year. Nationally, 29.2% of all houses and 34.6% of all units sold over the 2017-18 financial year transacted for less than $400,000. The share of sales below this price point has fallen from 30.7% for houses and 35.4% for units a year earlier. The share of sales below $400,000 has increased slightly over the past few months for both houses and units.
An historic low 13.9% of combined capital city house sales and 25.8% of capital city unit sales were under $400,000 over the 2017-18 financial year. The share of sales below $400,000 has fallen over the year from 16.2% of houses and 27.1% of units. Although capital city dwelling values are falling, there continues to be fewer sales occurring below the $400,000 threshold.
The share of sales below $400,000 is predictably much larger across regional areas of the country than within the capital cities. Over the latest financial year, 49.6% of all regional house sales and 57.3% of all unit sales were for less than $400,000. House sales under $400,000 were at a record low and down from 51.6% the previous year while unit sales under $400,000 have increased over recent months but are lower than the 58.0% a year earlier.
Then consider falling rental yields. The AFR reported that Andreas Lundberg from Montgomery Investment Management believes that the sagging yield on residential rental properties in Sydney could drive prices lower if investors seek higher yields without an increase in rents. Sluggish rental growth is weakening the income-generating prospects of property, giving buyers another reason to avoid the asset class and potentially forcing prices to fall further. Such a “de-rating” of residential property is not out of the realm of possibility. “In a rational market, rental yield should drift higher but don’t think it’s a rational market. Mr Lundberg said official data showed property rental yields in Sydney are about 2.7 per cent – well below the long-term average of 4 per cent. “In an environment where rates are no longer falling and indebtedness is very high, rental yields should become a more important consideration in where you should invest your money,” he said.
If you look at Sydney, the annual fall in rental rates is significant, according to CoreLogic data. This is one reason why property investors are, and will continue to head for the exits. Rental yields remain the lowest in Melbourne (3.04%) and Sydney (3.21%) which, given the dim prospects for capital growth and tougher credit conditions, is likely to act as a further disincentive to investors in these markets and help push prices even lower. Labor’s proposed negative gearing and capital gains tax reforms will also add to the downward pressures.
We discussed the state of the property market in a prerecord for Nines’ Sixty Minutes to be broadcast in a few weeks. You can see my video blog which tells the story of the days filming “Talking Finance and Property On Channel Nine”.
Building Company Lend Lease, in their results, which were strong, specifically called out that they were preparing for Australia’s housing slowdown. “We have been participating in a slowdown for some time and most markets are past their peak,” The Group Chief Executive Steve McCann said. Presold lots in its big residential communities slowed to 3,231 lots in financial 2018 from 3,896 in the previous corresponding period. Their sales were down -17% year on year. Their share price is off its highs but up 24% over the past year. As building approvals are still pretty strong, perhaps Lend Lease market share is lower here now. That said, they are still holding a huge land bank and have diversified from residential building. They can afford to wait for the next property boom, down the track.
Westpac’s quarterly update was a salutary lesson in what’s happening in their mortgage book. The biggest property investor lender in the country reported that its net interest margin in June quarter 2018 was 2.06% compared to 2.17% in First Half. The 11bp decline mostly reflected higher funding costs and a lower contribution from the Group’s Treasury. We discussed this in more detail in our post “Through The Westpac Looking Glass” but the primary source of higher funding costs has been the rise in short term wholesale funding costs as the bank bill swap rate (BBSW) increased sharply since February. Every 5bp movement in BBSW impacts the Group’s margins by around 1bp and compared to 1H18, BBSW was on average 24bps higher in 3Q18, reducing the Group’s net interest margin by 5bps. As well as reduced Treasury activity of 4 basis points, 2 basis points came from the ongoing changes in the mix of the mortgage portfolio (less interest only lending) along with lower rates on new mortgages. Deposit pricing changes only had a small impact on margins in 3Q18. And finally, while overall credit quality was fine, mortgage 90+ day delinquencies in Australia were up 3bps over the three months ended June 2018 with most States recording some increase.
So we see the pincer movements at work, deep discounting to try to attract new business, a switch from interest only loans, reducing interest take, a hike in funding costs and higher delinquencies. Combined these forces are enough to put considerable pressure on the bank, as well as others in the sector. Their share price fell 2.43% on Friday to 27.66, just above their 12-month low of 27.30 in June. We see more downside than upside in the banking sector and remember the Royal Commission is still grinding away.
In comparison CBA, the largest owner occupied lender was up 0.2% to 70.89 on Friday. The ASX 200 ended the week at 6,247, up a little on Friday after the ructions in Canberra this week, but below its recent highs. Again, we see more downside than upside.
The Aussie against the US Doller ended at 73.26, up 1.08% on Friday. Looking at the daily chart, AUD/USD was at one-point climbing back into its familiar consolidation range from June. By the close of play, it remains right on the May 2017 low. That was also its largest daily gain since June 4th. From a bigger picture, its dominant downtrend since February still remains in play. But for now, the pair may consolidate between near-term resistance and support. The former is around 73.82 or the August 21st high. A push above that exposes a descending resistance line composed of the July and August highs. This line also intersects the February trend, making for a potentially stubborn area of resistance. In the event Aussie Dollar pushes above that and potentially reverses its significant progress to the downside, we may eventually get to the June 6th high at 76.77.
On the other hand, immediate support is at 72.38 which is the low set on Friday. A descent under that then exposes the current 2018 low at 72.03. Continuation of AUD/USD’s dominant downtrend would then involve getting beyond the December/May 2016 lows between 71.60 and 71.45. We think the longer term trajectory will be lower as the local economy slows further. The risk is there to go below 70 cents ahead.
Across to the US markets, where the bull market is still running. The Dow Jones Industrial ended up 0.52% to 25,790, up 0.52% on Friday, still below its February highs. But the Benchmark S&P 500 stock index clinched its longest bull-market run on Friday, closing above its previous January high, as Federal Reserve Chairman Jerome Powell affirmed the U.S. central bank’s current pace of rate hikes.
The S&P had last reached a new closing high on Jan. 26, then retreated more than 10 percent, a correction that lasted until Feb. 8. Friday’s new closing high confirmed that the index’s bull run remained intact. Speaking at a research symposium in Jackson Hole, Wyoming, Powell said the Fed’s gradual interest rate hikes were the best way to protect the economic recovery, maintain strong job growth and keep inflation under control. His comments did little to change market expectations of a rate hike in September and perhaps again in December. Investors said they were reassured that Powell’s comments stayed in line with previous commentary from the Fed regarding policy. Economic data also boosted sentiment. New orders for key U.S.-made capital goods increased more than expected in July and shipments growth held firm, the Commerce Department said. The index was up 0.62% to 2,875.
However, Housing numbers continue to give the market pause. It’s recently been the part of the economy waving the most red flags. Data on existing home sales released by the National Association of Realtors on Wednesday showed a surprise drop. Existing home sales fell 0.7% in July from the previous month to an annualized pace of 5.34 million units. Economists had forecast a 0.6% increase to an annualized pace of 5.44 million. Sales are now 1.5% below a year ago and have fallen on an annual basis for five-straight months, according to NAR, especially at the lower end of the market. The report also showed that the median existing-home price for all housing types in July was $269,600, up 4.5% from July 2017 ($258,100). July’s price increase marks the 77th straight month of year-over-year gains. In addition, new home sales fell short, dropping to a nine-month low in July. New home sales fell 1.7% last month to an adjusted annual rate of 627,000 units. Economists expected a rise to 645,000 units.
And Moody’s highlighted that once again at the late stage of a cyclical boom, there are signs of excessive risk taking. This time, the most serious developing threat to the current cycle is lending to highly leveraged nonfinancial businesses. While businesses appear to be in good shape in aggregate, a significant number of highly leveraged companies are taking on sizable amounts of debt. This is evident in the rapid growth of so called leveraged loans—loans extended to companies that already have considerable debt. These loans tend to have floating rates—typically Libor plus a spread—with a below-investment-grade (Baa or less) rating.
Leveraged loan volumes are setting records, and loans outstanding have increased at a double-digit pace over the past five years to nearly $1.4 trillion. Businesses use the loans to finance mergers, acquisitions and leveraged buyouts, followed by refinancing, and to pay for dividends, share repurchases and general expenses.
Powering leveraged lending is demand from the collateralized loan obligation market. CLOs are leveraged loans that have been securitized, and global investors can’t seem to get enough of them. This is clear from the thin spreads between CLO yields and comparable risk-free Treasuries.
Approximately one-half of leveraged loans currently being originated are packaged into CLOs, with CLO outstandings approaching $550 billion.
To meet the strong demand for leveraged loans from the CLO market, lenders are easing their underwriting standards. According to the Federal Reserve’s survey of senior loan officers at commercial banks, a net 15% of respondents say they lowered their standards on commercial and industrial loans to large and medium-size companies this quarter compared with the previous quarter. The only other time loan officers eased as aggressively on a consistent basis was at the height of the euphoria leading up the financial crisis in the mid-2000s. Standards for loans to small companies have not eased nearly as much, since they are much less likely to be bundled into a CLO.
Considering the leveraged loan and junk corporate bond market together, highly indebted nonfinancial companies owe about $2.7 trillion. Their debts have been accumulating quickly as creditors have significantly eased underwriting standards. As interest rates rise, so too will financial pressure on these borrowers. Despite all this, global investors appear sanguine, as credit spreads in the CLO and junk corporate bond market are narrow by any historical standard.
Regulators are undoubtedly nervous—they issued guidance to banks to rein in their leveraged lending in 2013—but an increasing amount of the most aggressive lending is being done by private equity, mezzanine debt, and other institutions outside the banking system and regulators’ purview.
Now consider that subprime mortgage debt outstanding was close to $3 trillion at its peak prior to the financial crisis. Insatiable demand by global investors for residential mortgage securities drove the demand for subprime mortgages, inducing lenders to steadily lower their underwriting standards.
Subprime loans were adjustable rate, which became a problem in a rising rate environment as borrowers didn’t have the wherewithal to make their growing mortgage payments. Regulators were slow to respond, in part because they didn’t have jurisdiction over the more egregious players.
It is much too early to conclude that nonfinancial businesses will end the current cycle in the way subprime mortgage borrowers did the previous one. Even so, while there are significant differences between leveraged lending and subprime mortgage lending, the similarities are eerie.
We will make a longer post later on this important issue, but it does highlight that even amid the booming US markets, the bears are stalking their prey.
Finally, to round out our review, the fear index – the VIX was lower, down 3.38% to 11.99 on Friday, Gold was higher, up 1.53% to 1,213, though still well down across the year and Bitcoin ended the week at a slightly higher 6,722, up 3.5% on Friday though just one day after the U.S. Securities and Exchange Commission (SEC) rejected proposed rule changes for nine bitcoin ETFs, the Commission initiated a review of all related decisions. As a result, three rejection orders made on August 22 are now stayed pending the review by the SEC Chairman and the Commissioners. This is the first time the SEC initiated a review of its staff decisions on bitcoin ETFs. Their initial rejections were driven by concerns about the underlying markets so this just might indicate a change of view. Bitcoin of course is way off its highs of more than 18,000, but this might just signal a change in sentiment. We will see.
So in summary, the Bears are in town!
