+ About David Bassanese
David Bassanese is one of Australia’s leading economic and financial market analysts, who has authored several investment books and works in a number of advisory roles.
David is Chief Economist at BetaShares, which involves providing economic and investment portfolio advice to both retail and institutional investors. David is also an economic advisor to the National Institute for Economic and Industry Research.
Prior to these roles, David was Economics Commentator with The Australian Financial Review, where is regular “Bassanese” column appeared three times per week, as well as monthly in Smart Investor Magazine.
David’s analysis and commentaries cover local and international economic trends, interest rates, the exchange rate, and share market analysis.
Prior to becoming a Fairfax business columnist in 2003, David spent several years in financial markets as a senior economist and interest rate strategist at Bankers Trust and Macquarie Bank. David started his career at the Federal Treasury in Canberra, after which he spent several years as a research economist at the Organisation for Economic Cooperation and Development in Paris, France.
David has a first class honours degree in Economics from the University of Adelaide, and a Master in Public Policy from the J.F Kennedy School of Government at Harvard University.
Wednesday, February 15, 2017
Despite the shenanigans in Canberra, corporate Australia seems to be getting on with the job.
After I suggested just last week that the economy may be experiencing its own version of the “Trump bump”, we got more positive signs on the outlook in the past week. Business sentiment has gone through the roof, and the RBA has backed up its recent optimistic statements on the economy with a detailed justification of its views in the latest quarterly Statement on Monetary Policy.
Of course, it’s important not to get too carried away, but parts of the economy appear to be stirring. The hope is that this will eventually translate into stronger corporate earnings, especially in the non-mining sectors. That said, if the economy is really picking up, we can forget about rate cuts this year, and there’s even a chance of rate hike by Melbourne Cup day. Under such a scenario, the $A could also conceivably re-test US80c, especially if coal and iron ore prices also defiantly remain firm.
Last Friday in its statement, the RBA doubled down on its optimistic outlook for the economy by dismissing the negative September quarter GDP result as largely reflecting “temporary factors”. Bad weather delayed some high-rise residential construction projects, and ever-volatile public investment saw fit to decline in the quarter. More seriously, consumer spending was also soft in the quarter, but already retail sales volumes, at least, did bounce back nicely in the December quarter.
That said, even allowing for a reasonable bounce back in growth last quarter, the RBA concedes growth through 2016 was likely only around 2%. But this disappointment has done nothing to shake the RBA’s faith that growth will lift to a 3% pace in 2017.
Why the optimism? For starters, business surveys suggest the decline in mining investment is close to bottoming out, meaning it will be less of a drag on growth. What’s more, LNG exports volumes are slated to pick up nicely, contributing an extra 0.5% to growth both this year and next year.
Critically, however, the RBA is also counting on residential construction staying at a relatively high level despite the clear downtrend in new home building approvals that is now evident. Its confidence is based on the fact that much of the lift in home approvals in this cycle has been for high-rise apartment blocks, which take around three times longer (a year and half) to build than more traditional stand-alone homes – meaning there’s a lot more work still in the pipeline than is usual when building approvals start to turn down. Most of this work is slated to take place in Sydney, Melbourne and Brisbane.
Of course, this longer-than-usual lag between home building approvals and actual construction leaves us with two risks down the track: some current plans might still be mothballed if conditions change, and there’s a greater risk of an eventual supply-demand mismatch (most likely over supply) later. But for now at least, new supply is being absorbed reasonably well in the hot markets of Sydney and Melbourne, though new apartment prices have already started to decline in the less buoyant market of Brisbane.
Elsewhere in the economy, the RBA is also counting on household spending remaining reasonably steady, and the long-awaited recovery in non-mining investment finally gathers steam just as the home building boom eventually fades. Even public infrastructure projects are contributing to growth.
The great immediate test of this optimism will be the labour market.
Reflecting improved economic growth this year, the RBA is counting on some lift in employment growth in coming months after moderation through 2016 - and it expects the unemployment rate to “edge lower” over the next year or so. But while continued gains in job ads and a firming in corporate hiring intentions points in this direction, the RBA did note these lead indicators have proven overly optimistic on the labour market over the past year.
Of course, whether the RBA is right or not remains to be seen. But this week’s National Australian Business survey for January certainly counts in its favour. The NAB’s measure of business conditions shot up from +10 to +16 last month – or equal to levels seen in the pre-financial crisis boom period. While conditions in the consumer and business service sectors remain steady at a high level, driving the improvement in recent months has been decent recoveries in the mining, manufacturing, transport and wholesale sectors. To my mind, that suggests rising commodity prices and the cranking up in export volumes are making conditions at least “less bad” in these still relatively soft sectors.
Of course, we might still worry about what may happen when the housing sector eventually turns down if non-mining investment remains missing in action. But then again, one of lessons of recent years is that our remarkably resilient economy in recent decades has always seemed to find a growth driver to latch onto.
Wednesday, February 08, 2017
Is Australia already starting to enjoy the “Trump bump”? A smattering of positive economic data in recent weeks and an upbeat outlook from the Reserve Bank suggests the economy could well shake off the impact of the impending slide in home building fairly well. If so, it would be a great relief to Canberra and the RBA and suggests the share market could well post another year of positive returns, thanks to a belated lift in corporate earnings.
We’ll see of course, but to my mind, the tentatively improving outlook suggests simply persistent low inflation won’t be sufficient to goad the RBA into cutting interest rates further this year – especially with the Sydney housing market still red hot. What will also be necessary are clear signs that the labour market is deteriorating, as would be evident with the unemployment rate piercing through the 6% level again.
So why all the positivity? Perhaps the single best timely indicator on the economy is the National Australia Bank’s monthly business survey. The latest survey covering the month of December revealed an encouraging rebound in economy-wide business conditions, after having been on the slide since mid-2016.
The improvement was fairly broad-based across sectors, with gains in transport and wholesaling particularly impressive. The NAB economists – who have been calling two RBA rate cuts this year – tried to look for the weak spots, noting that conditions in the retailing sector remained poor. But even in retailing, the latest survey showed a strong lift in forward orders during the month. As an indicator of consumer spending, moreover, the NAB survey could be given as a misleading read or at least reflect lags, as we know retail sales volumes rebounded by a solid 0.9% in the December quarter, after close to flat reading in the June and September quarters.
What appears to be particularly hurting retailers is not sales so much (though new foreign entrants and online retailers remains an intensifying threat), but the sheer lack of pricing power. According to the official retail sales survey, retail prices rose a meagre 0.3% in the December quarter, and only 1.3% over 2016. It’s little wonder underlying consumer price inflation remains so low.
It’s just a hunch, but perhaps one of the reasons for the relative strength in transport and wholesaling as reported by the NAB is the rapid growth in online retailing – we’re buying online and having stuff delivered to our homes or offices rather than venturing into shops. The solid gain in resource export volumes is another factor supporting transport.
Otherwise, the strongest sectors in the NAB survey are in finance, property and business services, along with recreation and personal services. Again, another reason for the ailing traditional retailing sector is that we are buying more “experiences”, through services such as massages, travel and eating out, rather than clothing, take-home food or household goods.
The other clear positive percolating through the economy is the amazingly persistent strength in coal and iron ore prices. While they’ve come off their boil in recent weeks, they remain at high levels – and the outlook has improved from the despair of early 2016, thanks to signs that China has no choice but to continue pump-priming housing and infrastructure activity to keep the economy ticking over, while also cutting back on excess capacity in its own high cost and highly polluting coal and iron ore industries.
Judging by the RBA’s post-meeting Statement on Tuesday, the Bank still seems to see more blue skies than rain clouds ahead. For starters, it downplayed the negative September quarter GDP result suggesting it “largely reflected temporary factors” – which we know were factor like poor weather which hampered some construction projects and export shipments. The Bank then confidently expressed the view that its “central scenario remains for economic growth to be around 3 per cent over the next couple of years.” As gleaned from various surveys, that’s still toward the top-end of the range of market-economist expectations (including my own), and suggest the RBA won’t revise down its growth outlook by much at all in this Friday’s Statement on Monetary Policy.
Given the RBA talks to an extensive range of business contacts on a regular basis, the fact it remains relatively upbeat on the economic outlook is encouraging. That said, while the RBA is not the worst economic forecaster in the country, even it is not infallible.
More generally, however, my sense is that the RBA may be getting a little more comfortable with below-target inflation, especially if it coincides with above trend growth (as it expects) and associated downward pressure on the unemployment rate. Indeed, provided low inflation does not reflect deficient demand – but rather “positive supply shocks” such as new entrants and productivity-enhancing technology shocks – it could actually be construed as an economic positive that enhancing real incomes.
All this suggest that a rate cut as early as May will also be a stretch – even if annual underlying inflation stays close to 1.5% in the March quarter report in late April – unless we also start to see the unemployment rate defying the RBA’s optimism and push back above 6%.
Wednesday, February 01, 2017
Despite the various risk factors faced by the Australian equity market last year, it’s perhaps remarkable that it managed to produce a fairly decent outcome. In analysing the reasons, we can really focus on two factors: bond yields and China. Barring a spanner in the works from Donald Trump, the good news is that these factors may continue to keep the market ticking over fairly nicely this year also.
The Australian equity market’s total return in 2016 was close to 12% - which is little above the broadly 10% return we might expect from the market over the long-run. Of this, the usually reliable grossed-up dividend return was around 5%. Stock prices provided the extra 7% return, the contribution to which were broadly split between higher (forward) earnings and a modest rise in the market’s price to forward earnings ratio.
Indeed, one of the surprises of 2016 was that the market’s elevated PE ratio managed to stay elevated – in fact it rose a little further, from 15.6 to 16.1, compared to a long-run average closer to 13.5. The lesson, however, was that super-low bond yields continued to justify a higher than average PE ratio. Indeed, local 10-year government bond yields actually eased back a little last year to end at 2.77%, which by my estimates had the equity market on a “fair-value” PE valuation given long-run bond-equity relationships. So those, myself included, that continued to fret about a “regression to the mean” in PE valuations did not have their fears validated by the market.
The other big story in 2016 was the resources sector, which defiantly rose from the ashes in the face of considerable investor scepticism. But this was not all hot air. As it turned out, China’s decision to support wavering growth by relaxing constraints on home building and unleash even more infrastructure projects actually saw its steel demand strengthen last year, following what appeared to be the start of steady annual falls in 2015. Add to that cuts in China's own iron ore and coal capacity, and the stage was set for a lift in its resource imports which led to surging commodity prices. Weather related supply setbacks in both Brazil and Australia added to the upside in prices.
The result of all this was a stunning 50% rebound in resource sector forward earnings over the year, which led to a modest 5% gain in overall market earnings despite continued sluggish performance in the non-mining sectors. Indeed, last year resources were a classic cyclical play – a good time to buy was when the sector’s PE ratio was elevated, in anticipation of a rebound in depressed earnings, which in fact, was more stunning than most anticipated. In turn, this has allow PE valuations in the sector to fall to more reasonably (though still a touch pricey) levels in recent months.
Where to from here? While I’m increasingly nervous about Donald Trump, I suspect his more erratic ways will be eventually kept in check by those around him. As for the economy, the key take-way from his plethora of executive orders last week was that he’s clearly decisive – and keen to live up to his promises – which bodes well for his pledge to slash taxes and boost infrastructure spending when he eventually focuses on this.
Closer to home, while US bonds yields are likely to rise further this year, ours will likely rise by somewhat less – especially if the RBA cuts rates again as seems possible given persistently sub-2% underlying inflation. That, in turn, could keep the market’s PE ratio relatively elevated at around 15-16 times forward earnings.
Meanwhile, provided coal and iron ore prices don’t slump too far – which is a reasonable bet given China’s pledge to support growth and further rationalise its own resources industry – then further earnings upgrades could flow through in the resources sector. Indeed, even allowing for the natural tendency of bottom-up equity analysts to be overly optimistic on earnings expectations, I still see scope a further moderate 5% gain in overall market forward earnings this year, led by our miners. If the RBA cuts rates and the $A falls further, an overdue improvement in non-mining earnings could also emerge.
So Trump aside, key positives for the local market this year are the RBA’s lingering easing bias and China’s determination to keep its economy ticking over.
Wednesday, January 18, 2017
Global markets were somewhat disappointed last week following Donald Trump’s first press conference since winning the US Presidential election. As we’ve come to expect, The Donald said a lot of things about a lot of issues. But one issue that failed to get a mention is the key element of his policy platform that has Wall Street so excited: fiscal stimulus.
To be specific, Trump had promised to slash the corporate rate to 15% and boost spending on infrastructure programs (in partnership with the private sector). This promise has been the main factor behind the Trump rally in recent months. Despite high equity valuations and the pressure of rising bond yields, Wall Street has pushed markets into record territory on the hope that earnings growth – which has slowed over the past year – is set to rebound in 2017.
Donald Trump. Source: AAP
Investors need not fear. Having watched his press conference in its entirety, I didn’t get the impression that Trump was backing away from this fiscal pledge. Rather, he sought to focus his prepared remarks on bread and butter issues that the “rust belt” voters who elected him really seemed to care about – tougher trade deals, better veterans’ health support, and building “that Wall” along the Mexican border. He also spent a good deal of time explaining how his children will independently run the family business while he’s President.
When it came to journalists’ questions, no-one asked about his fiscal stimulus plans, so he naturally didn’t feel a need to discuss it!
When a man has so many views on so many issues, it’s likely that not all issues may get discussed at any given time – even if that issue happens to be very important to Wall Street.
Is fiscal stimulus the last thing the economy needs?
Of greater concern is that growing fear that fiscal stimulus may be the last thing the economy actually needs. After all, although Trump likes to talk about boosting jobs, the fact is that the economy is already very close to full employment, and wages growth is on the rise.
Over at the Fed, they’re openly warning that fiscal stimulus might overheat the economy, causing interest rates and the US dollar to rise faster than would otherwise be the case. And in its latest World Economic Outlook, the International Monetary Fund (IMF) made the same warning.
Adding to the upside risks to the US economy this year is the OPEC deal to limit oil production, which has lifted world oil prices and breathed new life into the beaten down US shale oil sector. That’s behind signs of a lift in US business investment.
Will Trump over-inflate the US economy? At the end of the day, I don’t think he’d be that dumb (Trump’s talk is blunt and often clownish, but he’s not dumb!) And neither is his market savvy Treasury Secretary, former Goldman Sachs guru, Steven Mnuchin.
To the extent there is fiscal stimulus to come, it’s likely to be staggered over many years, and Mnuchin will no doubt consult with the Fed to ensure it’s comfortable with what the Administration plans.
A mixed bag
Meanwhile, at a more sector level, Trump’s barrage of comments is having mixed implications. The financial sector continues to be buoyed by higher bond yields (which make it easier for them to make money) and talk of reduced regulatory constraints. But although Trump has promised to abolish Obamacare, he’s also been critical of high drug prices faced by consumers, which has hurt sentiment toward many health care companies. And while he’s talked about boosting defence spending, he’s also been critical of cost over runs on many programs, such as for the F-35 fighter-jet – which has struck fear in the hearts of many defence contractors.
All up, Trump’s domestic policy agenda still appears constructive for the US economy and further steady gains in equity prices – notwithstanding sector specific risks in the areas such as health care and defence.
That said, the other emerging wild card is Trump’s trade and geo-political policies. Trump is a negotiator, and it could be his tough talk over Taiwan and the South China Sea are merely intended as bargaining chips to win some politically popular trade concessions out of China. Similarly, his apparent disdain for NATO could be another tactic to get Europe to stump up more (and hence the US less) for maintaining the defence pact.
But whether countries would readily make concessions in the face of such overt pressure – at the risk of a humiliating public loss of face – remains to be seen. I’m doubtful – countries are not like companies where it’s only the bottom line financial calculations that ultimately count. Countries can be stubbornly irrational.
The great fear from Trump this year is not too much or too little fiscal stimulus. To my mind, it’s an escalation of trade and military tensions with China – as being tough on the other is politically popular in both countries, it’s hard to see who will back down first before things get too far out of hand.
Wednesday, December 28, 2016
Australians like to think of themselves as an optimistic bunch, with the “she’ll be right" attitude part of the national psyche. Yet judging from the national hand wringing associated with the lingering Federal Budget deficit, this optimism doesn’t extend to our national finances.
I mention this only because the recent swag of negative headlines associated with the deficit, and repeated talk of a “Budget crisis”, risks undermining increasingly fragile business and consumer confidence. It reminds me of the continual talk of a nation-wide house price bubble despite little evidence of significant prices pressures outside of Sydney and Melbourne, and even in these cities home loan affordability remains close to long-run average levels thanks to the step-down in interest rates.
Let’s set the record straight on the Federal Government budget deficit, given the headline writers following the 19 December Mid-Year Economic and Fiscal Outlook (MYEFO) again warned of a “billion dollar blow out” in the nations finances – and the dreaded risk that we could lose our Triple-A credit rating.
It turns out that the projected deficit for this financial year (2016-17) is now expected to be $36.5 billion, or $600 million less than projected in the Pre-Election Economic and Fiscal Outlook (PEFO). That small piece of good news seemed to be completed missed.
As for 2017-18, it’s true that the deficit is now projected to be $28.7 billion, or $2.6 billion more than expected a few months ago. But get this: while that seems a large deficit in dollar terms, it’s still only 1.6% of our $1,973 billion economy.
The upgrade to our deficit was a mere 0.2% of GDP – or practically a rounding error.
Herein lies one of the first misleading aspects of the national budget debate: as it sounds more impressive, our media and politicians continue to focus on nominal dollar amounts, given that a billion here or there seems to really matter – when in large part these are just incremental (or rounding error) adjustments.
The broad outlines of the budget’s trajectory have not really changed – which is to be expected given there’s been few new major policy announcements in recent months, and only incremental changes to the economic outlook.\
Indeed, the economy is still expected to grow at a modestly below trend pace both this financial year and next, before accelerating to an above-trend pace than eventually pushes down the unemployment rate to its “natural” level of 5%. Some may discount this forecast as overly optimistic – but the alternative is to assume the economy is incapable of reducing the higher than desired level of unemployment.
I regard it as a worthy aspiration which should figure most prominently in all budget discussion – indeed, the key budget issue is whether the economy ultimately manages to achieve above trend growth, and what can be done to ensure that it does. Yet the political and media obsession remains whether the budget balance in 2020-21 – in five years’ time – falls a few million dollars either side of the zero line.
But again given the size of the economy, whether the budget is in small surplus or small deficit (i.e. plus or minus 0.1% of GDP) in five years’ time is hardly material. Yet the Turnbull Government has staked it economic credentials on achieving even the most minuscule surplus.
Even more at fault are the rating agencies, who reckon our credit rating should also depend on whether we can credibly inch back into surplus in five years’ time, even though a modest short-fall should not really make that much difference to the level of debt.
While on the subject of debt, note also that even with the latest budget projections, net-debt is still forecast to peak at only 19% of GDP by 2018-19, up only 0.9% from the 18.1% ratio expected this financial year. In short, today’s budget deficit is still less than 2% of GDP and net-debt less than 20% of GDP.
Given this is being achieved at a time of sluggish growth and spare capacity, I’d argue it’s not that bad. Of course, it could be better - and to my mind the biggest budget challenge we face is stopping the revenue haemorrhage caused by the growing black economy and rampant tax dodging by multi-national companies.
It's not the fault of those on welfare or those living off their retirement savings. Either way, our budget position is certainly not worth all the hand wringing and misplaced talk of crisis, which threatens to make the economy even weaker than it is at present.
We are not in budget crisis – but we could easily talk ourselves into one.
Wednesday, December 14, 2016
The Australian economy has displayed remarkable resilience this year, thanks to solid contributions from consumer spending, public demand and export volumes. But as always, we can’t take our lot for granted, with evidence emerging that we’ll face even heavier challenges in 2017. So much so, the Reserve Bank may well need to cut rates again in the New Year unless Canberra offers more of a helping hand through “Trump style” fiscal stimulus.
To be sure, economic data remains mixed. Employment growth is still ticking over and job advertisements are trending up. Home building activity is at a high level and commodity prices have rebounded.
But as regards the labour market, the quality of jobs growth has deteriorated of late, with much of the growth in part-time rather than full-time employment.
Of course, I’ve got nothing against part-time workers – if that suits their needs – but surveys suggest many workers would prefer to work longer hours, as evident from the still heightened “underemployment rate” as measured by the Australian Bureau of Statistics (ABS).
While we can be thankful for growth in the services sector, the lack of decent paying jobs for many that want them is still a policy failure, and is starting to hurt the economy through undermining household income and (even more importantly) consumer spending.
Outside of labour market, moreover, there are other worrying signs. To my mind, possible causes include the lack of clear policy direction in Canberra and the persistently high Australian dollar.
The National Australia Bank monthly business survey, for example, is continuing to report a retreat in sentiment – with the business conditions index down to +5 in November from a recent peak of +13 back in March. In an ominous sign for consumer spending, the NAB survey reported a particularly sharp drop in retail sector sentiment last month.
Meanwhile, home building approvals have slumped in recent months, suggesting the pipeline of new activity is drying up. And the latest capital expenditure survey still suggests a fairly flat outlook for business investment over the remainder of this financial year, with the non-mining sectors failing to offset the slump in mining investment.
Given this backdrop, we can’t easily dismiss the weakness in the September quarter national accounts reported last week. The economy contracted by 0.5% last quarter, which marked only the fourth negative result since the early 1990's recession.
Of course, some of this weakness reflected poor weather interrupting construction. So the good news is that some bounce back in growth is likely in the fourth quarter – thereby avoided the dreaded “technical recession.”
But even a robust 1% bounce back in economic growth would still leave annual growth at around 2% - well short of the RBA’s 3% expectation as recently as last month. The Bank will likely need to take an axe to its economic growth forecasts in its February Statement on Monetary Policy.
Although growth was artificially weak last quarter, it was also boosted by favourable weather and lumpy public sector spending earlier this year. In a sense, therefore, the latest results are something or a “coming back to earth” or “reality check” to remind us that the economy is still stuck in a sub-par growth trajectory.
The biggest worry in last week’s national accounts was consumer spending, which represents 60% of economy. After solid growth through last year and earlier this year, consumer spending grew at an annualised rate of only 2% in the past two quarters – perhaps in belated recognition of the fact income growth has been quite weak. That said, an encouraging sign is that monthly retail sales have rebounded more recently, which bodes well for a better spending outcome in the December quarter national accounts.
But unless wages and/or hours worked lift in earnest, it’s hard to see consumer spending remaining solid in 2017. With home building and business investment also challenged, and Canberra not offering much support, the RBA may well be back in the spotlight before too long.
Wednesday, November 30, 2016
The rise and rise of property prices across Sydney in particular has once again led to the usual bevy of alleged causes and solutions. These days, it’s again popular to blame one alleged culprit in particular: negative gearing.
So desperate is the New South Wales Government to absolve itself from blame for the desperate plight of first home buyers within its borders trying to gain a foothold into the property market, it has conveniently pointed the finger at one of the few policy levers beyond its control – the Commonwealth income taxation system.
Yet those that would seek to blame negative gearing need to deal with a few awkward questions. If negative gearing is the problem, why aren’t property prices across the nation taking off? Why isn’t negative gearing causing an explosion in prices in Adelaide and Hobart?
And if negative gearing is the problem, why did Sydney property prices essentially go nowhere between for eight years up until mid-2012?
To my mind, short- and longer-term factors explain the specific strength in Sydney at present. There are short-term cyclical factors at play – especially the re-balancing of national economic growth back from the mining states of Queensland and Western Australia in recent years, which has allowed Sydney prices to largely catch-up after years of relative weakness.
Structural factors are also at play – namely the express preference of foreign investors (especially the Chinese) to buy in both along the more familiar East Coast cities rather than more remote counterparts. As regards Sydney, we can also blame geographical constraints that limit our ability to expand East and West.
And Sydney also faces a huge “proximity premium” from poor planning that has concentrated most job opportunities in the urban centre, yet provided far from adequate transport links to the regions where more affordable homes could be built.
Rather than blame negative gearing, the NSW Government should be concentrating on both improving regional-city transport commuting times and/or encouraging more jobs growth in the more affordable regions.
Of course, there's one factor that is largely to blame for the nation-wide lift in house prices relative to household incomes in recent years – and which also happens to have particularly hurt first home buyers.
That factor is interest rates. By now, most (but not all!) of those concerned about housing affordability tend to understand how lower interest rates have effectively allowed households to bid up the value of housing relative to their incomes. After all, if interest rates half, you can effectively double the size of your mortgage while keeping more payments as a percentage of your income broadly constant. In the main, that’s what we’ve done since the early 1990s.
Yes less well understood is the insidious effect lower interest rates and the associated lift in house prices-to-income have had on the ability of first-home buyers to get a foothold in the market. Indeed, if for example banks, have tended to demand a 10% deposit on home purchasers (i.e. the maximum loan to valuation ratio is 90%), then a doubling in the house price to income ratio doubles the upfront mortgage requirement as a share of household income.
Not only that, low inflation means share of household income devoted to the fixed nominal value of mortgage payments (as under a traditional credit-foncier loan) declines relatively more slowly – so the burden or mortgage repayments remains higher for longer.
Strange as it may seem, it’s been the structural decline in interest rates and inflation that has been the real killer of first-home buyer aspirations in recent decades.
Wednesday, November 16, 2016
The election of Donald Trump to the US Presidency has been blamed (quite rightly) for the spike in global bond yields over the past week, and the further trashing of what was once considered “defensive yield” sectors such as listed property and infrastructure.
But the reality is that global bond yields have been edging higher for several months already, even when it was though that Hillary Clinton was a shoo-in for the White House. We can’t just blame The Donald.
Indeed, as seen in the chart below, US 10-year Treasury bond yields have been rising since touching a low of 1.37% in early July in the wake of the UK’s Brexit decision. That’s even lower than during the depths of the global financial crisis in 2008, and the European financial crisis of 2012.
The latest rebound in yields clearly reflected the realisation that the world did not end when the UK (which, after all, accounts for a mere 2.5% of the global economy) decided to leave the European Union. Associated with this, the Bank of Japan and the European Central Bank have reconsidered their path toward further aggressive monetary easing, particularly as it now seems clear this would more hurt than help the ability of their banking sectors to extend further credit.
Last but not least, higher bond yields have reflected the realisation that the US economy continues to motor along, with a tightening labour market and rising labour costs. The market is pricing a near-certain probability that the Fed will hike rates next month and signal at least two further rates rises next year.
Of course, all this begs the question: how far can bond yields rise?
The most celebrated bond market sell-off was in 1994, when US 10-year bond yields rose 2.8 percentage points within a year to a peak of 8%. But as seen in the chart above, there have also been other bond market sell-offs since then, typically associated with an unwinding of fears concerning one financial crisis or another. Following the 2008 financial crisis, US 10-year yields rose by around 2 percentage points, and following the European financial crisis, by around 1.6 percentage points.
If the average of the last two bond sell-offs takes place over the coming year, it would push 10-year yields up another percentage point to around 3.25%.
Also noteworthy is that, unlike in previous bond yield cycles, the recent bottom in yields was quite close to the bottom in 2012 – a tentative sign that the trend decline in yields over recent decades may be finally bottoming out. Should 10-year yields push much above 3% - taking out the previous cycle high in 2013 – it would be further confirmation of the death of the multi-decade bond bull market.
Of course, there a good grounds to think that bond yields should not need to stay abnormally low. Though many commentators continue to bemoan allegedly weak global growth and low inflation, the fact remains that economic growth across much of the developed world has actually been above potential in recent years, with rates of unemployment falling. Weak wage growth is partly a result of weak productivity: indeed, as the Reserve Bank recently pointed out, unit labour costs in both Japan and the United States have been growing at “above average” rates.
And it may surprise some to know that global inflation indicators are also not unusually low. Core inflation in the US, in particular, is only just under the Fed’s 2% inflation target and close to its long-run average. Long-term economist inflation forecasts have hardly budged during the alleged “deflation scare” of recent years.
All up, baring a lurch back into recession by the US economy in 2017, further gains in bond yields – taking, for example, US 10-year yields back to at least around 3% - seems likely, which will continue to pressure the performance of former “defensive yield” darlings of the equity market.
Investors might instead start to focus on sectors that may benefit from higher bond yields, such as the global banks (exposure to which is possible on the ASX through the BNKS ETF). Even the local banking sector might benefit to the extent valuations have already been beaten down and their performance will be less hurt by rising bond yields than that of, say, listed property.
Wednesday, November 02, 2016
The Reserve Bank of Australia quite rightly decided to leave interest rates on hold this week. And it was not just because the September quarter inflation results were in line with expectations. I also suspect the RBA is quietly worried about the house price pressures that are starting to be unleashed by the current record low level of mortgage interest rates.
Indeed, among the myriad of reasons being advanced for the rapid increase in house prices in recent years, especially in Sydney and Melbourne, one culprit stands head and shoulders above everything else: interest rates.
I’ve run my nationwide housing affordability numbers once again, and they’ve again highlighted our typical householder response to lower interest rates: rather than use lower interest rates to spend on other goods and services, the marginal home buyer tends to bid up the prices they’re prepared to pay for a home. As seen in the chart below, mortgage rates began to decline in the latest cycle in mid-2011. Because the major cities of Sydney and Melbourne were still being damaged by the last stages of the mining boom, national average house prices remained weak for another year. But from mid-2012 these cities – and the national average level of prices – started to take off.
As evident in the chart, while house prices relative to after-tax household incomes have increased strongly in recent years (and now exceed the last two cyclical peaks), the rise in overall mortgage payments as a percent of household income has been more modest, and this measure suggests “mortgage affordability” is still not that far out of line with its long-run average.
In other words, most of the decline in interest rates has been used to bid up house prices relative to income, so as to keep overall mortgage affordability relatively constant. [Of course, all this assumes home buyers can afford to pay the 20% home deposit, which is also rising relative to income. This should be easier for buyers already with housing equity in a rising market, though it makes the task much harder for first home buyers trying to enter the market].
First home owner considerations aside, on the one hand, relative to household income, house prices seem grossly overvalued. Yet, relative to the prevailing low level of interest rates, they don’t seem so bad. Of course, the problem becomes what will happen to house prices relative to income once mortgage rates inevitably move back up to “more normal” levels. The evidence of past cycles suggests house prices will fall back relative to household income.
What’s a “normal” mortgage rate? At present, the average discounted bank variable mortgage rate is around 4.5% (according to RBA data). Based on the view that the RBA now thinks a “neutral” cash rate is around 3.5%, then based on prevailing mortgage to cash rate margins of 3%, the “neutral” variable mortgage rate would be around 6.5%. That’s also close to the average mortgage rate of 6.3% since early 2004 (a period in which the mortgage repayments to income has moved around a relatively flat trend).
What would happen to house prices if mortgage rates hit 6.5%? Assuming a mortgage repayment to household income ratio of 30% - in line with the long-run national average – then my estimates of the house price to income ratio would need be closer to 4.3 than the current 5.4, implying house prices are around 25% overvalued using a “normalised” mortgage rate.
In the case of Sydney and Melbourne, the overvaluation is closer to 40%. The median Sydney established house price (as measured by the Australian Bureau of Statistics) would be closer to $620,000 rather than the $880,000 reported for the June quarter.
Of course, that’s not to suggest house prices are about to slump anytime soon. Interest rates are likely to stay low for some time, and may even head lower sometime next year. But the longer rates stay very low, the greater the adjustment challenges housing valuations will face later – as those myopic marginal buyers will keep bidding up house prices.
At the very least, the above analysis suggests that when the interest rate cycle eventually turns, nationwide house prices are likely to underperform the growth in household income for several years, and will most likely decline in nominal terms to some degree.
For those worried about eventual nominal house price decline, I’ve got news for you: we’ve been there before. According to ABS data, there’s already been three periods of nominal prices declines in just over a decade, though even the sharpest decline in Sydney did not exceed 10%. Provided the move back up in interest rates is relatively gradual, and the economy remains solid, a combination of modest price weakness – and underperformance relative to incomes for an extended period - seems the most likely scenario.
Wednesday, October 19, 2016
Just when it seemed the Reserve Bank of Australia was happy with its current interest rates settings, this venerable institution has appeared to pivot once more. Indeed, there’s now a non-negligible risk of an interest rate cut at the November (Melbourne Cup) policy meeting, and the bias on rates heading into 2017 is firmly to the downside.
And for the first time in a long time, I don’t agree with the RBA’s policy inclination. To my mind, there are now strong reasons to leave local interest rates on hold for the foreseeable future.
A quick recap. Having already cut official interest rates twice this year, the RBA’s rhetoric had shifted to a more neutral tone in recent months. That’s seemed to reflect firmer business conditions overall, rising commodity prices and a declining trend in the unemployment rate.
Indeed, in his statement following the October RBA Board meeting, the newly installed Governor, Philip Lowe, pointedly excluded reference to the upcoming September quarter consumer price index report as having a potential bearing on the November interest rate decision – a departure from references to the March and June quarter CPI releases in the policy meetings prior to the rate cuts in May and August.
To RBA watchers such as myself, that seemed to suggest the RBA was not “sweating” over the next CPI release, and so was unlikely to cut rate in November even if inflation surprised on the downside.
So far so good. But in the minutes to the October policy meeting released this week, that loaded phrase was back again. Notably, the minutes indicated “[Board] [m]embers noted that data on CPI inflation for the September quarter and an update of the forecasts would be available at the next meeting. This would provide an opportunity to consider the economic outlook, assess the effects of previous reductions in the cash rate and review conditions in the labour and housing markets.”
Just to emphasise the point, Governor Lowe in a speech this week noted the RBA was on guard not to allow inflation expectations to drift much lower, and in that light he observed “one of the key influences on inflation expectations is the actual outcomes for inflation. We will get an important update next week, with the release of the September quarter CPI.”
To my mind, all this is a clear indication that the RBA stands ready to cut rates again in November if next week’s CPI result again surprised on the downside.
What constitutes a downside surprise? To my mind, that would require a drop in annual underlying inflation from the 1.5% rate seen in the past two quarters, to at least 1.25%.
Of course, all this begs the question: should the RBA cut rates if inflation drops lower? In cutting rates, the RBA’s aims is to counter any further downward pressure on inflation expectations by encouraging – and importantly in the near-term, being seen to encourage – even faster economic growth and inflation over the medium-term.
What’s more, while the RBA is mindful of possible bubble risks in the housing market from cutting rates further, it appears to be confident that these risks are contained – due to the fact that housing price strength is not nationwide, and rising housing supply should lead to a self-correcting market adjustment eventually.
I have several problems with this approach. First, the economy is healthier than it was earlier this year, even if some measure of labour market slack remains elevated. By continuing to react so strongly to near-term downside inflation surprises, moreover, the RBA risks creating the perception that it is less flexible and less focused on “medium-term’ inflation targets than it suggests. Critically, it’s then at risk of losing credibility to the extent it’s not able to arrest the decline in inflation anytime soon, particularly, as even the RBA acknowledges, it is at least partly structural in nature.
In regards to financial stability risks, the RBA also seems overly focused on the housing market – ignoring that equity valuations (particularly for defensive yielding stocks) are also overvalued. More broadly, low interest rates are creating financial distortions across the economy, not just housing.
Last but not least, the lower rates go, the less scope the RBA leaves itself to react should the economy actually take a serious turn for the worse.
I think it’s time to start saving ammunition.