Macro

Australian housing prices have fallen 8.2% nationally from their peak in 2017, with declines of 10%-15% in the two largest cities, Sydney and Melbourne, according to data from National Australia Bank and CoreLogic as of May 2019. We expect a further 5%–10% fall over the next 12–18 months, which would return prices to levels last seen around 2015.

The effects of lower housing prices will reverberate across the Australian economy. Since 2012, the bustling property market generated a wealth effect and created jobs that helped offset losses in the mining industry. Now, as the housing market weakens further, household consumption and animal spirits may follow suit. As a result, we have a cautious stance on Australian residential mortgage-backed securities (RMBS) and corporate bonds issued by the country’s banks.

Housing market sentiment to remain subdued over our cyclical horizon  

A major weight on the housing market comes from structural changes in mortgage underwriting standards, which will be virtually impossible to unwind. These resulted from increased public and regulatory scrutiny of bank misconduct, which culminated in a report by The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry that put a strong emphasis on “responsible lending”.

A key change is the incorporation of more rigorous and realistic assessments of living expenses at mortgage origination. Other adjustments include closer scrutiny of high loan-to-value and interest-only loans. Bottom line: Mortgage availability and borrowing capacity have declined.

Some borrowers also face higher mortgage payments. About a quarter of outstanding mortgages are interest-only loans. Most were underwritten in 2014 and 2015, when housing market sentiment was exuberant and origination standards loose. For most borrowers, the five-year contractual interest-only window will end in 2019 and 2020. Most will switch to principal and interest payments, which for the typical owner-occupier will increase monthly payments by more than 20%, adding a new source of mortgage arrears, according to PIMCO estimates.

China steps back

External forces are also at play. Foreign buyers, mostly from China, played an important role in bolstering Australia’s housing market between 2013 and 2016. At its peak, foreigners absorbed an estimated 15%–25% of new housing supply in Sydney and Melbourne, government data show. However, this demand has effectively vanished since 2017 due to tax disincentives targeted at foreigners and tight capital controls imposed by Beijing.

Australia is also in a delicate position as trade tensions between China and the U.S. persist. China is Australia’s largest export destination, while the U.S. is Australia’s traditional ally. Weaker growth in China, slower global trade and more divisive international politics would hurt the economic outlook in Australia, casting further downside risk to the housing market.

Recent developments to curtail left tail housing risks

Australian policymakers are taking steps to stem the housing price decline.

In a major surprise last month, the center-right Liberal-National party coalition won the federal election. The center-left Australian Labor Party, which had been widely expected to triumph, had promised to phase out several important tax incentives for property investors, curbing demand in order to improve housing affordability. The preservation of such incentives under the coalition government will help stabilize investor sentiment.

In addition, last year the Australian Prudential Regulation Authority (APRA) relaxed several key macroprudential measures that it had imposed in previous years to reduce risks in residential mortgage lending. Nonetheless, we do not expect these reforms to prompt a symmetrical recovery. Credit growth may recover slowly because market sentiment has already dampened.

Finally, the Reserve Bank of Australia (RBA) entered an easing cycle by delivering a widely anticipated 25 basis point cut to the cash rate from 1.50% to 1.25% on 4 June, ending a pause of almost three years. We think policy rate cuts remain an effective monetary tool in Australia because household debt levels are high and mortgages are predominantly in floating-rate format. Assuming no major external funding shock, Australian banks should be able to pass through the majority of policy rate reductions to retail customers.

Investment implications

Although we expect continued housing price declines across major cities in Australia over the next 12–18 months, we think the left tail risk of a disorderly collapse in housing has been curtailed due to the coalition’s victory and the easing bias implemented by both APRA and the RBA in macroprudential and monetary policies, respectively.

In credit markets, we favor being defensively positioned with RMBS. This is due mainly to a slowdown in mortgage prepayments that reflects lower transaction volume in the physical housing market and more difficult refinancing conditions. We remain cautious with the credits of Australian banks as we expect mortgage arrears to rise on higher debt service burdens and potentially a weaker labor market.

With domestic interest rate markets pricing the RBA to lower the cash rate to a little less than 1.0% over the next 12 months, we believe interest rate valuations are close to fair. However, macroeconomic risks, both domestic and global, remain skewed to the downside. That leaves us with two central investment implications:

  • One, we think the “belly” of the Australian dollar yield curve in the 5–8 year tenor offers attractive carry opportunities.
  • Two, the prospect of even lower terminal rates should a global recession eventuate means not only that low interest rates are likely to persist, but that their defensive and risk-diversifying characteristics should continue to be a central pillar in client portfolios as we enter the later stages of the business cycle.

In our view, the lower bound of the RBA cash rate at 1%, as previously advocated by the RBA governor, or even 0.5%, as currently argued by some economists, is porous and does not have to hold. We believe policy rate cuts remain an effective monetary tool that would be readily deployed to cushion an economic downturn stemming from the housing market slowdown. Australian bonds, therefore, should continue to provide strong diversification and defensive characteristics in investor portfolios.

Written by Toasha Wang, Jing Yang and myself 

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