Skip to main content

November 2022 / INVESTMENT INSIGHTS

Australian Housing: Boom and Bust

From The Desk - October 2022

Following a week on the road meeting with clients, the most common questions I’ve been asked surround interest rate rises. Some of the effects of rate increases across the globe have been more obvious than others (see prices of high valuation tech stocks). However, in Australia the most interest rate sensitive area of the economy and one yet to fully bear the pain of interest rate adjustments is housing. This has big implications for the broader economy and investors.

We have had the boom, and now we will have the bust. The question is just how big the fall will be? We believe the correction will likely erase all the house price gains seen during the Covid period, when prices soared to unsustainable heights. This would equate to the largest peak-to-trough decline on record, vastly eclipsing the previous correction of 10.2% in 2017. As illustrated below, it is already the fastest (Chart 1) and there is much further to fall back to the levels of January 2020 (Chart 2).

Chart 1 Current correction versus previous downturns
Chart 2 Peak versus now and January 2020

Another takeaway from past cycles is that price falls typically continue until we see the RBA not only stop rate hikes but shift into reverse and start to cut. At this stage, rate reductions seem like a high hurdle given the board’s determination to bring inflation back within a more tolerable band. Indeed the RBA has modelled it’s own expectation of housing price falls and seems comfortable with a 20% decline over two years. When was the last time our central bank was unperturbed by such a level of house price decline? As we know asset price declines are unpredictable and aren’t easy to control (both up and down)!

A large portion of Australian borrowers are still yet to feel the full effect of the RBA’s hikes to date. This is given the substantial proportion of loans written during the Covid period were at very attractive fixed rates. As a percentage of all loans, fixed rate mortgages ballooned from 15% pre-covid to 46% of new lending at its peak (Chart 3). We estimate that approximately 50% of the current residential mortgage loans on banks’ balance sheets was written over the Covid period. This risks associated with writing housing loans, in one of the biggest housing booms and lowest unemployment period in decades, will be evident in coming years. 

Chart 3 Proportion of fixed rate home loans

This translates to an enormous wave of mortgages that will transition to variable rates in 2023. The average fixed rate of roughly 2% will move to a rude variable rate of 6.5% at current forecasts. The debt servicing ratio (the proportion of household income that goes to principal and interest payments) is expected to rise to a record high of 18.4%.

Australia is much more sensitive than its US counterpart in this respect. For perspective, variable rate mortgages make up only 5% of US mortgages. Debt servicing there is expected to only rise to 7.6%.

The sensitivity to such rate increases are compounded by the high level of household debt in Australia (5th most indebted in the OECD). At its peak during the covid period, a quarter of all new loans were written at a debt-to-income ratios of more than 6. The combination of these factors ranks Australia as the 3rd most rate sensitive housing market globally.

That said, one potential source of support is the savings buffer that was built during Covid as expenses were slashed and transfer payments were squirreled away. This would help households bear the brunt of mortgage rate increases in the near-term. However, this savings buffer is rapidly evaporating  (higher cost of living expenses such as energy prices also impacting) and will not sufficiently protect households from their mortgage adjustments next year (Chart 4). The RBA’s Financial Stability Report highlighted that under current forecasts, even if variable-rate borrowers reduced their spending by 20%, a third would deplete their buffers within 6-24 months.

Chart 4 Household sector income, spending and saving

Not only will there be a hit to spending in order to meet higher mortgage costs, but the wealth effect will be real. Housing makes up roughly 68% of household sector net wealth, for a total of A$10 trillion. A simple calculation tells us that for a 20% fall, A$2 trillion of household wealth would be destroyed. In turn, falling prices should deflate some of the more boisterous consumer activity witnessed when homeowners saw the value of their primary asset rise so dramatically (Chart 5).

Chart 5 Household wealth versus consumption

Finally, the flow-on effects on construction are worth noting. 1 in every 10 jobs is tied to housing and construction contributes roughly 7.5% to GDP. Currently we are sitting in a construction backlog, blocked by supply constraints, labour shortages, and weather (can you blame them). As such the decline in construction activity will lag prices by longer than usual. However, as this blockage eases, construction should follow the substantial fall in building approvals and prices lower.

Overall, in what is a passionate topic for Australians, I probably have not made any new friends by highlighting the extent of the woes facing the local housing market. At the same time, we emphasise the importance to understand these issues and position appropriately. Our outlook and positioning has been cautious since late last year and we continue to prefer more defensive quality exposures that we believe will be better placed to weather the downturn.

IMPORTANT INFORMATION

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.  

It is not intended for distribution to retail investors in any jurisdiction.

Previous Article

October 2022 / INVESTMENT INSIGHTS

As Market Dynamics Pivot, Alpha Opportunities Are Set to Improve
Next Article

November 2022 / VIDEO

China—The Interplay of Policy, Growth, and Geopolitics
202210-2564811

October 2022 / VIDEO

Quarterly Australian Equity Market Outlook - September 2022

Quarterly Australian Equity Market Outlook - September 2022

Quarterly Australian Equity Market Outlook...

Inflation, interest rates & earnings dominate headlines

By Randal Jenneke

Randal Jenneke Head of Australian Equities