Feature Stories | Dec 15 2022
This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA
There’s not much we can do to control commodity prices. Otherwise, the biggest risk to Australia’s economy next year is the housing market.
-Banks and resources supported ASX200 in 2022
-House prices to fall the most in record
-Reverberations through the wider economy
-Where the bloody hell are ya?
By Greg Peel
As we head towards Christmas, consensus expectation is that Europe is already in recession, the US will likely see a recession from early next year and Australia will see significant slowing, but not a recession.
Beijing would never allow China to enter recession, but GDP growth may still slow to below the government’s 5.5% target. Forecasts have been as low as 3% but that was when it looked like there would be no change to zero-covid. Now that China is moving away from zero-covid, and is continuing to support the stricken Chinese property sector, the signs are more positive.
A rapid growth in covid cases as a result of reopening is the negative offset. With a low level of vaccinations to date, and Beijing refusing on principle to purchase mRNA vaccines developed in the West, growth could well slow anyway without zero-covid, if the economy is struck down by illness.
It is notable that as of yesterday, Beijing will no longer report a daily case-count, as the end of mandatory PCR testing means numbers would never be accurate.
This, of course, provides a swing factor for the global economy, and particularly the Australian economy, which is highly dependent on commodity prices.
At the time of writing, the S&P500 is down around -15% year to date while the ASX200 is down only -3.7%. The balance of performance is nonetheless misleading. The US stock market is dominated by technology-related companies, and particularly a small handful of Big Tech names, which have been trashed this year on aggressive Fed tightening due to the impact on longer duration valuation.
The Australian market is dominated by banks and resources.
On a trade-off between the margin benefits of higher RBA cash rates and the risk of loan defaults, Commonwealth Bank ((CBA)) hit an all-time high in late November. Oil & gas giant Woodside Energy ((WDS)) came close to a five-year high in early November.
Whitehaven Coal ((WHC)) hit an all-time high in early October having rallied some 800% in a year.
The pandemic brought us inflation. The war exacerbated the issue. While Chinese lockdowns held back some commodity prices, the European energy crisis ensured runaway prices for LNG and thermal coal.
Australia has its own share of technology stocks, but they are still just a small part of the index.
Commodity prices remain an important determinant of GDP growth (or lack thereof) and of the trajectory of the ASX200. But they are largely out of our hands.
Closer to home, there’s a different problem.
Safe as Houses?
In Australia, the most interest rate sensitive area of the economy, and the one to yet fully bear the pain of interest rate adjustments, T. Rowe Price believes, is housing.
“This has big implications for the broader economy and investors.”
How far can house prices fall? T. Rowe believes the correction will likely erase all of the house price gains of the covid period, during which prices soared to unsustainable heights. This would equate to the largest peak-to-trough decline on record, vastly eclipsing the previous -10.2% correction of 2017.
Morgan Stanley suggests the impact of this year’s RBA rate hikes will hit in 2023, and house prices will fall “the most on record”.
Peak to trough, Citi expects house prices to decline by -23%. Forecasting a peak RBA cash rate of 3.35% (which is at the low end of consensus), Citi anticipates prices will trough in the December quarter next year.
But the broker also offers a wide range of bull-bear case outcomes. If rates are not lifted as high as forecast and population growth provides demand support, Citi forecast only a -15% decline. The bear case scenario is -33%.
A takeaway from past cycles, T. Rowe Price notes, is that price falls typically continue until the RBA not only stops hiking rates, but shifts into reverse and starts to cut. At this stage that seems like a “high hurdle” given the RBA’s determination to bring inflation back down to a more tolerable level.
The board’s own modelling suggests a -20% fall in house prices, and it is not troubled by that.
Average house prices were down -7% from the April 2022 peak by end-November, according to CoreLogic. As Karen Carpenter wisely noted, we’ve only just begun. But CoreLogic does note the rate of month-on-month falls has slowed since August, from -1.6% to -1.0% in November. Surely this is good news?
A large portion of Australian borrowers are still yet to feel the full effect of the RBA hikes to date, many an economist is pointing out. This is due to the substantial proportion of loans written during the covid period 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. T Rowe Price estimates approximately 50% of the current residential mortgage loans on banks’ balance sheets were written over the covid period. The 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, T Rowe warns.
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 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%.
This compares to only 7.6% for the US, given only 5% of US mortgages are on variable rates and the rest on fixed rates out to thirty years.
Australian sensitivity to such rate increases are compounded by the high level of household debt. At the peak during the covid period, a quarter of all new loans were written at a debt-to-income ratio of more than 6x. The combination of these factors ranks Australia as the third most rate-sensitive housing market globally, T. Rowe Price notes.
A lot has been made of the “buffer” built up by households during the covid period, in which government handouts met much reduced spending due to lockdowns (and fear of the unknown at the time).
The RBA’s recent 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.
Housing makes up some 68% of average household new wealth. When house prices rise, homeowners “feel” more wealthy, and thus are more comfortable to spend. A -20% fall in house prices would much deflate that “feeling”, leading to much reduced consumer spending.
As T. Rowe Price noted above, falling house prices have “big implications for the broader economy and investors.”
If You Build It
Historically the commencement of a rate tightening cycle has been a powerful leading indicator for an inflection point in construction activity, notes Morgan Stanley.
The federal government introduced a Homebuilder stimulus package in 2020 in response to the pandemic. The program successfully stimulated demand at the time, but likely also brought forward a lot of demand, Morgan Stanley assumes. As construction of Homebuilder-funded construction starts to roll off, a gap in demand may appear.
Housing demand is driven by population growth, and population growth is dependent on migration. Net migration dropped to zero during 2020-21, and while now gradually returning, Morgan Stanley notes feedback suggests a delay of 18-24 months before a new migrant becomes a homebuyer.
Prices of building raw material costs began surging during the pandemic driven by lockdowns and supply chain problems, leading to some high-profile collapses of Australian building companies. The flow-on from this is increased consumer caution, depressing consumer demand, Morgan Stanley suggests.
All up, the above factors lead the broker to believe the building industry will not be let off with a “soft landing”. Instead, Morgan Stanley expects a “typical” sharp cycle decline, of the likes we haven’t actually seen for a while. Builders tend to carry a large amount of leverage, and Morgan Stanley’s earnings forecasts for building material stocks are “almost uniformly below consensus”.
There is one offset. It started with the 2019-20 bushfires, followed by covid lockdowns and restrictions, including forced isolation for workers either with or in close contact to covid, along with supply shortages, and then the floods – several of them – and wet weather in general. There is a backlog of building demand.
As such, T. Rowe Price suggests, the decline in construction activity will lag prices by longer than usual. However, as this blockage eases, construction should follow a substantial fall in building approvals and prices lower. To make matters worse, one in every ten Australian jobs is tied to housing and construction contributes roughly 7.5% to GDP.
The good news is that Citi notes house prices tend to trough one to two quarters after stock prices do. Citi expects a house price trough in December next year, which would imply a trough in stock prices in the June or September quarters.
Jack Be Nimble
I noted earlier Commonwealth Bank has recently hit a new high. The bank has rallied some 70% from its 2020 covid-crash low. While CBA has been the best performer among the majors, all four have enjoyed strength over the period.
From 2020 to 2022, Australian banks rallied back with the general market as lockdowns ended. They also enjoyed the benefit of thriving loan demand due to historically low interest rates. Historically low rates nevertheless came to an end in 2022 when the RBA started hiking, madly.
Hence 2022 has been the year the banks have finally seen a return to decent net interest margins. It has been those rising NIMs that have driven this year’s outperformance. But there has also been concern among investors that rising rates will lead to loan defaults and mortgage foreclosures.
We recall that over the next two years, mortgages on covid-low fixed rates will expire, and those on rates around 2% now will see a step-up to around a 6.5% variable rate. This has two implications for the banks.
Firstly, the risk of loan defaults and foreclosures will step up as well. But secondly, some 25% of the mortgage market is “up for grabs” at this refinancing juncture, UBS notes, compared to an historical 10% when fixed loans expire and borrowers can then switch banks. Subsequent intense competition and sub-economic pricing could nullify part of the expected benefits from rate increases.
NIM expansion could still surprise to the upside in the near-term, UBS believes, but thereafter is a riskier story. The broker is not so worried about household debt serviceability given aforementioned “buffers”, but is worried about flow-on effects to small and medium enterprises (SME).
A UBS survey of those with mortgages found “front-book” borrowers (new mortgage), which are more at risk than “back-book” borrowers (existing mortgage), have the capacity, via savings, prepayments (paying more than required each month) and emergency funds to absorb the higher interest cost burden ahead, estimated at greater than $7bn in total.
The first line of defence is income, and given historically low unemployment that’s still in good shape, UBS suggests, despite cost of living pressures. The brokers’ survey found 33% of respondents’ household spending is still well below income, while 42% are either “easily” or “somewhat easily” managing their finances so far.
Which brings us to the next sector…
Socks, Jocks and Chocolates
The Christmases of 2020 and 2021 were dour affairs, marred by lockdowns, travel restrictions and isolations. Under newfound freedom, Christmas 2022 was shaping up to be the biggest binge in years.
Except for the impact of the cost of living. A survey published last weekend in the Fairfax press found 66% of respondents will buy fewer and cheaper presents this year. Moreover, 62% will spend less on meals and going out (over the holiday period). And 52% will travel less or not take a holiday at all this year.
Post-Christmas, Morgan Stanley’s own survey found the discretionary retail sector is, unsurprisingly, where a slowdown in spending will be most evident next year. Fashion, dining and travel are most exposed to a switch back to “thrift” in the face of rising household costs.
Non-discretionary or staple retailing is usually a safe haven during economic slowdowns, but this time around the cost of fuel and groceries are two of the biggest drivers of inflation, leading to “trade-down” risk (buying the cheaper brands).
The same survey found that in order to save money, some 50% of respondents said they would stop home renovations, and/or buying whitegoods and furniture altogether rather than choosing lower-priced alternatives.
A spending slowdown flows through to retail landlords, ie retail REITs.
On the subject of REITs, Morgan Stanley was surprised to learn from its survey that 40% of respondents are working from home 3-5 days a week, which is a greater proportion than the same 2021 survey found.
A similar proportion of employers are shrinking office space rather than expanding, suggesting office market vacancies will remain elevated.
Dark Signs For 2023
The conclusion Morgan Stanley draws from its surveys is that while the macro backdrop has remained resilient year to date, sharply higher rates and lower house prices underpin the broker’s view this will deteriorate. Housing conditions and signals will weaken further, credit tightening is well underway with fixed rate switching a key risk, and reality is yet to bite for consumers.
Morgan Stanley sees the RBA going on hold in April. Assuming this means no rate rise in April, it likely means 25 point RBA rate hikes in February and March to take the cash rate to 3.35%. If it means no rate rise from April, then 3.85%, which is where ANZ Bank economists, for one, see the cash rate peaking.
Morgan Stanley believes the RBA will begin easing rates in 2024, forecasting sharper corrections in unemployment and inflation than the RBA, or consensus, expects. Within equity portfolios, the broker recommends Overweight in energy, healthcare and diversified miners and Underweight in banks, housing and consumer sectors.
“Buckle up,” says Macquarie. Equities are near the end of a bear market rally, not the start of a new bull market, as the balance of risks shifts from high inflation to recession.
There is still downside risk from high valuations in 2023, but the broker sees earnings downgrades as a greater risk. This contrasts with 2022 in which low unemployment and savings buffers allowed many companies to pass on cost inflation. Macquarie thinks this changes in 2023, as the global rate hikes of 2022 pressure sales and margins.
Momentum should also fade, as economies work through pent-up demand and extended order books.
But there is light at the end of the tunnel.
The best time to buy is in a recession, Macquarie notes. Stocks often bottom in the middle of a recession as policy easing supports a trough in the cycle. This marks the shift to Late Contraction, which is the best time to own stocks. In past cycles, the leaders out of recession include software, diversified financials and construction materials, while defensive groups will be the laggards.
Macquarie sees potential for the cycle to trough in mid-2023, but timing depends on the depth of the recession. Here US inflation and Fed policy remain a swing factor. China reopening, monetary policy easing and rising real disposable incomes (falling cost of living meets wage growth) should all be factors supporting the next bull market.
That’s the domestic situation, heading into 2023. But UBS offers up a contrasting perspective, by looking in from the outside.
The Australian equity market has been under-appreciated and under-owned for too long, UBS proclaims. Foreign investor apathy towards Australia is set to dissipate, the broker believes, as offshore investors recognise that Aussie equities have many of the characteristics required to stand out over the next decade.
Near term Australian strength is a product of the commodity inflation complex, and a resilient (on a relative global basis) consumer. UBS believes Aussie stocks hold significant relative appeal over the next decade due to several factors:
-Australia's population growth has been amongst fastest in the world, and this will continue.
-Australia's concentrated industry structure supports high profit margins.
-Australian company dividends yield almost double the global average.
-Australian stocks are relatively detached from the global economic cycle. Outside of resources, Australian businesses tend to be very domestic-focussed in their customer base. In the lower growth world which we are entering, “this may not be a bad thing!” concludes UBS.
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