In Brief: Housing Affordability, Wage-Price Spiral, Coal & Iron Ore

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Weekly broker Wrap: the Australian housing affordability crisis; the link between wages and inflation; market relieved by NSW coal royalty outcome & strong iron ore fundamentals.

-The housing affordability crisis deepens
-Do rising wages result in higher inflation?
-Market relieved by NSW coal royalty outcome
-Strong iron ore fundamentals, says Morgan Stanley

By Mark Woodruff

Housing affordability issues spreading across Australia

Should you be either an existing or prospective mortgagor or renter, the following will either confirm your pain or add to your trepidation.

Housing affordability is no longer an issue confined to Australia’s two main capital cities but has spread right around the country, observes Jarden.

The analysts’ definition of affordability, less than 30% of income directed to housing costs, also extents to the rental market where a record 13% gap has opened in favour of rental over mortgage affordability.

Despite this edge, renting is also unaffordable and chews up a record 30% of income compared to 24% in 2019, while mortgage payments have increased from 24% at that time to a record high of 43%.

In a potential reprieve for prospective house borrowers, the broker forecasts a double-dip for house prices as supply increases and interest rates remain elevated. It’s felt the crisis of housing affordability and the 13% spread between renting and owning is unsustainable for medium-term house prices.

Either a -3%-percentage point fall in the cash rate to 1.1% or a -25-30% fall in house prices would do the trick in bringing down housing costs, but Jarden suspects both scenarios are unlikely.

What may work, suggest the analysts, is a combination of factors including a -1.5%-percentage point fall, a -10% fall in house prices and a 10% rise in rents, which would return the 13% spread to pre-covid levels.

The unhappy conclusion by Jarden: "without a material reduction in dwelling values and interest rates, it is likely that home ownership could slip permanently out of reach for average households."

Under these circumstances the number of renters will continue to increase, which has important implications for the economy, financial system and society, notes the broker.

Security of tenure/minimum standards for renters will likely come into focus and necessitate a review of whether the superannuation/pension system is adequate for long-term renters.

Among these dire projections, at least someone is winning: those exposed to growth in the emerging Build-to-Rent (BTR) sector. While Jarden doesn’t individualise, companies offering BTR include Lendlease Group ((LLC)), Mirvac Group ((MGR)) and Stockland ((SGP)).

The wage price spiral, or not?

Do rising wages result in higher inflation?

While a tight labour market and high wage growth are often cited as a risk to price stability, necessitating tight monetary policy, a report out by Shaw and Partners notes the relationship between wages and inflation is more complex and nuanced.

A perusal of past literature suggests to the broker inflation is mostly driven by demand for goods and supply shortages, rather than wages and labour costs. It’s noted employer pricing behaviour has also contributed to past inflation outcomes.

The authors of the report also point to empirical evidence showing short-term inflation spikes resulting from wage increases do not normally lead to a sustained spiral in wages and prices. Instead, inflation and nominal wage growth tend to stabilise.

In fact, the data show labour cost has little-to-no impact on inflation and is instead absorbed by companies profit margins.

While wages don’t influence future inflation, Shaw and Partners note inflation impacts on future wages after a time lag. One explanation for this outcome is that companies raise selling prices before rising wage costs impact upon profitability. As such, employers are ahead of the game in anticipating the effects of a tight labour market, such that wages lag inflation.

The decision by business owners to raise prices due to changes in labour costs will also take into account changes in labour productivity, notes the broker. Unit labour costs adjust wage growth for changes in labour productivity. If productivity increases it will reduce the adverse impact of higher wages on profit margins and, hence, the pressure to raise prices.

After further analysing the relationship between headline and core inflation in the US, Shaw and Partners believes the easing in core PCE inflation since the end of last year should result in lower upcoming figures for headline inflation.

Market relieved by outcome of NSW coal royalty

Apart from a minor target price decrease for New Hope ((NHC)), Macquarie leaves it targets unchanged for the other three coal stocks under its coverage following a lower increase in coal royalties by the New South Wales government than the market was anticipating.

In both NSW and Queensland, thermal coal and coking coal are treated equally despite significant variances in prices and markets.

According to the broker, the market was somewhat relieved given the draconian precedent set in Queensland which involves a progressive system, with a 40% royalty set for prices over $300/t.

The NSW government will increase its coal royalties by 2.6% from July 1, 2024. The new rate for open cut mining will be 10.8%, while the rate for underground mining will be 9.8% and the rate for deep underground mining will be 8.8%. On the flipside, the miners had a win given the domestic coal cap and reservation measures will be removed.

Macquarie still prefers metallurgical coal exposure over thermal and favours Outperform-rated BHP Group ((BHP)) from among its coverage given copper and iron ore growth optionality.

The company is exposed to the NSW royalty rate increase via its Mt Arthur coal mine in the Upper Hunter Valley.

While the mine accounts for around 3% of the group’s overall revenue, Macquarie ascribes little-or-no value in its forecasts given the cost outlook, thermal coal headwinds and a large rehabilitation liability associated with the asset. The broker’s $47 target is maintained.

Morgan Stanley suggests the potential impact of the new royalty regime is minimal for Overweight-rated South32 ((S32)). By implication Macquarie (Neutral) agrees, given no changes to its $3.60 target price, though the broker does lower its EPS forecasts by -1-2%.

All of Whitehaven Coal’s ((WHC)) producing coal assets are in NSW with its rates for open pits and the underground rising to 10.8% and 9.8%, respectively.

Open pits include Maules Creek, Vickery and the Gunnedah assets, while underground is Narrabri. Macquarie points out open pit revenue accounted for 69% of group revenue in FY23 and Underground made up the balance. 

The broker keeps its Neutral rating and $6.00 target for Whitehaven, despite lowering its FY25-30 EPS forecasts by -5-8%. Morgan Stanley also maintains its Overweight rating and $8.20 target.

Bengalla is New Hope’s key producing asset and royalties lift to 10.8% from 8.2%. Underperform-rated Macquarie lowers its target by -2% to $4.30.

This mine currently accounts for around 100% of group revenue as New Acland was put on care and maintenance.

Strong iron ore fundamentals

Strong fundamentals for iron ore have surprised Morgan Stanley and present upside risk to its US$90/t forecast for the fourth quarter of 2023. The strength also raises questions as to where the floor price should be for the commodity.

The broker points to a resilient steel output in China and very low port inventories.

The market is anticipating a flat steel output target for 2023, yet the broker sees limited evidence so far, given monthly output would need to fall by more than -14% sequentially from here.

Moreover, while domestic steel demand has been weak, the export market is absorbing it all with net exports in China rising by 40% year-to-date.

Even if long awaited/expected steel production cuts do materialise, the analysts expect high-cost Chinese domestic iron ore supply may adjust, not seaborne flows, despite China accounting for 75% of seaborne iron ore demand.

Using history as a guide, Morgan Stanley points to 2021 and 2022 when Chinese steel output fell on average by -12% sequentially in the second half, the country’s iron ore imports rose sequentially in the second half. During both years port inventories built and domestic iron ore output softened.

There is potential for a raising of the floor for iron ore prices, in the broker’s view, if the marginal tonne for China's steel mills is coming from domestic supply.

The 90th percentile of China's supply sits at US$120/t, and the broker points out China's output began to fall as soon as prices fell below this level in both 2021 and 2022.

For comparison, the 90th percentile of the global iron ore cost curve is US$78/t, where prices hit a nadir in 2022, while the seaborne support is even lower at US$61/t, explains Morgan Stanley.

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