PIMCO Aust Housing Prices 2015
Transcript of PIMCO Aust Housing Prices 2015
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Your Global Investment Authority
Viewpoint June 2015
Aaditya ThakurVice PresidentPortfolio Manager
Laura Ryan, Ph.D.Vice PresidentQuantitative Research Analyst
A Look at Rising HouseholdDebt in Australia and theImplications for Policy
Australia’s economy is giving off mixed signals: Even as
GDP growth and income slow, household debt appears to b
rising. Understanding what is driving household behavior
has important implications for policy and interest rates.
During Australia’s most recent economic upswing, national income outpaced
output, but with larger-than-anticipated commodity price drops over the past
year, this trend has reversed. This is apparent on a per capita basis, with net
national disposable income actually falling, as seen in Figure 1. At the same
time, the main macro variables of unemployment, private final demand, wages
inflation and confidence have all weakened. (For a discussion of how the
Australian terms-of-trade cycle is now weighing on nominal growth andnational incomes, see Australia Credit Perspectives, August 2014.)
FIGURE 1: NET NATIONAL DISPOSABLE INCOME AND GDP PER CAPITA
Source: Australian Bureau of Statistics, Bloomberg, 31 December 2014
GDP per capita % chg Real net national disposable income per capita % chg
8.0
6.0
4.0
2.0
0.0
-2.0
-4.0
Jan
‘86
Jan
‘88
Jan
‘90
Jan
‘92
Jan
‘94
Jan
‘96
Jan
‘98
Jan
‘00
Jan
‘02
Jan
‘04
Jan
‘06
Jan
‘08
Jan
‘10
Jan
‘12
Jan
‘14
P e r c e n
t ( % )
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The Reserve Bank of Australia (RBA) has tried to cushion these
macro headwinds by lowering the cash rate to historically low
levels but is now faced with the risk of over-stimulating the
housing market. Indeed, common metrics of household
leverage and house price valuations remain elevated in
Australia, particularly compared with those in other developed
markets (see Figure 2).
FIGURE 2: HOUSEHOLD DEBT TO NET WORTH (%)
Source: Australian Bureau of Statistics, Bloomberg, 31 December 2014
Jan‘90 Jan‘92 Jan‘94 Jan‘96 Jan‘98 Jan‘00 Jan‘02 Jan‘04 Jan‘06 Jan‘08 Jan‘10 Jan‘12 Jan‘14
P e r c e n t ( % )
USAUS
10
15
20
25
30
How household leverage evolves will have implications
for policymakers and the potential path of interest rates.
A positive response to leverage in the face of weakening
fundamentals may increase the economy’s vulnerability to
a more severe downturn. This complicates the RBA’s reaction
function when setting policy by introducing financial stability
risk. Therefore, it is important to understand what is driving
household debt and how it may evolve.
The evolution of Australian household leverage
The run-up in debt at the household level was incurred during
a very buoyant period when nominal growth and wages were
high, as seen in Figure 3. From 2000–2008 debt relative to
income accelerated from 80% to 130%, while nominal
growth averaged nearly 8% and wages grew at 4% annually.
FIGURE 3: HOUSEHOLD LEVERAGE
Source: Australian Bureau of Statistics, Bloomberg, 31 December 2014
Household debt to income
160
140
120
100
80
60
40
20
0Mar‘80
Mar‘83
Mar‘86
Mar‘89
Mar‘92
Mar‘95
Mar‘98
Mar‘01
Mar‘04
Mar‘07
Mar‘10
Mar‘13
Average nominalgrowth 8%
Average wagegrowth 4%
P e r c e n t ( % )
Nominalgrowth 3%Average wagegrowth 3%
More recently, the end of the commodity cycle has resulted in
a larger-than-expected negative income shock. In fact, over
the past three years, nominal growth and wages have only
averaged gains of around 3% per annum, with the trend
continuing to fall. If this downward move persists over the
medium term, as expected by the RBA, household expectation
could start to deteriorate, leading to a slow but persistent need
to decrease leverage. As a result, consumers could increase
savings, and the response to low interest rates may be more
subdued than history would suggest.
However, it is also possible that lower mortgage rates and asse
price appreciation may drive a more irrational response relative
to the macro fundamentals, a “herd mentality” that assumes
continued capital price appreciation and creates the fear of
“missing out.”
The role of debt
Households often decide to incur debt to finance assets that
will provide a future expected payoff and maximize their net
worth. Therefore, the level of debt incurred is typically tied to
n expected future capital gains in the asset
n expected future income related to the productivity
of the asset
n debt-servicing costs
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Should expectations rise for future capital price or income
gains and/or should debt-servicing costs fall, households may
increase their desired levels of debt. The problem is that
expected future capital price gains may become unrealistic
when extrapolated from recent history (“irrational
exuberance”), leading to excess borrowing, which, when
unwound, can lead to large negative externalities.
Rather than commenting on the appropriateness of any
given debt level, we have focused on what is driving the
change in debt metrics. Due to the importance of household
debt ratios in consumption, which is ultimately what
policymakers are concerned about, we use debt-to-income
as our preferred measure of household leverage.
Australian housing in an international context
Given the importance of expected future capital gains in
household behavior, it is worthwhile putting Australian houseprices in an international context. Based on data from the
OECD (2014), two commonly used valuation metrics place
Australian house prices at the higher end of international
comparisons, as seen in Figure 4. With this starting point, it
seems questionable to embed expectations of continued
high price growth.
Analyzing household behavior
In a recent speech (April 2015), RBA Governor Glenn Stevens
touched on the vulnerabilities created by household leverage
“Household leverage starts from a high level… the extent to
which further increases in leverage should be encouraged is
not easily answered.“ He described dwelling prices as having
“already risen considerably from their previous lows, at a
time when income growth has been slowing,” adding that
“it is hard to escape the conclusion that Sydney prices – up
by a third since 2012 – look rather exuberant.” He also
acknowledged the importance of financial stability issues:
“The conduct of monetary policy can’t allow these financial
considerations to dominate the ‘real economy’ ones
completely, nor can it simply ignore them. A balance has
to be found.”
Given the increased weight the RBA places on these
vulnerabilities when setting monetary policy, analyzingwhat drives household debt is highly relevant.
To determine which factors drive household leverage, we
statistically tested the response (the change) in household
leverage against changes in several key variables including
wages, unemployment, asset prices, confidence and the
cost of credit.
FIGURE 4: HOUSEHOLD LEVERAGE BY COUNTRY
Source: OECD Economic Outlook, Volume 2014 Issue 1
A u s t r a l i a
C a n a d a
D e n m a r k
F r a n c e
G e r m a n y
G r e e c e
I r e l a n d
I t a l y
J a p a n
K o r e a
N e t h e r l a n d s
N e w
Z e a l a n d
N o r w a y
S p a i n
S w e d e n
S w
i t z e r l a n d
U n i t e d K i n g d o m
U n i t e d S t a t e s
E
u r o a r e a
T o t a l O E C D
10
15
20
25
30
Price-to-rent ratio
A u s t r a l i a
C a n a d a
D e n m a r k
F r a n c e
G e r m a n y
G r e e c e
I r e l a n d
I t a l y
J a p a n
K o r e a
N e t h e r l a n d s
N e w
Z e a l a n d
N o r w a y
S p a i n
S w e d e n
S w
i t z e r l a n d
U n i t e d K i n g d o m
U n i t e d S t a t e s
E
u r o a r e a
T o t a l O E C D
Price-to-income ratio
0
0
0
0
0
0
0
0
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We first tested the explanatory variables individually to see
whether they are significant, and from that subset, we tested
them together to see how they interacted and whether some
variables dominate others. Importantly, we also tested various
lags in these explanatory variables to proxy for expectations.
That is to say, individuals’ expectations and responses may
change under a persistent set of conditions. So, for example,
a quarter of strong wage growth may not be sufficient to
shift expectations, but over several quarters, strong wage
growth may result in an increase in leverage as expectations
for future income are revised higher. (An upcoming paper,“A Model of Australian Household Leverage,” will provide a
detailed explanation of our methodology.)
Conclusions
The modelling results reveal that asset prices and mortgage
rates largely explain the change in household leverage. These
two factors appear to dominate all other variables regardless
of how significant they are individually.
From this we infer several probable outcomes in Australia:
n Households’ decision to incur debt is dominated
by the cost of debt (the mortgage rate) and
recent asset price appreciation, which may not
be sustainable or linked to the productivity of
the asset.
n Of concern, households are exhibiting irrational
exuberance because they are placing little weight on
broader fundamentals like unemployment that may be
more representative of future incomes or asset price
returns, increasing the likelihood of asset price bubbles.
n Australian households appear to respond rather quickly,
needing only two quarters of favourable changes in asset
prices and mortgage rates to increase leverage.
n Australian households will react faster and more
vigorously to a shock in asset prices or mortgage rates.
This could result in a feedback loop where falling asset
values induce further deleveraging.
Based on our model for household leverage alone, if an
exogenous shock sparked a deleveraging cycle in Australia, it
would be expected to be quite severe given the large co-
efficient for asset prices and the quicker household response.
wClearly other factors not captured in the model may mitigate
such a severe outcome, and no model is perfect, but as a
starting point this statistically highlights the potential
vulnerability of high and rising household leverage incurred on
the basis of past asset price movements. We believe macro-
prudential measures should be strengthened to address
financial stability risk and give the RBA maximum flexibilitywhen setting policy for the aggregate economy.
Finally, given the sensitivity of households to mortgage rates,
the peak in the cash rate in the RBA’s next hiking cycle is
likely to be much lower than in previous cycles. This is in
accordance with PIMCO’s New Neutral view that calls for
much lower policy rates for an extended period.
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