Property: So hot right now

With strong capital growth over the 2013 calendar year and the most recent data now available, let’s examine the state of play in the Australian housing market.

In the capital cities, house price growth accelerated over the second half of 2013. The ABS saw growth increasing from 3.2% in the first half to 6.1% in the second with RP Data and Residex reporting similar figures. Units also experienced a sharp acceleration.

That momentum looks set to continue. Auction clearance rates recently hit an all-time high on heavy volumes, suggesting buyer interest remains intense. Moreover, arguably the single best short-term indicator for house price growth – housing finance commitments – continues to grow strongly (see Chart 1).

Meanwhile, the release earlier this month of the ABS’ labour price index revealed that wages growth has slumped to the lowest level on record, with wages nationally rising by just 2.5% in the December calendar year, slightly below the rate of inflation.

With house prices nationally growing at around 10% in 2013, Australia now finds itself in the precarious position whereby housing values are growing at roughly four times the pace of wages.

That’s not sustainable. When adjusted for inflation, Australian housing values are fast approaching their mid-2010 peak and right now are only 5% below their all-time highs. Australian housing could hit peak valuation sometime this year, as Chart 2 suggests.

Even more worrying is how much of this is investor-driven. Investors’ share of housing finance commitments (excluding refinancings) hit 45% in the December calendar year, just below the all-time peak of 46% in mid-2003.

This places Australian housing on a more fragile footing than if demand was driven primarily by owner-occupiers, who tend to buy into housing for the longer term because investors are more likely to cut and run as soon as conditions change.

Still, why worry? Australia’s high housing values have hovered around this level for a decade, so what’s new? The fact is Australia’s economy is on a very different trajectory than was the case a decade ago, with the economy facing multiple challenges. It really is different this time.

A decade ago, Australia’s economy was about to embark on the biggest commodity price and mining investment boom in the nation’s history. The extra disposable income generated from it arrived just as the growth of mortgage debt was beginning to wane, enabling home prices to remain elevated. Rising housing debt was the key driver of Australian home prices up until 2004 but strongly rising incomes have played the greater role since, with rising debt reasserting itself only recently.

That situation could now reverse, with falling commodity prices and the terms of trade (the ratio of export prices to import prices) weighing on house prices. As commodity prices fall, national income is reduced, pulling down wages growth, company profits, and budget revenues.

Poor wages growth

That already seems to be occurring. Over the decade from 2000, real per capita income growth averaged an extraordinary 2.8%, well above the 1.2% average growth rate experienced over the 1990s. By contrast, between 2010 and 2013 that figure averaged just 1.0%.

Indeed, late last year the Australian Treasury forecast that average per capita income growth would halve over the next decade to the lowest rate in 50 years, weighed down by the falling terms of trade.

Commodity prices and the terms of trade are heading back towards their longer-term average levels, and that will detract from household income growth. So much of the income gains enjoyed over the 2000s will be unwound, weighing on asset valuations, including housing.

The deteriorating employment situation isn’t helping either. For the first time in more than a decade Australia’s unemployment rate has hit 6%. Unemployment may be rising now but in July 2003 it was falling. That’s another reason for thinking it’s different this time, especially as a decade ago employment was growing at 2.1% per annum compared with 0.3% in the year to January 2014, the 14th consecutive month where employment grew by less than the size of the labour force.

So for more than a year not enough jobs have been created to absorb the new entrants into the labour force. It wasn’t like that a decade ago.

So while the housing market was just as inflated a decade ago, values were at least supported by strong employment growth and falling unemployment, followed by strongly rising incomes. Today, the labour market is deteriorating and we face anaemic income growth.

Worrying outlook

The medium-term outlook for the economy is also worrying. The once-in-a-century mining investment boom is set to decline sharply over the next few years as large mining projects, such as the three liquified natural gas projects in Gladstone (valued at over $60 billion), are completed. The exact timing of the unwinding is uncertain but the decline is steep. With the mining sector accounting for nearly 10% of employment, unemployment could well worsen.

One area the RBA has targeted to pick up the employment slack is dwelling construction but it’s poorly placed to fill the mining investment void. For every 10% decline in engineering construction, dwelling construction would need to increase by around 25% just to keep overall construction levels constant. That’s most unlikely.

With capital expenditure intentions for 2014-15 coming in far worse than expected (-17%), signalling a sharp contraction over the next year, a perfect storm could be developing in the labour market. The planned closure of the Australian automotive assembly industry by 2017, which is expected to lead to the loss of up to 50,000 jobs, coinciding with the collapse of mining capex and the loss of tens of thousands of mining-related jobs won’t help, to say nothing of the longer-term decline in the participation rate.

Already, these two factors – lower labour force participation and a falling employment-to-population ratio – have begun to manifest in the official figures, with both measures trending down sharply since late-2010. Population ageing will see a continued contraction in the share of workers in the economy, creating headwinds for the economy and future asset valuations.

While Australian housing is likely to be well supported in the short term, propelled by positive sentiment and intense investor activity, it appears to be heading for trouble.

Australian housing valuations are likely to hit their highest level on record later this year just as the economy enters its biggest adjustment since the early-1990s recession.

Australia’s authorities do have some ammunition in the form of further interest rate cuts and stimulus, such as the reintroduction of first-home-buyer grants, which should help to support housing values. Equally, however, immigration could fall significantly as the economy deteriorates – as generally occurs during economic downturns – taking some of the steam out of housing demand.

Nobody knows how the deteriorating economy will play out for the housing market but the unfolding structural adjustment makes gearing up into property a risky proposition despite some favourable cyclical signals. The risk of a correction sometime in the near future is arguably greater now than at any other time in living memory.

Leith is an economist previously of the Australian Treasury, Victorian Treasury and Goldman Sachs. He writes as the Unconventional Economist at Macro Business.