Good morning. Another week dominated by macroeconomic data and central bank speculation. US inflation hit a four decade high at 9.1% while Australian unemployment hit a 48 year low at 3.5%. We also started to hear about how US companies are faring as reporting season kicked off. Remember to stay focused on the long-term in this headline driven market environment.

Down down, prices are down

Everyone is convinced house prices will fall, so what happen if (when) they do?

The question is far from hypothetical. Capital cities Sydney and Melbourne are already trending lower as higher interest rates shut off the conveyor belt of new buyers. Sydney notched its fifth straight month of falls in June 2022 and is 3.2% off the February peak. Melbourne dipped 1.1% last month.

Boffins expect prices have much further to go. Chief Economist at AMP, Shane Oliver, is calling a 15% to 20% decline nationwide. Economists at mortgage-machine Commonwealth Bank tip 15% from peak to trough. Christopher Joye warns about the “Aussie housing crash” from the Australian Financial Review.

Falling house prices are particularly nasty because much of the economy’s plumbing runs through the housing sector. When well-appointed, spacious townhouses depreciate, they trigger changes in spending that ricochet through the economy, pinging everything from banking to airlines. At its worst, sliding prices accelerate into a downwards spiral of spending and employment that had its apotheosis in Japan’s brutal property market bust in the 1990s. That’s unlikely happen in Australia. So, what will? It goes something like this.

First, homeowners take a hit to their paper wealth. After the first 10%, the savvy owner of a $1 million asset becomes the slightly-embarrassed occupier of an asset worth $900,000. In what is called the ‘wealth effect’, people who feel poorer tend to spend less money. They are also likely to have less on hand as rising interest absorbs more income.

A rough rule of thumb is a 1%-1.5% fall in consumption for every 10% decline in property prices. The upper-end of Shane Oliver’s 15%-20% forecast decline would equate to losing roughly a year’s worth of consumption growth using his rule.

Consumer discretionary stocks bear the brunt of less spending. People who feel poorer buy fewer flights and washing machines and are less likely to splash out on dinner or the movies.
The sector has already taken a drubbing this year due to fears a recession will cut into spending. The S&P/ASX 200 Consumer Discretionary index is down 20% year to date. A similar benchmark in the US is down 30%.

These stocks take a beating in every downturn, but housing downturns have the potential to be wider and more vicious, hitting construction and renovation, furnishings, real estate and services such as solicitors. All get squeezed by falling prices and fewer houses changing hands. The magnitude can also be more severe because houses are most owners’ largest asset. Tim Lawless, researcher director at CoreLogic calls it the housing multiplier effect.

Banks are among the most exposed to falling house prices, especially in Australia where many blue-chip banks are glorified mortgage writers. The first risk is to earnings. Falling house prices mean less demand for mortgages. Then, those mortgages that are written will be smaller. As the mortgage cash cow slims down, earnings do too. This is compounded by less demand for other types of credit.

A dip in house prices doesn’t automatically translate into more bad debts per se. People in negative equity can still pay their mortgage, even if they don’t want to. Australians cannot simply hand over the keys without the debt staying with them. The risk for banks is that whatever triggers the decline in house prices (rising rates in our case) also causes people to lose jobs (and rising rates are designed to slow the economy and job losses are standard collateral damage). If defaults spread, banks need to provision for losses, further hitting earnings.

As we’ve covered previously, bank investors aren’t waiting to find out how bad defaults get. Commonwealth Bank and Westpac hit bear market territory in June as the sector dived.
Eventually prices dip low enough to entice buyers back into the market and the cycle starts again, says Lawless. Policymakers help by making lending conditions easier or cutting interest rates.

This played out just before the pandemic. Between 2017 and 2019 national capital city house prices fell 10%, the worst dip in nearly four decades. In Sydney, the decline hit 15%. The trigger was the prudential regulator tightening lending standards, and the crack down on investors was particularly severe.

It played out as one might expect. Housing loans were throttled. Bank shares tumbled by roughly a quarter between 2017 and 2019 (with a helping hand from the Royal Commission revelations). The economy slowed too. Retail spending growth dropped by a third nationally relative to the period before. Construction activity slumped. But despite some bumps, unemployment trended lower.

There were “no signs of real distress”, says Lawless. Homeowners took the fall in equity on the chin and, for the most part, kept paying their mortgages.

And that’s what most people expect will happen again. Oliver expects a moderate cyclical downturn. Lawless sees growing affordability and a gradual relaxation of credit conditions eventually luring buyers back. Bad for banks but only a nagging cough for the economy.

In April the Reserve Bank published its bi-annual Financial Stability Review, 65 pages of whizz-bang charts that say one thing: most homeowners have lots of equity, big payment buffers and are employed.

But housing busts start at the margin and a small chunk of borrowers are clearly at risk. The bank estimated that a 2% jump in rates would see repayments rise by 30% for a quarter of variable-rate borrowers. Half that group had less than a year of their April minimum repayments squirreled away.

Also concerning are the millions of fixed-rate loans that will switch to variable over the next 18 months. The bank expects roughly 10% of owner-occupiers and 20% of investors on these loans to see repayments jump more than 30% if rates are 2% higher by the end of 2023.

When the bank released its modelling the cash rate was at zero, and a 2% rise was a reasonable stress-test scenario. Today, with the cash rate at 1.35% and set to be north of 2% by Christmas, it looks dangerously lax.

So, what would it take for a larger downturn? The domino to watch is employment, agree Lawless and Oliver.

People out of work miss mortgage repayments. They become distressed sellers and drive prices lower. As people stop spending, more jobs are lost, and more houses dumped on the market. Banks reign in credit as loan books sour. Savage property busts cripple the economy for years. US house prices and unemployment levels took a decade to recover after the global financial crisis. Japan is still feeling the effects four decades on. Here’s Oliver on the risks:

“Once you go in a particular direction, there is always a risk it feeds on itself and keeps going. A modest initial fall becomes a deeper one. The risk here is if you don’t see some let up in the pressure in the next three or four months that it keeps going down and it’s harder for the Reserve Bank to turn around.”

Historically, Australian policymakers have always been able to cut rates by the time unemployment reared its head. In the next year, it will not be so easy. If inflation remain stubbornly high, the Reserve Bank could be stuck choosing between a rock or a hard place: help the economy recover and let inflation off the hook or curb rising prices and kill the economy.

One silver lining: In the depths of the pandemic, the Reserve Bank ran a modelling exercise to see how the banking sector would cope with a doomsday scenario. The banks survive a situation where unemployment rises to 8% and house prices fall 40%. It’s not pretty, but no 2008-style Lehman Brothers collapse.

More from Morningstar

Catch up on what happened this week in the usual place.

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