A recession is now underway that may be quite deep. The global and domestic slowdown on the back of the COVID-19 outbreak will see new challenges emerge for the construction industry. Demand will moderate on weaker sentiment and incomes, particularly on the residential side. Projects could be delayed and costs increase, intensifying financial pressures that already exist for some as a result of squeezed profitability, credit constraints and low cash buffers. The lower OCR will ease financial pressure for construction-related firms by lowering debt-servicing costs, although the availability of credit will remain a constraint for some. Firms will need to actively manage risks in the difficult and uncertain period ahead that may be prolonged.
Rising house prices are a mixed blessing. It tends to encourage increased spending in aggregate, with some households benefiting from wealth gains and easing collateral constraints. This boosts GDP, though usually debt as well. But for other households, higher house prices mean home ownership slips further out of reach. And the low interest rates than can be the driver of higher house prices can adversely affect older households, even if they own their own homes - they are typically savers rather than borrowers, so lose when rates fall. Currently, households are feeling pretty good on the back of the strong labour market and better economic news (at least up until recently). However, risks are looming. Deposit growth has not kept pace with strong credit demand, meaning banks' balance sheets are under pressure, and credit availability may become a headwind. And emerging global risks are in the spotlight. We expect economic impacts associated with the tragic COVID-19 outbreak to be sharp but short at this stage. However, a larger impact cannot be ruled out. Such risks could see household optimism slide. But for now, momentum is on the up
House prices have rebounded a bit more rapidly than we - or the RBNZ - expected. Monetary policy is working, though rising house prices are most definitely a mixed blessing for the economy. We have upgraded our forecast, with house price inflation now expected to reach 8% y/y, supporting our revised call for the OCR to remain at 1% this year. There is some upside risk to that 8% number - the market is tight and house price expectations have increased - but we think a number of headwinds will keep the market in check. Given the current low interest rate environment, house prices could prove volatile. The RBNZ will be watching financial stability risks closely when setting macro-prudential policy to ensure a growth-positive pick-up in housing does not come with a risky speculative dynamic.
The state of the New Zealand economy can both reflect and determine the fate of the housing market. Some of this simply reflects that population growth swings are a huge driver of both the New Zealand economic cycle and the housing market. But it is also true that the housing cycle – both construction and prices – has a big impact in and of itself. The construction sector provides 9% of jobs. And the state of the housing market has a big say in consumers’ willingness to spend. So to round out 2019, let’s take a look at the state of the broader New Zealand economy, and put the housing market in context.
The Official Cash Rate (OCR) has been cut 75 basis points over the past six months and mortgage rates have fallen. But because household deposits are an important source of bank funding (eg for home loans), banks have had to strike a balance, meaning both mortgage and deposit rates have fallen by less than the OCR has. And as the OCR goes lower (we're forecasting a further 50 basis point reduction by August 2020), we think the pass-through to mortgage (and deposit) rates will diminish. Indeed, there's a real risk that if deposit rates go lower, household deposit growth could slow markedly as depositors seek higher returns elsewhere. This would mean banks have a lower deposit base from which to provide new loans, reducing the positive impact to the housing market and broader economy. So even if the price of credit (ie the interest rate) is low, supply constraints (credit availability) can be a significant headwind.
Loan to Value Ratio (LVR) restrictions were never intended to be a permanent feature of the housing market. But, six years after their implementation in 2013, they remain a key element, contributing to less risky lending and putting downward pressure on house price inflation. Numerous tweaks to the LVR restrictions have been made in recent years, but is it time to loosen them a little more? Recent housing market outturns have been modest, particularly on the sales activity side. But there are lots of moving parts, and significant regional divergence. While household debt levels are certainly high, growth in household disposable income does looks to be running at around the same pace as housing credit growth - and above house price inflation. Both we and the RBNZ expect house price inflation to remain modest relative to previous cycles over the next few years, but frankly, a wide range of outcomes is plausible given the recent drop in mortgage rates, possible developments in credit availability, the softening economy, and policy changes. All up, we think a small loosening in LVR restrictions is likely at the upcoming November 27 Financial Stability Report.
With the Government having announced a KiwiBuild ‘reset’, we go back to basics; thinking about demand and supply in the housing market. The New Zealand housing market is prone to boom and bust cycles, and subject to large swings in demand, often coming from swings in migration. But constrained housing supply means that increases in housing demand tends to lead to higher house prices, while housing construction reacts more slowly. A focus on easing supply constraints is what is really needed, so we review what is being done on that front. The KiwiBuild reset this month offered some goodies for first home buyers, but the newly announced ‘reset’ policies are likely to just add to housing demand. That said, elements of the KiwiBuild programme may still be able to add some value by addressing supply constraints. Other policies are also in train in the background – the Government is building a record number of state homes and the National Policy Statement on Urban Development has the opportunity to transform local land-use planning and infrastructure. But this is all coming against a backdrop of downside risks to the construction sector outlook.
Land makes up a pretty hefty chunk of the price of housing, and has made some significant contributions to house price inflation over the years. After taking a drive though the New Zealand countryside, you could be forgiven for thinking that New Zealand has an abundance of land and that a simple way to address housing affordability is simply to extend a few urban boundaries, pop in some roads and get building. But alas, land appropriate for housing might not be as abundant as you think and the stuff we do have, particularly around key urban boundaries, is currently being put to good use. Given the numerous downsides of urban sprawl, increased housing density is definitely going to have to be part of the solution to addressing housing affordability in New Zealand. While the data suggest construction activity is shifting towards multi-unit dwellings, there's still a decent way to go. And with cost pressures eroding profitability in the sector, and construction firms recently becoming increasingly pessimistic about their own outlook, activity risks are skewed to the downside.
The rules and regulations governing the New Zealand rental property market have undergone a number of changes over the past few years, and it looks like more are on the way. Law changes have generally focused on improving the lot of renters and first home buyers. And while some, such as the Healthy Homes Standards, have broader economic benefits (eg fewer sick days), there's no such thing as a free lunch. Higher-than-otherwise rents and a lower-than-otherwise stock of rental properties are costs that from a social perspective are just as difficult to quantify as the benefits. But for now, let's look at the coal face; at how some of the rules have changed for residential property investors, and how they might change further. Given some of the costs of non-compliance, it is pretty important stuff of which to be aware. Regarding their impact on the housing market (and the economy more broadly), we think policy changes have been - and will remain - a key headwind. But the fundamentals (a shortage of houses and downward pressure on mortgage rates), suggest there are enough supports out there to keep things from rolling over.
This month we take a closer look at housing market performance across different regions in New Zealand. Weakness in the Auckland and Canterbury markets have weighed on the nationwide picture, with these regions comprising 42% of house sales combined. But a number of other regions have experienced strong price gains recently. Based on a number of metrics, we identify Gisborne, Manawatu-Whanganui, Tasman-Nelson-Marlborough and Otago as hotspots, while exceptional heat is being seen in Southland and Hawke's Bay. In addition, Bay of Plenty, Waikato and Wellington markets are also running hot, just not as hot as they have been. Conditions can change quickly and the outlook is uncertain, but all else equal, strong demand in these markets appears conducive to further regional price increases. This delayed cycle relative to Auckland is not unusual for the New Zealand housing market. On the whole, we expect that the nationwide market will remain contained. But regional divergence is expected, with hotspots expected to continue to outperform while headwinds blow strongest in Auckland and Canterbury.
The OCR has been cut to an all-time low of 1.50%, and mortgage interest rates have fallen. In addition, the Government has taken the possibility of a capital gains tax taken off the table. Given these developments, now seems like an appropriate time to reassess our outlook for house price inflation. After adjusting for supply and demand imbalances, we estimate that a 1%pt fall in the mortgage interest rate would typically bump up annual house price inflation up by around 2.5%pts after 6-12 months, all else equal. However, the lengthy list of policy changes this cycle means all else most certainly isn’t equal. Indeed, we find evidence that the recent moderation in house price inflation is owing to factors other than the typical “macro drivers” of population growth and interest rates. This supports our view that the policy landscape and affordability constraints have had a significant role to play, and will continue to do so. All up, we’ve baked in a small bump into the house price inflation outlook, but don’t expect it to shoot for the moon.
For a number of years, construction demand has been strong; activity has ramped up to a high level and firms have been run off their feet. But recently, firms have started reporting that growth in new building work has started to drop off and the outlook is looking less assured. Pent-up demand for housing and KiwiBuild will provide a floor for activity, but that may not be enough to sustain today’s very elevated levels. Construction firms’ costs continue to escalate, but in the context of wariness about the demand outlook, they are finding it more difficult to increase prices, causing profitability stresses. And this comes against the backdrop of an industry already grappling with broader financial, productivity and staffing challenges. So far this cycle, such challenges have been manageable in the context of strong growth in building work, but they will be difficult to bear should demand start to wane, even if activity remains elevated as we expect. And with construction a bellwether of the economic cycle more broadly, this adds to the picture that has formed of an economy past its best.
Credit availability is a significant determinant of housing market developments and the economic cycle. Lending has generally been conservative this cycle, but from 2016, reduced credit availability contributed to cooling in the housing market and loss of economic momentum. Credit has been less of a constraint recently; the housing market and GDP growth are being held back by other headwinds. And banks’ funding positions have been favourable, conducive to continued prudent lending supportive of the housing market and ongoing economic growth, albeit below trend. Nonetheless, some businesses and farms are facing challenges on this front, and waning deposit growth poses the risk that credit becomes a more significant constraint once more. Adding to that, proposed (and probable) changes to bank capital requirements, if implemented, would impact both the price and availability of credit, with potentially quite significant implications for the economy, including for the housing market.
Rental inflation has been trending higher recently, with policy changes aimed at making property investment less attractive playing a role. Rental affordability has not worsened in aggregate, but some households will nonetheless be feeling the pinch. Going forward, waning population growth is likely to see pressure on rents subside somewhat. Yet with the pipeline of policy changes continuing, including possible extension of capital income taxation, rental inflation is likely to remain solid as investors attempt to maintain returns. Overall, we expect the recent trend of rental inflation outpacing house price inflation to continue for a while yet. Headwinds are expected to continue to act on the market for existing housing, while property investors attempt to recoup some yield by increasing rents.
In our August 2018 Property Focus we took a look at how property markets globally relate to the New Zealand market. We concluded that the New Zealand housing market was probably not being dragged down by global developments, but that it could be in the future, with global housing markets having become increasingly synchronised over time. This month, in that context, we take a look at recent developments in housing markets abroad. In summary, housing markets are certainly cooling in synch with each other, but outside of Australia there is no sign that the cooldowns are anything unusual.
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