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 (%)


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


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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PIMCO Aust Housing Prices 2015

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