For something that cannot be directly observed, and changes through time, the neutral level of interest rates generates an awful lot of debate, says Strategist Russell Silberston.
25 Apr 2023
25 April 2023, From 1870 to 2015, it’s estimated that the global housing market returned 11.06% per annum, or 7.05% in real terms1. Impressive when we compare that to the more volatile and more modest 10.75% return from global equities over the same period. It should come as no surprise then that the phrase “as safe as houses” has entered the common lexicon.
What people may not know, is that that period also captures one of the greatest housing downturns in history which scarred the US economy with a deflationary shock for nearly a decade and left many questioning the validity of property as an investment.
This begs the question, are houses as safe an investment as some like to suggest? And more to the point, what are the economic implications when things go wrong?
Looking back it is easy to see the imbalance that was building within the US economy in the lead up to the Global Financial Crisis; real disposable income ratios peaked at 1.1 times and household debt to GDP reached 99%. It seems incredible then, that after many years of low interest rates and cheap money globally, certain countries have repeated these errors of the past leaving household balance sheets on the brink just as central banks commenced the fastest policy tightening cycle in history.
Specifically, we identify six countries that face particular challenges: Australia, New Zealand, Canada, South Korea, Sweden and Norway. These economies never really delevered after the Global Financial Crisis, as the US did, and as a result have seen housing markets continue to inflate and household debt balloon. Real house prices to real disposable incomes for example in the three-dollar bloc economies (Australia, New Zealand & Canada) are around 2.5x with household debt at or above 100% GDP. While debt levels are lower in the Scandinavian countries, with nearly all household debt having floating interest rates in Norway and the highly controlled Stockholm market seeing especially exorbitant prices in the city, these markets are vulnerable to rising rates too.
In a world where central banks are still battling to control inflationary pressures the impact of these imbalances may well become critical in turning the tide. As interest rates rise rapidly and banks tighten lending standards, these economies face significant headwinds to both growth and inflation as consumers try to overcome the hit to their disposable income.
Typically, as housing demand fades, leading indicators such as new housing starts fall and property prices turn over, feeding directly into inflation and growth. This is further exacerbated by the negative wealth effect on consumption and broader use of debt. Rising interest rates drive a tightening in bank credit standards, making any new loan or re-mortgage that much more expensive weighing on consumers disposable incomes and undermining consumption. As growth and inflation fall, central banks are ultimately constrained in their ability to raise interest rates.
This is precisely what we are seeing in these vulnerable markets. In both Australia and Canada, for example, housing starts have fallen 33% from the post Covid highs, and property prices are well off their peaks in both countries. The Reserve Bank of Australia, therefore, slowed the pace of interest rate hikes and began to look towards a pause stating in its latest meeting that “Growth over the next couple of years is expected to be below trend. Household consumption growth has slowed due to the tighter financial conditions and the outlook for housing construction has softened.” The Bank of Canada has similarly held at a level 1% below where we project Fed Funds to reach. Meanwhile, on the other side of the world, Sweden’s Riksbank is trying to find the line between the prospect of “falling house prices leading to lower housing investment, which will reinforce the economic downturn” and a weaker currency.
For reference, we see the UK housing market as falling somewhere in the middle of these dynamics; while it hasn’t inflated as much as the economies highlighted, households have failed to delever to the same degree as the US. With housing associated activities making up over a quarter of domestic GDP it is likely that we will see some impact closer to home.
Thus, we would be surprised if, as higher interest rates begin to bite, those economies that have grown material household and housing market imbalances over the past decade of easy money don’t find themselves exposed to notable downside surprises in both growth and inflation over the next 12-18 months. We believe this presents opportunities in government bonds in these markets and is likely supportive of currency depreciation in these nation’s currencies against structurally stronger reserve currencies.
1Jorda, Oscar, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2017. "The Rate of Return on Everything, 1870–2015" Federal Reserve Bank of San Francisco Working Paper 2017-25.