In several ways, Australia is better placed than many other countries to withstand the global recession now underway.
We have plenty of scope for fiscal and monetary stimulus, our financial system is still operating comparatively well and growth in our trading partners is slowing but will be above that in the US, Europe and Japan.
However, there is one area where Australia is particularly vulnerable and this is the intersection of high household debt levels and high house prices.
If house prices slide too much, then we risk entering a sort of debt-deflation spiral where sliding house prices trigger further falls in spending which in turn trigger further increases in unemployment, further falls in house prices, and so on.
The AMP’s Dr Shane Oliver says that so far this year the Australian housing market has started to slow with house prices off by two to four per cent from their recent high. Expect more.
US and UK house prices on the slide
The last decade has seen a massive surge in house prices in many countries.
The surge in Australian house prices relative to income levels has gone hand in hand with a massive rise in household debt, as evident below.
This has been the same in other countries, except that the rise in household debt has been much faster in Australia and so we have gone from the bottom of the pack in terms of comparable countries to the top. See the chart below.
Similarly, the gains in Australian house prices have been greater than in many other countries. See chart below.
From their highs, US house prices are off 20% and UK house prices have fallen 12% or so and they are still falling.
The slump in house prices is weighing heavily on consumer spending in both countries because it leads to a loss of wealth and has stopped the phenomenon of mortgage equity withdrawal.
The case for optimism on house prices
Despite all this, many would argue that there are good reasons for optimism regarding Australian house prices.
Firstly, while America’s housing boom ended because of an oversupply of housing, Australia has a huge shortage.
This is reflected in 1% or so vacancy rates for rental properties and 10% pa rental growth.
Secondly, whereas the US housing boom saw a huge reduction in lending standards with more marginal borrowers getting finance, in Australia the surge in borrowing was focused on existing home owners trading up who tend to be older with higher incomes.
Thirdly, the slump in US house prices may have been accentuated by non-recourse mortgages which result in a strong incentive for home owners to hand over the keys once the house value falls below the value of the loan.
This is not the case in Australia where full recourse mortgages provide a powerful incentive to keep servicing the loan.
Fourthly, it’s argued that the fall in mortgage interest rates of nearly 2 percentage points since early September combined with increased first home owners’ grants will spur an upswing in Australian house prices.
Finally, if the economy is better able to withstand the global recession for the reasons noted in the introduction then demand for housing should be underpinned.
Reasons for caution on house prices
However, against this there are several reasons to expect further weakness in house prices going forward.
Firstly, despite the turn in the cycle to falling mortgage rates most housing related indicators remain very weak.
Housing finance is continuing to fall, new home sales are falling and weekly auction clearance rates are running 20 to 30 percentage points below year ago levels even two months after the first rate cut.
Secondly, past periods of house price strength have commenced when housing affordability is good, whereas affordability today is poor despite falls in mortgage rates.
This is because house prices remain so high.
Thirdly, despite recent softness Australian housing remains very overvalued – by an average 23%.
In real terms (i.e., after inflation), Australian house prices remain well above their long term trend (by 23%).
Over the last 80 years or so the trend rate of growth in real house prices has been 3.1% per annum, which is consistent with long term real GDP growth around the same level. But since the mid 1990s house price gains have been well above trend growth. See the next chart.
Average Australian house prices remain very high relative to average weekly wages and need to fall about 22% to return to more normal levels.
The ratio of house prices to median household income in Australia is more than double what it is in the US.
Despite strong growth in rents, rental yields remain very low.
Gross rental yields of 3.6% for houses and 5% for units are well below the 6.5% plus net rental yields available on directly held commercial property, the 10% distribution yields on listed property trusts and a grossed up dividend yield of over 7% available on Australian shares.
House prices would need to fall about 25% to bring the ratio of house prices to rents (adjusted for inflation) back to its long term average.
Finally, at a time when housing affordability is poor, household debt levels are high and h
