Despite my optimism regarding residential property's performance over the rest of the decade, nothing is ever without risk. Many would point to the current "upside risk" to interest rates emanating from exogenous inflationary pressures. While this is a risk, I believe it to be a "lesser" one. The key risk may, perhaps ironically, involve a declining interest rate scenario. It emanates from the troubled US housing market which, if it experiences a collapse, could throw our global "soft landing" base case forecast out and send the world economy towards recession, along with significant slower economic growth in the domestic economy. This would probably be a low inflation scenario, offering the Reserve Bank (SARB) scope to reduce interest rates. The crucial question is would the SARB respond aggressively? Possibly not, given its concerns with local credit growth and a wide current account deficit. The combination of sharply lower economic growth and very slow interest rate cuts could be more problematic for the housing market than solid economic growth and further mild rate hiking.
THE KEY RISKS TO RESIDENTIAL PROPERTY ARE CURRENTLY FROM GLOBAL SOURCES
Much is made of rising interest rates and their potential negative impact on the
residential property market, and to be sure we are seeing some negative impact
from the latest cyclical hiking phase. Given the current "upside risks" to
inflation and interest rates, it is natural that many people may act with
caution in the residential property market at present.
However, I would contend that the key risk to the residential property market
may ironically involve a declining interest rate phase.
Crucial to this view is, firstly, the fact that we have had a change in monetary
policy from the 1990s policy that sometimes involved sharp hikes in interest
rates in order to support the level of the rand. 1998's 725 basis points' worth
of hikes in less than 2 months was a good example of what could happen those
days, and the housing market was sent reeling. Today, however, official CPIX
inflation targeting makes such shocks far less likely because the CPIX is a far
less volatile variable than the rand. Indeed, the Reserve Bank has behaved in a
far more stable way during the last two rate hiking cycles, despite a very
severe rand crisis in 2001, supporting the notion that sharp and big interest
rate moves are far less likely these days.
Therefore, even should our forecast of unchanged interest rates until well-into
2008 prove to be incorrect, and rates were to rise further, the pace of hiking
is likely to be very moderate, and the negative impact on the overall housing
market mild.
In addition, neither the South African household's debt service ratios, nor
affordability in terms of the repayment value on an average priced house
expressed as a percentage of average income, are particularly high. This also
serves to reduce the risks involved with interest rate hikes.
The declining interest rate scenario that I refer to as a bigger risk is one in
which the troubled US housing market could play a major role. The graph below
shows the sorry state of the US housing market. The NAHB-Wells Fargo surveys
home builder confidence and they, similar to households, have experienced a
severe dent in confidence which is widely blamed on the so-called sub-prime
market.
The sub-prime market refers to that group of borrowers that do not normally
qualify for prime financing due to low credit scores. They borrow from sub-prime
lenders at higher interest rates, which are supposed to compensate for the
higher risk of default on such loans. However, it is becoming apparent that some
major lenders in this market did perhaps not get their pricing for risk right,
bad debt risk is mounting, and lending policies are tightening.
Interest rate hikes were the key catalyst for the sub-prime problem. The US Fed
raised its Fed Funds target rate from 1% around mid-2004 to 5.25% by 2006. This
has had an impact on long bond yields, which also peaked above 5% in mid-2006,
important for the strongly long-bond-linked US housing market. Since then, long
bonds have come off their peak slightly, which may have helped slow the rot a
little, but the situation still appears shaky.
The big danger to the US and global economy emanating from the US housing slump
comes from the term "equity withdrawal". There is a widely held view that US
households have neglected saving for some years due to the positive impact of
housing values on their household balance sheets. If this is indeed the case, it
could mean that should the housing market collapse and house prices decline
sharply, households could raise their savings rates significantly to compensate
for balance sheet deterioration, which could severely impact on consumer demand.
Given the importance of consumer demand in driving the US economy, this could
prove disastrous and recessionary, not only for the US but for the global
economy too.
Don't panic yet though. Having raised interest rates so significantly, the
Federal Reserve does have substantial ammunition, in terms of considerable scope
for cutting rates, with which to fight off a recession so the "soft
landing"/slower but positive growth scenario for the US still remains a distinct
reality.
What we are talking about here is still merely a risk scenario, where a US
housing market collapse dents confidence to such an extent that the US Fed is
not able to revive consumer spending even through cutting rates aggressively,
resulting in a lengthy US and Global recession.
In such a "risk scenario", South Africa would struggle to escape unscathed.
Global recession implies a drop in demand both for commodities and manufactured
exports from this country, while if Fed rate cutting causes dollar weakening,
the pressure on the domestic economy could conceivably be exacerbated by rand
strengthening.
The net result could be a low inflation scenario, but a sharply lower economic
growth scenario, and economic growth (which drives disposable income growth) is
also crucial to the performance of residential property.
As to how sharply growth, and the residential market, slows, could to a certain
extent be in the hands of the SARB. Does it cut rates (the other key driver of
the residential market) aggressively to counter negative global forces or not?
From an inflation point of view, and given the relatively high level of SA
interest rates, there would probably be significant scope to cut rates
aggressively. And past behaviour (2003) has shown that the SARB did lower rates
aggressively.
However, the environment has changed since 2003. A higher level of household
debt has increasingly become a SARB concern, as has a far wider current account
deficit. Both of these variables could be exacerbated by sharp interest rate
reduction which would stimulate domestic demand. So this time around, the SARB
may be decidedly more cautious and far slower in the pace of reduction.
SO THE BOTTOM LINE IS…
Our base case scenario, based on a global "soft landing", of slower but still
solid 4.5% real domestic GDP growth in both 2007 and 2008, accompanied by
sideways interest rate moves for most of the period, is a fairly positive
environment for the residential property market.
Even a mild interest rate hike, which would assumedly take place under a fairly
healthy economic growth scenario, would not be too problematic for the property
market.
But I believe that a global recession scenario, spurred on by a prolonged US
housing slump and sharp "reverse equity withdrawal", is a far more serious risk
for the local housing market. It could bring about significantly lower economic
and middle class growth in South Africa compared with our base case forecast.
Lower inflation in such a scenario would in theory be a positive, since it would
theoretically allow the SARB more scope to cut interest rates and cushion the
global blow to the local economy. But other considerations may restrict downward
rate moves.
CONCLUSION
The residential property market, therefore, is not without its risks. But at
present the major risks would appear to emanate from global economic factors,
combined with the possible mild nature of the SARB response.
Local housing affordability issues that may arise from further mild interest
rate hiking seem to be less of a threat, in a market still very affordable, with
a household sector not overly indebted, and with a moderate modern-day SARB.
Again though, I emphasise that the above is the risk scenario, and that the most
probable scenario is for solid economic growth in the years to come, helped by a
global "soft landing", and a residential market bottoming in 2007 before
beginning to strengthen gradually from 2008.
