We're into 2008, and as yet there is little sign of the 3-year+ broad slowdown in the
residential property market coming to an end. As things got worse in 2007, so
the talk regarding possible house price declines, rising bad debt in the housing
market, further upside risks to interest rates and prospects for a slowing
economy, and the negative impact of the National Credit Act, seemed to escalate.
Understandably, therefore, many property owners are concerned about where it's
all going to end. Human beings are often prone to doing their mental forecasting
by extrapolating a recent trend in a straight line into the future. Fortunately,
real life doesn't work in this manner. Rather, cycles are the order of the day,
and my view remains that 2008 is the year in which the cycle will bottom out and
begin to turn for the better.
But let's consider the risk of a crash in residential property. Well, firstly,
it may be comforting to know that residential property crashes are not common.
In fact, in over 40 years since the mid-1960s there has only been one, and that
was in the mid-1980s. Already, therefore, this would suggest that the chances
are slim.
Examining the graph below, which utilises Absa figures, one sees that since the
early-1970s it was only once in 1984/85 that SA experienced a nominal house
price decline. That was at the end of a major slump from a price inflation level
in excess of 40% in 1981, to deflation of -9% at a stage in 1985.
In real terms (deflating the house price index using the CPI), however, price
deflation is far more common. We saw a significant real house price decline in
the latter half of the 1970s just prior to the gold-boom-drive housing boom, the
slide of 84/85, and further gradual real decline over much of the 1990s to a low
in 1997.
Nevertheless, only the mid-1980s slump could possibly be a crash, so it is
worthwhile considering its causes.
The 1970s through to the early-1990s was a time of stagnating long term real
economic growth, as the country's political situation worsened and isolation and
boycotts started to bite; not to mention all sorts of structural rigidities
created by restrictive Apartheid legislation at the time. Making matters worse
was the onset of commodity price slump from the early-1980s.
If one were to calculate the sum of national GDP for 5-year periods, and then
calculate an average annual growth rate for these 5-year periods, thus cutting
out short term growth cycles; it is clear that from the early-1970s onward the
economy (all-important to the housing market performance) was becoming less and
less supportive to the property market in SA;
bar a very short period of spectacular economic growth during the gold price
boom of the early-1980s. Mining was a more key industry in SA in those days, and
it was little surprise, therefore, to see real GDP growth touch 6.6% in 1980
followed by 5.4% in 1981. In fact, in one particular quarter, year-on-year GDP
growth was close to 8%.
But it was all set to end in tears. The gold-boom-driven economic boom was
short-lived, proving to be a mere blip in a period of longer term growth
stagnation. The housing market began to slide after peaking in 1981, as the
economy slid into a recession in 1982/83. The stay of execution came towards
1984, with the economy experiencing a brief recovery, but by 1985 the negative
forces were far too great. Not only did GDP growth slip back into negative
territory in 1985, never to really impress again until the current decade, but
extreme interest rates also contributed to the end of that property party. From
1981 to 1985, prime rate had risen by 10.5 percentage points from 11% to 21.5%.
If that wasn't enough, confidence in the country was not exactly at an all time
high, as we headed nearer to Rubicon Speech time in the mid-1980s.
The series of interest rate hikes, coupled with extreme house price inflation,
had driven what is arguably the most important measure of affordability to its
worst levels on record by 1983.
The ratio I am referring to is the repayment instalment value on a 100% loan on
an average-priced house, expressed as a percentage of average income (in index
form). The graph below illustrates just how extremely this measure rose in the
early-80s boom.
Such levels of "in-affordability" could conceivably be maintained in a thriving
economy, but when stagnation returned following the brief growth boom, there was
only one way for real house prices and that was down.
And that was the environment which contributed to SA's only house price "crash"
in over 40 years.
How does the current environment compare? Well, glancing back at the first graph
showing real house price levels, you may be tempted to say that we're at far
more risk now than even at the peak of the 1980s boom; with real house rice
levels today far higher. And as at late last year, real house price levels were
still rising. Such an assertion would be too simplistic, however, as
sustainability of house price levels has everything to do with what the market
can afford and not what the price level is.
What the market can afford is determined by the combination of price, household
incomes, interest rates (for many households) and overall levels of
indebtedness.
Going back to the affordability graph, which combines all of the above factors
except overall indebtedness, one will see that the recent boom has not seen
affordability deteriorate nearly as badly as the early '80s. The index
reflecting the average house price/average income ratio (more relevant for the
cash buyer) has shown a sharp increase since the late-1990s, but is still not
back at early-1980s levels. Due to the massive interest rate drops from 1998
onward, though, the index reflecting the ratio of repayment instalment value on
a 100% bond on an average priced house/average income has risen far less
extremely, and at a reading of 181 by the second quarter of last year was still
far lower than the 297 level reached at a stage in 1993. This containment of the
deterioration in affordability is not only due to interest rates but also in
part to strong household disposable income growth as a result of a strong
economic growth performance in the current decade, growth which has been far
more stable and seemingly sustainable than the boom/bust cycle of the
early-1980s.
The continuation of this solid growth performance is crucial in staving off the
risks of collapse in the housing market. And risks there are. Globally, the
increasing possibility of a US recession looms large, while locally it is the
spectre of rising interest rates that threatens growth. If we were to go back to
interest rates near 20% (or even above), then indeed significant real house
price decline would most probably be on the cards. This would contribute
directly to the affordability deterioration for credit home buyers, as well as
indirectly by stifling job creation and income growth.
So one's view on whether housing is in trouble or not must essentially be driven
by your view on interest rates and economic growth, to name but the most
important 2 macro variables.
Based on our expectations for a fairly moderate growth slowdown in 2008, and, if
any, only limited further interest rate hiking, a deterioration in the local
economic environment to such an extent that it would precipitate SA's second
major housing market crash on record seems unlikely.
The long term economic growth graph indicates that SA has been on a long term
growth acceleration since the early-1990s. This was to be expected following the
end of restrictive Apartheid laws along with boycotts and sanctions, and the
country is still positively adjusting to the greater degree of economic freedom
that this political change brought about.
So, when we talk about real economic growth slowdown in 2008, we're talking
about to around 4% from an estimated 5% last year, hardly a train smash. Can the
US economy's woes drag SA's growth far lower than this? It isn't impossible, but
our view is that other regions of the world, most notably East Asia, are these
days better equipped to grow endogenously, with less dependence on the US, thus
providing an important growth engine whilst the US sorts out its issues.
Therefore, we anticipate a soft landing for both the global economy and
ourselves despite the US and its sub-prime and other challenges.
But even should the economic and interest rate moves in 2008 prove to be
moderate as we anticipate, you may well ask whether households can keep head
above water given their high levels of indebtedness?
If one were to emphasise the household debt-to-disposable income ratio as the
key predictor of a looming credit crunch, one may be tempted to raise the alarm
bells as this ratio heads towards 80%, now by far the highest ever.
But more important is the debt-service ratio, i.e. the debt servicing cost of
the total household sector debt burden (interest + capital)/household disposable
income. This ratio had risen to 10.4% by the third quarter of 2007. The rise
signifies greater stress for the household sector mounting, but by historic
cyclical increases it would not appear out of kilter. The previous 3 big
cyclical peaks saw debt service ratios of around 12% (ignoring the 14% blip in
1998 and the small rise in the abnormally good 2002 cycle).
So deterioration yes, but crisis no…based of course upon our moderate
macroeconomic assumptions.
What then do the bad debt figures for banks show to date? Once again, a fairly
moderate situation. DI500s unfortunately only go back as far as 2001. Special
mention mortgage loan accounts (accounts 1-2 months in arrears) rose through
2006/07 to near 3% of the total mortgage book for SA's banks, similar levels to
the peak of the 2002/03 cyclical deterioration (the abnormally good cycle).
Sub-standard loans (in arrears by 3-5 months) have risen to 1.5% of the total
book; doubtful loans (in arrears by 6-12 months) sit at 0.6%; and losses (more
than 12 months in arrears) measured 0.9% of the total book as at November 2007.
Some alarmists may want to emphasise that losses have risen by over 60% since
end-2006, and this is true. But off a low base that growth figure is largely
insignificant, and of course the total book has grown by near 30%, since then.
Therefore, while deteriorating, and I expect further deterioration in credit
quality during the first half of 2008, these ratios would hardly point to a
crisis situation in which a major portion of households would be having houses
repossessed.
Therefore, at current interest rate and economic growth levels, the key ratios
suggest that SA's residential property market is in far better shape than was
the case in the mid-1980s.
There are no guarantees that things can't still go pear-shaped, should the
interest rate and economic growth environment turn dramatically for the worse;
as the risks are always there. But based on our forecasts of a mild growth
slowdown to 4% in 2008, and interest rates going into a sideways trend very
soon, disaster should be avoided.
OUTLOOK
This doesn't mean the end of the road for market weakening just yet. I
believe we should prepare ourselves for a dip into single-digit year-on-year
house price inflation within the next few months, and it is conceivable that
house price inflation could dip below a resurgent CPI inflation rate briefly in
the near future, indicating some real house price decline.
But later in 2008, I remain of the view that we will see the turning point in
the market, and a resumption of real house price inflation to even higher
levels. As soon as interest rates level out, we can expect to see some recovery
in growth in new mortgage loans granted (which showed negative growth in the
third quarter of 2007), a good indicator of residential demand. This is
anticipated during the second quarter. This event normally coincides with an
upturn in month-on-month house price inflation, and with a considerable lag and
turn in year-on-year house price inflation.
