Caddie's Content and Engagement Manager, Chris Barnett, recently caught up with Founding Principal of Digital Finance Analytics, Martin North, to get his insights on the current economic landscape, including the RBA, interest-only loans, the housing market and plenty more. Read on to find out what Martin had to say...
Chris: The Reserve Bank recently set the Australian record for the longest consecutive period without a rate movement. There is no consensus in the industry as to when rates will rise, some are predicting spring, other say it won’t be till 2020. When do you forecast rates will rise and why?
Martin: The RBA is driven most strongly by its inflation mandate, plus the desire for financial stability.
Their public statements are to the effect that the next rate move is likely to be up, not down.
But given the current economic and employment data, plus wages growth we see little evidence that a rate rise will happen any time soon.
However, there are more risks on the downside, as the FED lifts rates in the US, and so flows through to the capital markets.
This could translate to banks here needing to lift their mortgage rates (the BBSW has been somewhat higher of late).
Of more concern would be a local or global economic shock, requiring a rate cut. Given the number of uncertainties (from the middle east, North Korea, Italy, Trade Wars etc.) the RBA may have to react to a downturn.
So the RBA may cut rates to counteract this effect, as they are conscious of the pressure on household budgets.
That said, rates are low now, so there is little wriggle room, and banks may not pass on cuts at these low levels.
Our central scenario is no movement for at least the next 12 months.
Chris: One of the buzz words in the property market is “interest only loans”, you have regularly written about the risk these loans pose to the property market. What key warning indicators should Financial Advisers been look for regarding a client’s interest only loan?
Martin: Interest only loans were in vogue up until a few months back, thanks to lower servicing costs and the ability to maximise the interest tax offset by keeping capital repayments to a minimum.
At an industry level more than 40% of loans were being written as interest only loans, mainly to property investors. Some lenders have more than half their loan portfolios in interest only.
However, there are higher risks to interest only lending, especially if a slowing market, because the assumption often is that the capital, which needs to be repaid at some point, requires the sale of the asset.
In a falling market this may not work, and from our surveys around half of interest only borrowers have no firm plans as to how to repay.
Others may not be aware they have an interest only loan.
APRA came to this late but has since specified tighter lending criteria, for example, a 20% hair cut on rental streams, the need to ignore any potential tax breaks, and the requirements to assess a loan on a principal and repayment basis on review (which often is a 5-year fixed term).
In addition, lenders are required to document the firm plans a borrower has to repay later.
So we estimate around $120 billion of ~$700 billion interest only loans will not be refinanced on next reset, requiring the borrower to agree to a more expensive principal and interest loans (monthly repayments would rise by 20% or more).
Most of these problem loans will hit in the next 2 -3 years.
Whilst there are some mitigating offsets – for example that the interest rate on a principal and interest loan are lower – this has the potential to become a structural issue for investors in Australia.
Some will be forced to sell, as happened in the UK when they executed a similar strategy a few years ago.
So Advisers need to consider whether borrowers have firm repayment plans, can service the loan assessed on a principal and interest basis, and the implication of the 20% haircut on rental streams.
Some potential borrowers may not meet current requirements, and risk being sold unsuitable loans, with the potential of litigation later.
Chris: Based off your industry analysis what do you expect from the housing market in the next 12 to 24 months. Will it grow, will it contract, or will it remain steady and how by what percentage do you expect the market to shift?
Martin: My central scenario is home prices will fall 15-20% over the next couple of years as lending rules are tightened, thus reducing credit availability.
Credit is by far the strongest influence of home price movements.
Demand from investors, both local and foreign buyers, is falling, and while there is a small uptick in first time buyers, this is not sufficient to keep prices going higher.
Migration alone won’t hold the market up. We have already see a fall in auction clearance rates to mid-50’s down from mid-70’s last year.
Our worst case scenario is a fall of up to 40%, with the top of the market dropping the fastest.
It is unlikely that extra incentives to, for example first time buyers will change this outcome.
Thus we expect building approvals to be weaker in the months ahead.
Chris: A follow on from the above, do you expect the movement in the housing market will be uniformed across Australia or do you expect some capital cities or regional areas to buck the trend?
Martin: Prices will fall fastest in Sydney, then Melbourne, where rises have been strong in recent years, but because of the size of these relative markets, there will be a spill over effect elsewhere.
Regional prices, which have not risen so fast recently may be more resilient.
We do not expect Perth, which has languished in recent years to buck the national trends.
Chris: The Australian property market is quite diverse regarding who owns property, you have retirees, mums and dads, first home buyers, investors and many more.Which demographic do you think is most at risk in the current market and why?
Martin: Property investors are most at risk, and most fickle in a down turn. We are already seeing some selling before prices fall further, especially in Sydney.
In addition, prospective investors are sitting on the sidelines believing that prices will fall further.
There are more than 1.2 million down traders – people seeking to sell to release capital, and these are a risk, if prices fall.
Many need to sell to fund their retirement, or other investments.
First time buyers need to be careful buying in at the top of the market. They might prefer to wait to prices to fall further, as we think they will.
People living in a property, wishing to move, however should still do so, assuming the market is not frozen, because the value of one house, is the value of one house.
If you sell and buy at the same time, the relative movement of prices is less significant.
Finally, those seeking to trade up, to buy a larger place, may prefer to wait, again because relatively the top end of the market is likely to fall fastest.
Chris: Final question for the day - You have been involved in Financial sector for over 25 years now, if you could go back in time and give yourself once piece of advice when you first started out, what would that advice be?
Martin: First, understand the power of compounding – interest on interest – time in market is your friend. So be in the market, and stay in the market.
Second, no one knows the future – it’s all a guess, and mostly people will be wrong. This includes the experts. Be sceptical.
Third, fees in particular erode returns, and so do consider ongoing fees and charges – even small changes to fees have a significant impact on results.
Fourth – build a cash flow so you understand your finances – only half of households have any real sense of their net available cash flow after outgoings. You cannot manage what you do now know.
Finally, diversify – do not just bet on say property or shares, best to spread the risk. And keep some funds liquid so you are not forced to transact in a falling market.
About DFA
Digital Finance Analytics is a boutique research, analysis and consulting firm providing advisory services to clients in Australia and beyond. Services are delivered virtually using the web, blogs, social media, online conferencing and other digital means. We also produce corporate education and training videos for some of our clients.
Martin North, Digital Finance Analytics founding Principal, data scientist and banking sector analyst is often quoted in the media. He curates the Digital Finance Analytics Blog which provides commentary on our research programmes as well as covering broader industry issues.