Weekend Economist: Home improvement

The Westpac-Melbourne Institute Index of Consumer Sentiment increased by 3.8 per cent in August, from 94.9 in July to 98.5 in August.  That was a pleasing result. The index is now only 1.2 per cent below its level prior to the federal budget on May 13. Over the last three months the index has increased by a total of 5.9 per cent, indicating that much of the damage to confidence in the aftermath of the budget has been repaired. However, the index has not reclaimed any of the ground lost between November 2013 and April 2014, when enthusiasm associated with a new government appeared to wane.

The index is still around 10.8 per cent below its post-election peak. There seems to be a number of politically-based factors that may be boosting confidence. Firstly, since the last survey it has been announced that the unpopular carbon tax has been repealed. Secondly, households have also probably been buoyed by resistance in the Senate to many of the unpopular budget measures.

 It would seem that households are now assuming that some of these measures will eventually be moderated or abandoned. With the Senate set to reconvene on August 26, households will be anticipating a restructuring of the budget that was released on May 13. If instead we see renewed disorder and indecision in the Senate, that runs the risk of dissipating this encouraging lift in confidence.

While the Reserve Bank did not cut interest rates over the month, some banks have been lowering rates for new loans, reflecting recent declines in market rates as the slowdown in activity has seen a reassessment of prospects for the official cash rate.

In August we saw the confidence of those households with a mortgage jump 12.8 per cent.

In particular, the reduction in the five-year fixed mortgage rate by most banks to 5 per cent should encourage investors. Consider the relationship between the discounted variable mortgage rate and the rental yields in Sydney and Melbourne. The last time the Australian market experienced an investment property boom was in the 2001-2003 period where the margin between the discounted variable mortgage rate and the Sydney rental yield was around 200bps compared to the current margin of 50bps.

Further, our research shows that a marked slowdown in house price appreciation is only sustained when the Reserve Bank begins to tighten rates.

Westpac’s expectation is that rates will be on hold for another 12 months; market pricing is pointing to flat rates well into 2016. It is therefore reasonable to expect that investor driven housing activity is likely to gather further momentum through the remainder of this year and well into 2015. With Sydney rental yields around 4.5 per cent investors are now able to fix their funding costs at only 0.5 per cent above this, a much more attractive proposition than prevailed in the last property investment boom period.

The proportion of new lending being attributed to investors has now reached the record high we saw in January 2004 (47 per cent) when the margin between rental yields and the variable mortgage rate had blown out to 300bps under the weight of 100bps of rate hikes.

Despite this unattractive spread investors proved to be resilient in the face of expected capital gains. Current market conditions seem to be much more favourable for investors -- potentially signalling a further surge in investor housing. It is reasonable to expect that the proportion of new lending being attributed to investors will easily exceed the previous records.

There was other good news for the housing market. The index tracking assessments of ‘time to buy a dwelling’ jumped by 9.7 per cent to be 12.1 per cent above its post-budget read. Expectations for house prices have shown similar gains, with the Westpac-Melbourne Institute House Price Expectations Index rising 7.6 per cent  to be up 20.6 per cent  from its May read. This result is consistent with the boost in confidence we saw among respondents with a mortgage and may also be reflecting the lowering of some market interest rates.

The lift in confidence among respondents with a mortgage has come despite little change in the outlook for interest rates. A clear majority of consumers are still expecting rates to rise. The August survey found 63 per cent of consumers expect mortgage rates to be higher in 12 months’ time, with 28 per cent  predicting ‘no change’ and just 9 per cent  expecting rates to decline. That mix is very similar to the last time we ran this question in February, which found 61 per cent expected interest rates to move higher.

The Reserve Bank next meets on September 2. The bank has made it clear in both the governor's recent statement and its August Statement on Monetary Policy that it expects the period of rate stability to continue. However it has lowered its growth forecast in 2015 from 3.25 per cent (trend) to 3.0 per cent (below trend). Its forecasts also imply a very robust 2 per cent expected annual growth momentum for the remainder of 2014.

In theory that would imply its forecasts are pointing to lower rather than higher rates. It should be a challenge for a central bank to keep policy on hold when it is forecasting below trend growth in the policy year.

It is reasonable to speculate why the bank did not move to an easing bias once it moderated its forecast to below trend growth in 2015. There are a number of possible explanations: the “new trend” is now 3 per cent implying the forecast is still around trend, changing a forecast by 0.25 per cent is within the range of forecast uncertainty to not trigger a policy change; nervousness around the property market (see comments above) is constraining the policy decision.

For our part, we think the bank is being overly cautious on the growth outlook. We expect the consumer to be running at a faster pace in the second half of 2014 than in the first with some spill-over to non-mining business investment and employment.

That prospect has certainly been boosted by the reported lift in confidence and the recently reported rise in business confidence. However, maintaining and lifting this confidence will be particularly dependent on a resolution to the current political discussions around the budget that will resume on August 26.

It is our expectation that such a result can be expected and we remain confident that the next move in rates will be up, although not before the September quarter of 2015.