How Australia’s residential property downturn could impact your investments

As an Investment Committee, we continue to hold several concerns about the Australian economy; namely lack of wage growth, the high level of household indebtedness and high residential property valuations. Coupled with the four classic signs of a bubble (high valuations, high levels of indebtedness, cheap credit, and a pervasive ongoing narrative about why the situation should continue), we continue to be cautious about Australia’s economy and assets reliant on residential property and property construction.

What’s behind the fall in the domestic residential property market?

There is evidence that regulatory restrictions on access to credit, and an increase in the price of that credit (via bank mortgage rates) have brought about falls in most residential property markets in Australia. Those falls have been largest in Sydney and Melbourne. The price weakness looks set to continue and is having knock-on effects into the rest of the economy. Residential property transaction numbers are down 12.8 per cent year-on-year (putting a hole in state finances reliant on stamp duty) and building permits are down 27 per cent year-on-year. Both construction activity and mortgage lending are also down.

These moves are negatively affecting consumer confidence and will likely increase the household savings rate. Low confidence and increased saving will likely flow through to a fall in consumer spending. Given consumer spending makes up about 55 per cent of the Australian economy, a fall in spending will constrain economic growth.

In combination, these factors appear to have prompted the Reserve Bank of Australia (RBA) to modify its messages about interest rates (moving from ‘next move is up’ to ‘risks are more balanced’). The market has gone even further, such that many market makers and commentators expect that
the RBA will have to lower rates later in 2019 as Australia edges closer to recession for the first time since September 1991.

For investors, there are a number of potential implications 

  1. Australian interest rates are likely to remain static or even fall in the near to medium term, leading to further downward pressure on deposit rates.
  2. If Australian rates fall and the US Federal Reserve (Fed) keeps rates on hold as it has recently indicated, the Australian dollar will face renewed downward pressure as the interest rate differential with the USA widens. The floating nature of the Australian dollar would provide some offset to difficult domestic conditions in this case.
  3. As house prices fall, the appetite and capacity of the banks to lend will likely fall, which may accentuate any downturn. This has negative implications for bank earnings and share prices, and the same therefore for overall Australian index returns.
  4. The performance of other economies becomes more critical to Australia’s situation. For example, if the Chinese authorities manage to engineer a boom to combat their domestic issues, that could provide a much- needed boost to our economy via our resource exports and foreign direct investment, which could help Australia to avoid a recession.

What is the likelihood of Australia falling into a recession?

While it is not a given that Australia will fall into recession, it has become more likely as our residential property market continues to fall. As we move towards the general election, party politics, adds another layer of uncertainty. We are concerned about downward pressure on Australian interest rates, and potential loss of franking credit refunds leading to pressure on income in our portfolios. We continue to look for well diversified sources of income to help defend against these effects and continue to recommend investors hold reasonable allocations to international investments to protect against any domestic downturn.

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward-looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.

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Patrick Broughton

Investment Committee Member

Patrick has 32 years of investment banking experience spanning over a broad range of financial markets, including equities, fixed income, hybrids and convertibles and foreign exchange.

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