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Investment Enews
JUNE 2017

It’s been a huge month or so in the world of economics and investment. In that short period of time we have seen some substantial policy releases. In this edition of Investment Enews, we take a quick look at the Financial Stability Review, an important speech from the Reserve Bank Governor on the Australian property market and some implications for investors coming from the federal government’s 2017 budget.

Financial Stability Review

Twice a year, economists and market watchers hold their breath as the Reserve Bank of Australia (RBA) releases its Financial Stability Review (Review). The RBA describes the Review as its “assessment of the current condition of the financial system and potential risks to financial stability.” Each Review also singles out particular topics of special interest for more in-depth review. All in all, the Review gives a great insight into the thinking of the leading regulator of the Australian economy.

The latest version of the FSR was released in April. Focussing first on the global economy, the RBA is clearly of the view that the situation has improved over the last six months, although longstanding vulnerability remains and some new risks have emerged. In particular, the Review singled out increased longer-term interest rates and equities markets as pointing to optimism about growth corporate earnings, particularly in the US.

Of course, this optimism itself carries the seeds of new risks. Given the extended period of low interest rates, increases could be disruptive to portfolios, especially riskier assets that could fall sharply if the ‘search for yield’ seen since the global financial crises ends quickly.

Treading delicately, the Review also singles out “some international political developments” as contributing to risk, whilst noting that markets have reacted in an orderly fashion so far. Somewhat more controversially, the Review argues that some of the trade and financial regulation policies of the Trump administration could adversely affect both growth and financial stability, whilst the rise of Eurosceptic parties could undermine the resilience of European banks and sovereign debt markets.

As always, the position of China also attracted some commentary. The Review argued that the level of debt, particularly in less regulated and more opaque parts of the financial system generated an elevated level of financial stability risk. This is exacerbated by slowing income growth in the more indebted parts of the Chinese economy, which makes the debt more difficult to service.

In our view, there is nothing in this analysis that would surprise any balanced reader of the financial press in recent times. But it does stand as a reminder to investors that, even in a relatively benign, low volatility environment, risks abound. Portfolios must be positioned to protect against the bad times, as well as to benefit from the good times.

The Review presented a nuanced review of the Australian economy. It conceded vulnerabilities relating to household debt, investor activity, house price growth rates in Sydney and Melbourne and a large supply pipeline of apartments in Brisbane. However, it also noted that indicators of household financial stress are contained and low interest rates continue to support households’ ability to service debt and build repayment buffers. Certainly this accords with the performance and leading indicators in relation to La Trobe Financial’s portfolios.

One topic of discussion in the Review was the work by the Council of Financial Regulators (CFR) to enhance lending standards across Australia’s credit industry. The Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulatory Authority (APRA) have both played a role to date and the Review foreshadows that further steps will be taken if necessary in the months ahead, although it notes that the Australian banking sector remains very well placed to meet future challenges.

At a broader level, conditions in commercial property markets have strengthened in Melbourne and Sydney, with Brisbane and Perth still lagging. Non-mining business profits are solid and indicators of stress (again, ex mining sector) are contained. Even mining businesses have seen conditions improve with the unexpected increase in commodity prices through 2016 and resultant profit increases.

Overall, one cannot help reading an air of quiet confidence into this Review. Risks and vulnerabilities are not ignored, but given the difficulties that the world economy has experienced over the last decade, there is a remarkable sense of calmness in the RBA’s analysis that is a refreshing contrast to the “every day is a disaster” approach of our ever-feverish economic commentariat.

Governor Lowe on the property market

An interesting side note to the Review came in the form of a speech by Governor Lowe to the Economic Society of Australia in Brisbane on 4 May 2017. This timely speech focused squarely on the biggest economic topic of the moment, being household debt and housing prices.

Governor Lowe made a series of interesting observations. In relation to aggregate trends, Governor Lowe noted that, whilst both housing prices and household debt have started to rise again (after about a decade of moving sideways through the early 2000s), the ratio of debt to the value of housing stock has not risen. This, of course, reflects the increase in housing prices. At the same time, household financial assets have increased significantly, with the result being that the ratio of household wealth to income is at record levels. In other words, both assets and liabilities have increased relative to income.

Governor Lowe argued that ratios of housing prices and debt to income have risen largely because financial liberalisation and the lower nominal interest rates that came with the lower inflation of the 1990s increased people’s ability to borrow. Supply-side constraints for new housing meant that increased borrowing pushed up the average price of housing. Population growth, a continued preference for large land sizes and concentration in a small number of cities also played a part.

More recently, Governor Lowe argued that debt ratios have been adversely affected by slower growth in household incomes seen since the GFC. Furthermore – and this is a highly significant admission of a ‘gamechanging’ trend from a key regulator – at least some of our cities have now become major global cities. In these markets, there is (and is likely to continue to be) strong demand from overseas investors. Population growth has accelerated and the lag in supply response (now seemingly being at least partly addressed) has supported significant ongoing price growth.

These factors can be seen at play in Melbourne and Sydney where population growth has been the fastest over recent times. It is here that the price gains have been largest, and these price gains have helped induce more supply. Governor Lowe observes that Victoria and New South Wales account for all of the recent upward movement in the national housing price-to-income ratio. In the other states, the ratio of housing prices to income is below previous peaks. Factors other than the level of interest rates are clearly at work in the house price equation. In our view, this is a significant conclusion. Contrary to what some commentators appear to suggest, interest rates are just one factor, albeit an important one, in the house price equation. Without strong demand/supply fundamentals, the support necessary to drive prices up simply does not exist. On the other hand, with some of our larger cities now effectively open” to offshore demand, we are likely to face continued housing affordability pressures into the future.

Governor Lowe also spent some time discussing the distribution of housing debt across households. This is important, because stress occurs at the “tail” - it is not the ‘average’ household that gets into trouble. Interestingly – and perhaps contrary to expectations - the rise in the debt-to-income ratio has been most pronounced for higher-income households. This is a clear point of distinction from the US pre-GFC, when many lower-income households borrowed a lot of money. In Australia, it is those who can most afford it who are borrowing.

On the other hand, debtto- income ratios have risen for households of all ages, except the very youngest, who tend to have low levels of debt. Borrowers of all ages have taken out larger mortgages relative to their incomes and they are taking longer to pay them off. Older households are also more likely than before to have an investment property with a mortgage and it has become more common to have a mortgage at the time of retirement.

Governor Lowe also noted the high level of mortgage buffers in the system. According to the RBA’s database (of securitised loans) around two-thirds of housing borrowers are at least one month ahead of their scheduled repayments and half of borrowers are six months or more ahead.

Turning to the meaning of all of this, Governor Lowe’s views are enlightening. He noted first that the RBA is not concerned about the quality of the banks’ loan book. In his view, the Australian banks are resilient and they are soundly capitalised. Stress tests overseen by APRA show that the banks are resilient to large movements in the price of residential property. In our view, this is spot on. Despite the media hype, credit standards across the lending industry in Australia are – by every measure – stronger than they have ever been. Borrower analysis, serviceability testing and “responsible lending” standards have been progressively increased over the last decade. In aggregate, portfolios are strong. Instead, Governor Lowe stated that he is most concerned about the possibility of future sharp cuts in household spending because of stretched balance sheets. This could turn an otherwise manageable downturn into a more significant economic slowdown. This is one of the reasons that it is critical that we identify a clear policy towards restoring wages growth.

Turning to future prospects, Governor Lowe stated that there are some reasons to expect that a better balance between housing supply and demand will be established over time. The first is the increased rate of homebuilding. As the situation in Brisbane and some parts of Melbourne shows, increased supply does affect prices. This increase in supply is also affecting rents, which are increasing very slowly in most markets. The second reason is the increased investment in some cities, including in Sydney, on transport. Over time, this will increase the supply of well-located residential land. The third reason is that – at some future point - interest rates will increase.

The Federal Budget – focus on SMSFs

Last year, the Federal Budget contained some very significant changes for SMSF investors. The changes this year were not as fundamental, but will also have significance – particularly in the area of housing.

The Government announced that persons aged 65 or over can make a non-concessional contribution of up to $300,000 from the sale of their home from 1 July 2018. These contributions will be exempt from the $1.6 million balance test for non-concessional contributions. Both members of a couple will be able to take advantage of this measure. This is a significant move and should be welcomed. It reduces a barrier to downsizing for older people, which should work to free up larger homes for younger families.

An interesting further use was made of superannuation with the introduction of a first home super saver scheme, which allows voluntary contributions to super by future first home buyers. This gives a tax-advantaged environment for these savings and is designed to help the all-important savings for deposit process. It will be interesting to see whether this policy gains any traction. A similar, previous scheme failed because of excessive complexity. Watch this space.

The Government also announced measures designed to improve the integrity of the superannuation system by including limited recourse borrowing arrangements (LRBAs) in a member’s total superannuation balance. Once again,however, the spectre of complexity raises its head. It will be interesting to watch the final implementation of this policy.

Finally, the Government announced that it will reduce opportunities for SMSF members to use related party transactions on non-commercial terms to increase superannuation savings. The non-arm’s length income provisions will be amended to ensure expenses that would normally apply in a commercial transaction are included when considering whether the transaction is on a commercial basis. This should be seen mostly as an extension of the continued push from the ATO to target improper use of related party transactions by SMSFs.

In summary

The Australian economy continues its unbroken run of twenty five years without recession. Not that you’d know it, from the pervasive negativity of much of our economic commentariat. It goes without saying that we continue to face challenges. There has never been a time when we haven’t. And there will never be a time when we don’t. At present, low wages growth, indebtedness and housing affordability in our biggest cities are attracting a lot of attention and rightly so. But there continue to be grounds for optimism.

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La Trobe Financial Services Pty Limited ACN 006 479 527 Australian Credit Licence 392385
La Trobe Financial Asset Management Limited ACN 007 332 363 Australian Financial Services Licence 222213 Australian Credit Licence 222213 is the issuer and manager of the La Trobe Australian Credit Fund ARSN 088 178 321. It is important for you to consider the Product Disclosure Statement for the Credit Fund in deciding whether to invest, or to continue to invest, in the Credit Fund. You can read the PDS on our website or ask for a copy by telephoning us on 1800 818 818. *Returns on our investments are variable and paid monthly. Past performance is not a reliable indicator of future performance. The rates of return from the Credit Fund are not guaranteed and are determined by the future revenue of the Credit Fund and may be lower than expected. Investors risk losing some or all of their principal investment. An investment in the Credit Fund is not a bank deposit. Withdrawal rights are subject to liquidity and may be delayed or suspended. Visit our website for further information.

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