Research

FNB – There are some things that are different between now and the end of the early-1980's residential boom, but some are ominously the same

While the residential market is no longer “booming” in terms of demand or house price growth, it remains in “boom time” territory” when it comes to the level of house prices in real terms (i.e. when we adjust house prices for consumer price inflation over time).

Real house prices are only marginally down from all time recorded historic highs reached around 2007/8. And while the residential market itself these days is no longer in an “irrational” frenzy of speculative activity and “buyer panic”, real house prices are kept at “boom time” levels by “boom time” policy measures, which include low real interest rates and big deficits. Ultimately, a wide deficit on the country’s Current Account on the Balance of Payments, which reflects Gross Domestic Expenditure being well in excess of National Income (i.e. a country living beyond its means), needs to “correct”. This correction is not always a smooth process. It wasn’t after the early-1980s property boom. Is it different this time?

The early-1980s residential price boom was kick-started by the combination of low real interest rates along with rampant economic growth which was supported by a major commodity price boom, most notably Gold. The period of high real house prices went on after the commodity price boom had ended, with real house price levels peaking only at the end of 1983.

Economic growth performance had begun to weaken long before this stage, but for a time, the country could sustain strong domestic expenditure, well above its national income, in short living beyond its means and running a wide Current Account Deficit on the Balance of Payments. This could not last indefinitely, however. Ultimately, the foreign capital inflows needed to finance that current account deficit would slow, as economic growth performance increasing concerned investors, along with an increasingly turbulent environment as the political and social situation deteriorated. This ultimately translated into a sharp Rand weakening. From the 3rd quarter of 1983 to the 4th quarter of 1985, the Real Trade Weighted Rand Index fell by -48.5%.

The Reserve Bank at around that time, had a more “discretionary” approach to setting interest rates than these days, and viewed interest rates as a tool not only with which to achieve price stability (influence price inflation), but also to achieve macro-economic stability through focusing on variables such as the Balance of Payments equilibrium too.

Understandably, it responded to restore some semblance of macroeconomic order. From 8% early in 1981, Prime Overdraft Rate moved up sharply to 18% by the end of 1982, and after a brief period of cutting rates in 1983, the level went up still further to 24% by the end of 1984. Prime mortgage rate followed a similar path.

In real terms, the resultant drop in house prices was a massive -44.3% from the 1st quarter of 1984 to the 1st quarter of 1987.

While those were different times to today, many things these days appear ominously similar. In recent times, we once again have had a major commodity price drop, and while the Mining Sector may indeed be a smaller part of our economy today, there can be a significant impact on exports, jobs and already-high social tensions in the country.

Like the early-1980s, we run a large Current Account Deficit these days, which has aided a significant Rand weakening since around 2011. As economic growth stagnates, as social tensions rise, and as ratings agencies lower SA’s sovereign rating, once again investors become increasingly nervous, which adversely affects the capital inflows from abroad needed to fund the current account deficit. Admittedly the political system of today is not nearly as unacceptable to the world as that of the 1980s, so weak capital inflows are more driven by weak economic performance than by orchestrated “boycotts” or disinvestment campaigns.

The wide current account deficit, therefore ultimately has to be reduced significant for the sake of economic and price stability. The country needs to start living more “within its means”. Treasury has started the process of trying to reduce its fiscal deficit, and the SARB has started to raise interest rates, which will further this cause. We believe that this monetary and fiscal “stimulus withdrawal”, while necessary, will lead to a corresponding real house price “correction” down from what we still believe are “boom time” levels

However, while many things look similar to the early-1980s, some things are indeed different, though. These days, the SARB appears more sensitive to the shocks that interest rate moves can cause if “too rapid”. In addition, today we have far higher levels of especially household indebtedness than in the 80s, making the economy more sensitive to interest rate moves. The SARB of today is therefore likely to move far more slowly in its interest rate hiking process. We thus forecast Prime Rate to reach 10.5%, one percentage point higher than its current level, only by 2017.

This, we believe, makes the chances of house prices correcting gradually over a number of years, still rising in “nominal” terms, but at a rate broadly lower than CPI inflation, which translates into a real downward correction. And such a slow correction is crucial for both mortgage lenders as well as mortgage borrowers, so as to avoid a situation of widespread “negative equity” Negative equity occurs when a home owner owes more on a home than what the home is worth. It is a troublesome environment to be in because it makes it difficult to “trade out” of one’s home and settle all of the debt during tougher financial times. All out nominal house price drops are thus a key risk to the mortgage sector.

However, for as long as the big deficit hasn’t yet gone away, unemployment is high and social tensions threaten to boil over, the Rand remains at risk. This in turn poses “upside” risks to an inflation forecast, and the SARB is of course primarily focused on its 3-6% CPI inflation target. And therein lies the big question. Will the global economic environment “play ball”, and allow the SARB the time to engineer the “soft landing” that the economy as well as the residential market needs? Will the US Federal Reserve start to hike interest rates in September as some speculate it will? This could weaken capital inflows to South Africa. If not Fed hiking, will China suffer a “hard landing”, in the process further softening commodity prices and SA exports further, while also potentially raising investor concerns regarding Emerging Markets (of which SA happens to be one)? Finally, does the economic growth deterioration in South Africa raise social tensions to “uncontrollable” levels, again raising investor concerns.

It is clear that we can’t continue to run the wide Current Account Deficit on the Balance of Payments indefinitely. These possible events have the potential to exert increased pressure on the Rand, and should the turn for the worse in foreign capital flows be swift, we may find ourselves in a position where we are forced to move to a Current Account surplus situation rapidly, helped on by more rapid interest rate hiking than perhaps the SARB had planned.

The last rapid move from a wide deficit to a surplus was in the early-to-mid 1980s as capital flows turned rapidly. And that was the last time we had a sharp and sustained downward correction in real house prices.

Read more here: FNB Property_Barometer_Residential_Property_Monthly_Aug_2015