Investment insights

New Zealand Outlook: Housing and Ination

MARCH 2013

Auckland housing market: supply and demand

While the reason for the rise in house prices in Christchurch is quite straightforward (ie the earthquake destroyed or degraded a signicant part of the housing stock), the Auckland situation is not as immediately obvious. In Auckland fundamental demand (basically net growth in population, specically households) has consistently grown, driven by three factors: > natural population growth (births minus deaths); > net migration (more people coming to NZ and living in Auckland than leaving); and > domestic migration (with a one-off rise from people leaving Christchurch, and people following jobs as a number of companies have relocated their head ofces to Auckland). Auckland demand growth has outstripped supply
20,000 Demand vs Supply mismatch Demand Supply

New Zealand is seeing what could be the beginning of another housing boom. The course of events in the housing market will have a profound impact on the New Zealand economy in the year ahead. A resurgent housing market will be supportive for economic growth, but will also have implications for ination and the way the RBNZ implements policy in the medium term. Investors should note that these factors all have implications for New Zealand asset classes.

The house price picture

The New Zealand housing market has steadily gained momentum over the past year with annual house price growth rising above 5%, house sales volumes growing strongly, construction showing signs of accelerating and household credit growth also starting to accelerate (albeit well below the 10-15% level of the early to mid 2000s). The key driver of national level house price growth has been Christchurch and Auckland, but there is emerging evidence of this strength spilling over into other regions. House prices, credit and construction trend up

15,000

No. Dwellings

10,000

5,000

-5,000

4000 3500 3000 2500 2000

30 25 20 15 10 5

97

98

99

00

01

02

03

04

05

06

07

08

09

10

11

12

NB: Demand = population growth divided by average household size i.e. no. new households, Supply = number of dwellings approved. Source: Statistics New Zealand, AMP Capital estimates

1500 1000 500 0 NZ Dwelling Approvals REINZ House Prices YoY [RHS] Household Credit Growth YoY [RHS] 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

0 -5 -10 -15

The problem is the supply side has yet to catch up, with the key dwelling consents numbers showing Auckland building is still well below the mid 2000s building boom. A number of factors are restricting supply, some of these are regulatory but theres also the psychological aspect. For example, there needs to be a greater willingness and ability to go up, ie more and better quality apartments, which is how many big cities around the world accommodate population growth, and/or smaller houses. The trend has been for average house sizes to rise, this impacts on affordability and demand for land. Other factors are more structural. There are limits on how fast a city can expand, such as the consenting process, infrastructure upgrades and build outs, zoning and land availability, etc. Theres also the important matter of capacity in the construction industry. New Zealand is currently undertaking an unprecedented level of construction in the Canterbury rebuild, with estimates that it will cost as much as $30 billion.

Source: AMP Capital, Statistics New Zealand, RBNZ, REINZ

The Reserve Bank of New Zealand (RBNZ) is concerned about the trends depicted in the chart above. This is because during the mid 2000s a credit-fuelled housing boom emerged and the RBNZ could do little about it except for raising interest rates. There are two reasons the RBNZ should be concerned: 1. Price stability. Housing related price rises ow through to specic components of ination directly and indirectly as construction activity comes up against capacity constraints and the wealth effect boosts aggregate demand, lifting generalised ination. 2. Financial stability. Excess credit growth, particularly when driven by asset booms, presents risks to the nancial system as banks aggressively expand their balance sheets, exposing themselves to falling asset prices and lending to potentially poor credit risks.

While some amount of price appreciation is needed to stimulate a supply response, too much price appreciation could turn fundamental demand into speculative demand. Thats the risk. Its also rightly been identied1 as an impediment to productivity growth as it encourages overinvestment and enthusiasm in an unproductive sector, crowding out resources that could have gone into things like building businesses or investing in skills.
1

the potential costs of lifting rates too early probably outweigh the potential benets. If the RBNZ starts to become particularly worried about nancial stability in relation to the housing market, the use of macro-prudential tools could be a viable option in curbing the impact of housing market excesses on nancial stability. The RBNZ is currently accepting public submissions on its proposed macro-prudential tools, and these tools could certainly be implemented to offset the risks that an overheated housing market would have on nancial stability. But thats the key point macro-prudential policy is designed to support nancial stability. While these tools would likely have some impact on the aggregate demand picture, they are more of a complement than a substitute for the cash rate. Its also worth asking whether taming house prices is worth doing. Higher prices should encourage more development, with this supply response potentially fullling the usual self-regulating feature of the free market. However, as noted previously, there is a real risk that a fundamental supply/demand mismatch can be self-perpetuated as fundamental demand turns to speculative demand, and panic buying as buyers seek to avoid missing out. Indeed, looking to history, many asset bubbles could be soundly justied in the early stages.

The New Zealand Productivity Commission recommended addressing these issues in its Housing Affordability Enquiry. Key areas recommended for addressing were: urban planning, infrastructure costs, building consent costs, building costs, social housing, and Maori housing.

The ination picture

Going back to price stability, what is the present trend in ination? We are at cyclical lows in consumer price ination and we already know ination will increase. Looking ahead, the ination outlook will be driven by underlying trends in aggregate demand in relation to potential growth (ie the output gap) and capacity. We expect the housing market to be a key contributor to seeing ination head towards 2% by year end as a result of rising housing related ination and stronger aggregate demand. Housing related ination starting to rise
8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% 00 01 02 03 04 05 06 07 08 09 10 11 12 NZ CPI Headline Inflation Housing and household utilities Non-Tradeable

The outlook and investment implications

Factors specic to the Auckland and Christchurch housing markets have led to increased prices, credit growth and construction activity. As for the rest of New Zealand, record low mortgage rates have been broadly supportive for house prices, and there is the possibility that elevated activity spills over from Christchurch and Auckland to the broader market. We know that higher prices and activity in the housing market ows through to higher housing related ination, puts pressure on construction sector capacity and boosts aggregate demand through the wealth effect. We expect this strength in the housing market to eventually ow through to higher ination over the year which will likely prompt the RBNZ to act. This will result in winners and losers when it comes to the nancial markets: > Bonds will likely see lower returns as the improving outlook, higher ination and prospects of interest rate increases drive up market yields, reducing total returns. > Currencies continue to be dominated by offshore drivers, but a surge in credit growth will reinforce the structural current account decit. In the immediate term however a rise in rates will likely be supportive for the New Zealand dollar(NZD), directly and indirectly, in that it reects improved economic conditions. > Cash may begin to see higher returns if interest rates begin to rise, but ination will be a hurdle to real returns. > Property may see support as economic conditions improve, and historically it has acted as an ination hedge. However, rising interest rates may put downward pressure on valuations, and put pressure on the reach for yield. > Equities will be faced with opposing forces. On the one hand, earnings will be supported by improved demand from the wealth effect and from construction activity. On the other, valuations could come under pressure if interest rates rise, while a small increase in ination can be supportive (see Equity valuations, ination and interest rates). 2

Source: AMP Capital, Statistics New Zealand, RBNZ

The RBNZs options

On the ination outlook, the RBNZ probably still has some time up its sleeve before it has to hike rates (our base case is for an interest rate increase in December this year). But with the housing market gaining momentum, will the RBNZ be forced to move earlier? The current trends in the Auckland housing market are top of mind when the RBNZ thinks about price stability. The question on what can be done depends whether the pace of activity, particularly credit growth, starts making the RBNZ more worried about nancial stability.

Price stability vs nancial stability

The RBNZ has specic mandates and targets under the Reserve Bank Act and as agreed with the Minister of Finance. Price stability is set out in the Policy Target Agreement (PTA) as keeping CPI ination between 1% and 3% on average over the medium term, with a focus on average ination near the 2% midpoint. On nancial stability, the RBNZ is responsible for oversight of the banking system, non-bank deposit takers, the insurance sector and payment system. Essentially this means maintaining a sound and efcient nancial system. On the one hand, the RBNZ could move to act now by lifting interest rates early, but this would risk setting back non-housing related economic activity. On the other hand, if it waits too long it could risk falling behind like it did during the mid 2000s. For now

Appendix: Property prices around the world

Prior to the nancial crisis many countries around the world saw strong gains in property prices, which transmitted through to excessive credit growth and overheating economies. This was a major contributor to the nancial crisis, and is a key reason why increasing attention is being placed on the housing market as a potential driver of nancial instability. Global property prices - YoY%
30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% 01 02 03 04 05 06 07 08 09 10 11 12 13 US China New Zealand Australia UK

Source: AMP Capital, REINZ, NBS, Bloomberg

But rising house prices are not all bad the issue is how far things go. Indeed, improving house prices in the US and UK have turned the housing market from a headwind to a tail wind for growth as the negative impact on wealth reverses and credit quality improves as collateral values increase.

Callum Thomas Research Analyst

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