Signs aren’t too good in the property market. According to this article in the SMH, credit ratings agency Standard and Poor’s (S&P) has stated the blindingly obvious by saying a slowdown in China will hit residential property hard.
It reckons that if China’s growth rate drops to 5 per cent, Australian property prices could drop more than 20 per cent. S&P quickly distanced itself from such a scary prediction by saying such a fall is unlikely. But even Chinese growth of 7 per cent would result in a 10 per cent fall in Australian house prices.
So what is the link between China and residential property? In a word – commodities. Below, we join the dots between China, commodities and house prices. But first, check out the chart below, which will help you understand the explanation that follows.
We found it on the Sober Look blog. It shows the under or overvaluation of house prices for various countries based on the house-price to disposable-income-per-capita ratio. To get the level of under or over valuation, today’s incomes are measured against the 1990-2011 average.
On this basis,
Australian houses are overvalued by around 40 per cent. The key input here is the average per capita income for 1990-2011. Back in the 1990s (and for probably the first half of the 2000s) Australia’s average income levels were much lower.
Inflation counts for some of the difference. But the biggest boost to national income – and therefore individual incomes – in the past five years or so has come from the massive boost to the terms of trade. And rising commodity prices – specifically iron ore and coal – are the reason for the jump in the terms of trade.
Now the terms of trade do not have a big effect on the headline economic growth figures you read about in the paper. The effect seeps in gradually via other means.
But in reality, the terms of trade have a major impact on incomes. Check this out from the ABS’s recent release of the National Accounts (emphasis ours):
Real Gross Domestic Income
The real purchasing power of income generated by domestic production is affected by changes in import and export prices. Real gross domestic income adjusts the chain volume measure of GDP (the headline economic growth rate – ed) for the Terms of trade effect. In seasonally adjusted terms, during the December quarter, Real gross domestic income fell 0.6%, while the volume measure of GDP increased by 0.4%, the difference reflecting a decrease of 4.7% in the Terms of trade.
Terms of Trade
The Terms of trade represent the relationship between the prices of exports and imports. An increase (decrease) in the Terms of trade reflects export prices increasing (decreasing) at a faster rate than import prices. The Terms of trade fell 4.7% in seasonally adjusted terms in the December quarter following a 3.2% increase in the September quarter. This is the first fall in the Terms of trade since September quarter 2009.
Real Net National Disposable Income
A broader measure of change in national economic well-being is Real net national disposable income. This measure adjusts the volume measure of GDP for the Terms of trade effect, Real net incomes from overseas and Consumption of fixed capital
During the December quarter, seasonally adjusted Real net national disposable income decreased 0.9%. Growth over the past 4 quarters was 4.9% compared with 2.3% for GDP.
There’s a fair amount of economic jargon in there. But the point is that the terms of trade make a big difference to national income and national economic well being, even if they don’t show up in the headline number.
Now, before we confuse you even more, let’s get back to the chart. We would guess that Australia’s per capita disposable incomes are much higher today than they were based on the average level from 1990-2011.
So if you think we’re in a new paradigm or a permanently higher plateau for commodity prices, the level of overvaluation of Australian property as shown by the chart above is clearly misleading. (Permanently) higher commodity prices mean a higher than long-term average level of income…meaning property prices are about right.
But if you think China’s credit boom has inflated Australian incomes via the terms of trade, then we could be in for a bit of ‘mean reversion’ in the coming years. We made a similar argument to this a few weeks ago. Mean reverting household income levels would send Australian property prices much lower.
It may happen in a few years or over a decade, but our guess is that it will happen.
for The Daily Reckoning Australia