20/07/2021 - 09:00

Known unknowns as rates to rise

20/07/2021 - 09:00

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Borrowers beware; warning bells are ringing that a change in market conditions has started.

Known unknowns as rates to rise
Developers are churning out new projects as fast as possible. Photo: Atisha Turnock

Western Australia’s economy has rarely been as strong as it is today, thanks to near-record prices for its commodities exports.

There is, however, a problem that might upset the good times: a shortage of people hampering most industries and potentially dampening property prices.

The people shortfall has been the subject of several recent reports, including a claim by Chamber of Minerals and Energy of Western Australia that the state’s mining sector needs to find a further 40,000 workers over the next two years.

Blame for the shortage is attributed to the combination of strong demand and the COVID-19-caused national border closure, which is preventing an inflow of migrants to fill job vacancies and exacerbated by the occasional closure of WA’s border with the rest of the county.

The shortage of workers is a much deeper problem than not having enough people to operate machinery, staff hospitals or serve in restaurants, with a local outbreak of inflation already developing as wages are pushed higher, and a property crisis is brewing.

In its simplest form the issue with property, especially high-rise units, is that developers are churning out new projects as fast as possible because raw economic data points to strong demand. What they are not doing, however, is questioning whether there are enough potential buyers in a state suffering a population shortfall.

Without population growth, it is awfully hard to achieve property growth. The shortage of workers should eventually ease with the reopening of borders. But as that occurs, perhaps some time next year, an overdue increase in interest rates is likely to occur. Exactly how the property market will be affected by what is happening with the population problem and the inevitable rise in rates is a question most people in the real estate industry are dodging because no-one really knows how it will play out.

For most families and property investors, however, there should be warning bells ringing that a sea-change in market conditions has started, and even when the worker shortage is overcome the higher cost of borrowing will start to bite.

Seasoned observers of the economy have been stepping up their warnings about what’s likely to happen as economic settings return to normal when the COVID-19 crisis passes.

Even if vaccination rates in Australia are slower than other countries, there is an end in sight; it’s just not as close as most people would like.

However, increased vaccination rates and a return to normality will accelerate the interest rate process that unofficially started on June 30, when a key COVID-19 relief policy, the Term Funding Facility, closed.

Time to lock in?

The Term Funding Facility pumped $188 billion into the national economy, with funds created by the Reserve Bank of Australia flowing to commercial banks.

They, in turn, created low-interest loans for business and households, with the lion’s share going into low fixed-rate home loans. The TFF made possible unusual market conditions whereby fixed loans were available at rates below the traditional floating rate: a situation that has now ended, with no fresh TFF money available after June 30 and the scheme itself ending in mid-2024.

Now comes the troubling issue for the property market to flow from low population growth and rising interest rates, with a clue to what it all means contained in an obscure government document, federal Treasury’s ‘2021 Intergenerational Report’.

Two standout features of the 200-page document are nothing more than what we are witnessing today in WA, albeit on a national level: slower population growth and higher interest rates.

Deloitte Access Economics partner Chris Richardson provided a particularly disturbing interpretation of the population and interest rate projections for the property development industry, calling the combination “machine gun alley”.

Mr Richardson told the Australian Financial Review that, as population growth slowed, it would put pressure on property developers, especially in Sydney and Melbourne, magnified by interest rates returning to long-term trends, such as the 10-year bond rising to 5 per cent, pointing to home loans at 7 per cent or more.

The key to Mr Richardson’s sobering view of the property market, admittedly over the next three to four decades, is that mortgage rates will revert to their traditional relationship with the 10-year bond: i.e., one follows the other.

For property buyers and households with a mortgage, right now might be the best time to sign up for a fixed term, low-rate loan, before vaccination rates rise, the economy normalises, and interest rates follow.

Defying the odds

On the stock market, WA’s highest of high-flyers, Fortescue Metals Group, is showing the same sort of gravity defying powers as the Perth property market, with the background fundamentals of iron ore going down while Fortescue goes up.

One reason for the 6 per cent increase in Fortescue’s share price over the past month – even as the iron ore price flat-lined at around $US217 a tonne – is that the company is getting ready to report a bumper profit and shower its shareholders with a record dividend.

Good as that news might be, there is enough evidence to argue that the profit for the financial year ended June 30 will be the peak in the current cycle.

Lower profits are likely ahead; something Fortescue acknowledges by providing its shareholders with a link on its website to the consensus production and profit forecasts of financial services company Vuma.

According to Vuma, Fortescue will report a profit in late August of $US9.6 billion. In the current financial year, the profit will slide to $US6.7 billion, and then down to $US4 billion in the 2023 financial year.

It could be worse, because iron ore is being buffeted by the return of price discounting on second grade ore, material assaying 58 per cent and lower, whereas the more widely quoted price is for higher grade (62 per cent) ore.

In past periods of grade discounting, Fortescue has been hit the hardest of WA’s big iron ore producers. Investment analysts are certain to be watching carefully for a further slide in what’s called the ‘realisation’ price when the company files its June quarter report on July 29.

Fortescue said it received 91 per cent of the price paid for 62 per cent ore in the December quarter last year, with a fall in the realisation price to 86 per cent in the March quarter, and perhaps down further if a recent report by the investment bank Morgan Stanley is a guide. It reckons the discount gap is growing again.

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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