Financial Armageddon Looming? A Look Ahead for 2023

Financial Armageddon Looming? A Look Ahead for 2023

The purpose of this blog, in collaboration with Bluewealth Property, is to offer accessible content that can assist you in making a well-informed decision in 2023.

The relationship between the economy and asset prices is a complex one, as recent events have shown. It seems counterintuitive that bad news for the economy can actually be good news for asset prices, but this is precisely what has been happening. In fact, asset prices have become increasingly divorced from the real economy over time. Economic downturns have been met with the same policy response by central banks since 1987: cut interest rates and/or fire up the money printer. This excess capital flows into asset markets first, leading to a widening wealth gap over time. The effect is that asset owners get richer, while everyone else gets poorer. Unfortunately, we have no choice but to play this game, as it has become the only game in town.

Interest rates are a critical tool in a central bank’s arsenal to manage an economy. The central bank has the power to increase or decrease interest rates, depending on the state of the economy. When an economy is growing too fast, inflation can start to rise, and this is where increasing interest rates come into play. By increasing interest rates, the central bank is effectively making it more expensive to borrow money. This, in turn, makes people less likely to spend money, which can help to reduce inflation and slow down economic growth.

On the other hand, when the economy is struggling, and there is a risk of recession or deflation, the central bank will lower interest rates. This is done to encourage people to borrow and spend money, which can help to stimulate economic growth. When interest rates are low, it becomes cheaper to borrow money, and this makes it more attractive for individuals and businesses to invest in the economy. Lower interest rates can also encourage people to buy homes, as mortgages become more affordable.

So, in essence, interest rates can be used to either slow down or speed up an economy. When interest rates increase, people tend to spend less money, which can slow down economic growth. Conversely, when interest rates decrease, people tend to spend more money, which can help to stimulate economic growth. It’s a delicate balance, and central banks must carefully manage interest rates to ensure that the economy remains stable and healthy.

Australian House Prices vs Cash Rate

Economic Landscape – How did we get here?

The year 2022 was one of two distinct halves, marked by contrasting economic trends. In the early part of the year, there was a sense of optimism as the global economy started to recover from the impacts of COVID-19. Material prices and shipping rates had started to fall, and this was reflected in the buoyancy of global financial markets. The national property market in Australia also peaked around March. Although inflation continued to rise, the central banks were cautious about raising rates too quickly and potentially stifling the recovery.

However, as the year progressed, inflation remained stubbornly high, and tensions between Russia and Ukraine escalated. Asset markets started to decline as central banks began to raise rates in mid-2022. The US Federal Reserve launched its most aggressive cycle of rate hikes in history, while the Reserve Bank of Australia (RBA) implemented its fastest rate rises since 1994. By the end of the year, the RBA’s cash rate had reached 3.1%, the highest in a decade.

Despite the higher interest rates, the Australian economy showed remarkable resilience. Consumer spending remained strong, and unemployment rates remained at a historic low of 3.5%. The economy grew 6.4% larger than when the pandemic first hit, and wages increased at the fastest pace since 2007. The global GDP was expected to exceed 3%, and Australian GDP was around 3.5% for the year.

However, it is worth noting that the economy and asset markets are not the same things. We live in a world where bad economic news can be good news for asset prices. This is because central banks tend to lower interest rates and print more money to stimulate the economy during times of hardship. The excess money flows into asset prices before the economy recovers, resulting in soaring asset prices despite terrible economic news.

Employment numbers are typically the last to fall during an economic downturn, and we have already started to see the labour market ease with the opening of borders and the return of overseas migrants. Once the unemployment rate rises further, it is likely to prompt the RBA to drop rates and begin to stimulate the economy.

In 2023, asset allocation professionals will be monitoring the official CPI rate and the RBA’s policy response. Interest rates are expected to remain high in the first half of the year, but as the successive interest rate hikes work their way through the economy and the mathematical effect of CPI being divided by a higher denominator, inflation is likely to decline sharply by Q3. This could signal a turning point in the interest rate cycle. The higher cash rate gives the RBA some breathing space to stimulate the economy if things get worse than anticipated.

Where is the Sydney Property Market Up to?

The Sydney housing market experienced a significant correction in 2022, with the median price peaking above $1.5 million before falling by 8.3% over the course of the year. The initial decline was sparked by decreased affordability, and successive interest rate rises accelerated the pace of declines. Sydney remains the most indebted housing market in the country, and continued softness is expected until Q3 in 2023.

Although Sydney saw the largest price decline of any capital city, rental yields have been on the rise since January 2022, marking a trend reversal not seen since 2010. This is a positive sign that at least one fundamental driver is being reset. Despite being technically undervalued based on the exponential regression line, prices are expected to remain stagnant until the Reserve Bank of Australia changes its policy stance on interest rates.

The newly introduced First Home Buyers Choice initiative now allows first home buyers to choose an ongoing property tax instead of a large upfront stamp duty payment, providing a lower cost of entry into the housing market. This is expected to help put a floor under the lower end of the housing market as the year progresses.

The vacancy rate in Sydney has been on a rapid decline since peaking in May 2020, bottoming out at 1.3% in October 2022 before creeping up slightly to 1.8% in December 2022. This indicates a market that remains undersupplied, with upwards pressure on gross rents.

All sectors of the property market in Sydney have more than recouped the loss in gross rents caused by the pandemic, with unit rents growing by 21.9% and houses growing by 17.9% over the course of 2022. Rents are expected to continue to rise in 2023, with skilled migrants returning and driving growth. However, 2024 is likely to see a tapering of growth, with rents falling back to mid-single digits.

Although rental yields in Sydney dipped during the pandemic, they have since surpassed their pre-pandemic levels, with rental growth overtaking price growth over much of 2022. As of December 2022, units are yielding 4.1% and houses yielding 2.7%. These yields are expected to increase over the course of the year as gross rents continue to increase and property prices stagnate over the first half of the year.

Looking forward, the combination of real wage growth, improved affordability, higher rents, and lower interest rates is expected to build a solid base for a housing market recovery to begin.

Where is the Melbourne Property Market Up to?

In the two years leading up to March 2022, Melbourne’s housing market saw a 22% increase in prices due to easy money and government stimulus, despite the pandemic lockdowns. However, with the tightening of credit conditions, the market has since softened, resulting in a 7.2% decrease in prices over the past 12 months. This decline has mostly affected the luxury housing market in the upper quartile, which is historically the case.

The Melbourne housing market is expected to remain soft in the first half of 2023, with prices expected to move sideways. However, the pace of decline has slowed considerably, and Melbourne houses are still under the exponential regression line by a significant margin. Melbourne’s heavy reliance on net overseas migration has been severely impacted by the pandemic, making it the city most affected. However, this technical indicator suggests that there is still a solid opportunity for buyers over the coming cycle, especially when considering Melbourne’s long-term growth among the top capital cities.

The number of listings in Melbourne has been decreasing, shrinking the entire market’s size. This implies that a small capital inflow could create a rapid move to the upside. The middle and bottom end of the market have likely found a floor, and the vacancy rates have decreased from 5.5% during the pandemic to 1.7% in December 2022. The Melbourne housing market remains undersupplied, resulting in gross rents rapidly rising and completely recovering from pandemic losses. In 2022, unit rents grew by 21.4%, and house rents grew by 13.6%. Melbourne’s gross rents are still comparatively cheap compared to other capital cities, and rents are expected to rise by 17% for houses and 15% for units over the course of 2023.

Melbourne is likely to see the highest influx of population among all capital cities in the medium term, especially with the reopening of borders. The rental yields in Melbourne decreased during the pandemic due to lower gross rents and higher property prices, but they have since returned to their pre-pandemic levels. As of December 2022, units are yielding 4.1%, and houses are yielding 2.7%. These yields are expected to increase over the course of the year as gross rents continue to increase and property prices stagnate over the first half of the year. This improvement in yields resulting from flat house prices and rapidly rising rents is likely to see the necessary precursor conditions for the last leg of the property bull market in Melbourne to play out.

Where is the Brisbane Property Market Up to?

In 2021, the Brisbane housing market experienced a remarkable turnaround after almost a decade of flat growth. The median house price rose by 25% in FY2022, making Brisbane the best performing market in Australia. However, the market’s momentum slowed down in the second half of the year as a result of successive interest rate hikes by the RBA. This setback only delays the market’s recovery timeline, but it is expected to outperform by the end of the upcoming cycle, despite experiencing more declines in the first three quarters of 2023.

The Brisbane housing market became overextended after running up aggressively, and a pullback and consolidation was necessary. Nevertheless, prices have remained cheap relative to other markets, and the recent correction has provided some breathing space for prospective investors. The cancellation of the land tax changes, which would have increased the land tax liability of large interstate investors, is a positive development for the market.

It is worth noting that much of Brisbane city is low-lying, and over the long term, the tropical band of earth between the Tropic of Cancer and Tropic of Capricorn will likely broaden, increasing the likelihood of flood risks. Investors should exercise caution when targeting specific areas in Brisbane.

Despite these concerns, the population growth rate in Brisbane remains high, and the market remains undersupplied. Brisbane’s population growth is primarily driven by interstate migration from the southern states, with net interstate migration reaching a record high of over 50,000 in 2021. Brisbane was less affected by the pandemic than the other eastern states, and vacancy rates peaked at 3% in April 2020, indicating a balanced market. Currently, vacancy rates have declined to 1.1%, and there is upward pressure on the rental market.

The tight rental market has caused rents for houses and units to rise sharply, with house rents increasing by 14% and unit rents by 22.4% in 2022. This is the fastest rate of increase among all capital cities, and these conditions are expected to continue through 2023, with rents expected to rise by 10% for houses and 12% for units before tapering off to mid-single digit growth over 2024.

Rental yields in Brisbane have remained relatively flat, with rental growth tracking price growth. As of December 2022, units yield 5%, and houses yield 3.6%. However, these yields are expected to increase over the year as gross rents continue to rise while property prices remain stagnant during the first half of the year.

In Summary

The year 2023 is expected to see significant changes in the economy, particularly in the area of interest rates. One of the most significant developments that we can expect is the raising of interest rates. Many analysts predict that we are nearing the peak of the interest rate cycle, and that rates are likely to rise gradually over the coming months. This is in response to inflationary pressures and the need to maintain price stability in the economy.

Once interest rates reach this peak, it is expected that the Reserve Bank of Australia (RBA) will keep rates at this level for a period of time. This will help to stabilise the economy and prevent any sharp increases in inflation. However, eventually, the RBA will need to start cutting rates again, as economic conditions change.

When the RBA does start cutting rates, it is expected that the property market will shoot back to life. Lower interest rates make it cheaper for people to borrow money, which means that more people can afford to buy homes. This increased demand can lead to a surge in property prices, particularly in hot markets like Sydney and Melbourne.

However, it is important to note that the timing and extent of any interest rate changes are difficult to predict. The economy is complex, and many factors can influence interest rates, including global economic conditions, political events, and unexpected shocks. Nevertheless, keeping an eye on interest rate trends and their potential impact on the economy and property market is essential for anyone looking to make informed financial decisions in 2023.