Animal spirits is the term John Maynard Keynes coined to describe the instincts, proclivities and emotions that ostensibly guide human behaviour. He argued that economic indicators, like consumer confidence, were direct measures of these animal spirits. A person’s impression of their own level of wealth can then be seen as a strong bellwether of their willingness to spend. For most Australians, the largest portion of their wealth is tied up in their own homes. The belief that prices will keep rising indefinitely has inflated their sense of wealth, encouraging them to increase their spending.
What happens then, if housing prices peak in Australia’s major cities? Recent data (illustrated in the charts below) suggest we may be nearing this point.  First, commencements have begun to fall in line with greater developer caution – a result of tighter lending conditions and perhaps some capacity constraints following the record levels of activity observed in years past. We believe commencements will fall back towards historical levels over the next two years, as shown below.
 

Figure 1. Residential dwelling commencements (4-quarter sum)
Source: ABS, Clime estimates
 
A reduction in development won’t necessarily mean falling prices but simultaneously, tighter capital controls in China are weighing on foreign demand. Stricter documentation requirements have been imposed on FX transactions despite the official quota remaining unchanged. This may increase the risk of non-settlement, particularly in off-the-plan apartments.
Other signs, such as the reduction in the number of renovations and an expectation of flattening total housing investment, have already begun to weigh on the minds of consumers. Two charts from a recent UBS report looked at recent responses to the WMI consumer confidence survey questions: ‘Is this a good time to buy real estate?’ and ‘Is real estate the wisest place for savings?’ – both have fallen dramatically. Answers to the first question have typically been an accurate leading indicator of future housing activity, which does not bode well. In the case of the latter, despite enjoying record low interest rates courtesy of the RBA, consumers clearly have lost faith in real estate as an asset class.
 

Figure 2. Time to buy a dwelling consumer sentiment remains depressed
Source. ABS, Westpac, Melbourne Institute, UBS
 

Figure 3. Share of consumers saying ‘wisest place for saving’ is real estate, slumped to a ~record low

Source. ABS, RBA, Westpac, Melbourne Institute, UBS
 
For now, none of this has translated to housing prices, which continue to climb at unprecedented rates. In fact, housing affordability is worse than ever, with the benchmark house price to income ratio climbing above 6x in 2016 (and almost 12x in Sydney). This is not surprising given the massive decline in mortgage rates over the last 30 years. With people struggling under the weight of their mortgages and many utilising negative gearing to extend the viability of property investment, even a ‘soft’ correction of 5-10% in housing prices could be extremely damaging.
 

Figures 4. House price to income ratio, nationally
Source. CoreLogic-RPData, RBA, UBS
 

Figure 5. House price to income ratio, Sydney 
Source. Abelson and Chung, ABS, REIA, Stapledon
 
The obvious casualties are the banks, REITs and household goods retailers. But if we think back to the Keynesian concept of animal spirits, with so much leverage in the system and mounting trepidation over our housing market, it wouldn’t take much for this to translate into a massive loss in consumer confidence more generally. This would impact most retailers, whose products and services are non-essential and for which demand can quickly disappear. The perception of a decline in wealth can quickly translate to compensation via reduced spending.
This has yet to happen and the widespread belief remains that current homeowners will continue to enjoy capital appreciation, even if growth does moderate. We believe the inflexion point for consumers would be the point where mortgage rates surpass capital gains – currently around 2%. This is the point where the massive leverage buttressing our housing market would begin to unravel.
In the meantime, retailers are under pressure from a disappointing Christmas trading period, the result of both weaker demand and aggressive discounting in November. Retail appears to be particularly vulnerable to changes in sentiment right now and, with the exception of a few high product segments and individual operators, we are generally bearish.