The New Zealand housing market is overvalued relative to both incomes and rents. The question is whether the necessary adjustment will be gradual or nasty. On both inflation and financial stability grounds the Reserve Bank is keen to see a cooling in the housing market, and it tends to get what it wants, eventually. Interest rates are rising: two OCR lifts already, with more expected and already built into fixed mortgage rates. LVR restrictions won't be removed until much later in the year. And household debt is already very high, providing a natural brake.
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But the housing market has supports, too. The Canterbury rebuild will keep construction costs high, implying no wave of cheap housing onto the market. There are housing shortages in Auckland and Christchurch, natural population growth, and strong net migration. Of course, cynics point out "it's always a supply shortage" when it comes to justifying what turn out in the fullness of time to have been house price bubbles, and indeed, history provides some lessons on this front. In 2007 Ireland thought it had a housing shortage based on extrapolating strong net migration trends. The economy turned, migration went into reverse, and house prices more than halved in Dublin.
So what could cause a nastier correction in the housing market than the soft landing the Reserve Bank is aiming for? New Zealand has three main points of vulnerability:
• The inflation genie gets out of the bottle; interest rates move up sharply. Ouch for borrowers.
• We see another global financial crisis; many of the world's problems have not gone away. Credit spreads blow out: retail interest rates rise and loans become harder to get.
Thankfully New Zealand is far better placed than in late 2008/09; the financial plumbing has been strengthened a lot. But the indirect effects on housing via the negative general economic impact of a global slowdown could still be large.
• China's growth story turns out to be a mirage and a disorderly adjustment ensues. This would hit us directly (commodity prices would tank, and with them our national income and job creation), and also indirectly via Australia (joined at the hip with China). There are some similarities between Japan in the late 1980s - where the real estate market bubble popped spectacularly in 1991 - and China today. The situation bears close watching.
And let's not forget other global factors such as quantitative easing (QE) by central banks. QE works by artificially - and temporarily - increasing asset prices beyond levels justified by fundamentals, through the provision of easy money. Glancing round global financial and asset markets, one would have to conclude it has worked - though whether the desired subsequent positive wealth impact on consumption has followed is less clear.
But the confidence trick has to be reversed at some point. The global cost of capital is now on the rise as the foot is eased off the QE accelerator. Eventually, real asset prices must realign with economic fundamentals, of which the most important, in the case of housing, is incomes.
All up, one would have to conclude that although Kiwis love bricks and mortar investment, the New Zealand housing market is facing more headwinds than tailwinds. A slowing in activity and price appreciation is unsurprising and welcome, and we expect this slowing to continue. A more painful correction is a possibility.
But for now, solid growth in migration and household incomes provides reassurance that the strength in the New Zealand housing market is not all froth.
