While housing has definitely helped support the Australian economy over the past four to five years, any further increases in house prices that are in excess of wage growth will represent potential systemic risks for the Australian economy.
Bank hybrid securities, domestic equities, residential mortgage-backed securities and residential investment properties all essentially contain big bets on housing, and it follows that Australian income portfolios may now carry much higher risk than many would expect.
In this current environment of a fully-priced Australian residential property market, increasing exposure to deeply subordinated Australian hybrid bank capital instruments or stocks as a source of income further concentrates this portfolio risk.
The high investment risk is of particular concern for investors approaching or in retirement. To understand and quantify it, we modelled the total wealth of a typical (hypothetical) Australian retiree using proprietary asset allocation tools developed by PIMCO's Client Analytics team.
We found that over 95% of the volatility in an average retiree's total portfolio is currently driven by the equity risk factor - which is basically sensitivity to changes in the equity markets. This high exposure to equity risk is mainly the result of three factors.
- Australian shares tend to pay fully franked dividends making them, on the surface, attractive income providers and therefore a large component of retail portfolios.
- Equity risk contributes disproportionately more to total portfolio volatility when compared to other risk factors.
- Australian property is highly exposed to the equity risk factor.
The objectives of a typical retirement portfolio should be to produce an attractive total return, preserve capital and provide income. The major concern for retirees is the risk of capital loss stemming from market downturns, as retirees have a shorter time horizon to recover losses.
Unfortunately, a further consequence of having high exposure to equity risk is an increase in tail risk - the likelihood of extreme events - and drawdowns (large losses).