The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Monday, August 8, 2011

Calm pays during chaos

You’ve probably woken up this morning a little confused. The US government has been downgraded from a AAA rating to AA+ over the weekend. Every newspaper or media outlet you read is talking about financial markets mayhem. One minute you are hearing about higher interest rates, the next there is confident talk they will be slashed. The Aussie dollar has fallen more than seven cents from its high last week to have traded as low as 1.0378 US cents in this morning’s markets. The local sharemarket is off more than 10 per cent in recent days. Media commentators are working themselves up into hysterics about how Australia is hurtling towards recession. All this turbulence is probably doing your head in.

At times like this, it is useful to reflect on the hard facts. The so-called G7 economies—the US, UK, Germany, France, Japan, Italy and Canada—only actually account for about 30 per cent of global economic growth, which is what we are really worried about (see chart). The higher-growth emerging and developing countries account for about 60 per cent (ie, they are far more important). Around 30-40 per cent of Australia’s exports go to two of these countries alone: China and India.

So while the IMF projects that the world economy will advance at a healthy 4-5 per cent per annum clip this year and next--with Australia’s trading partners expected to expand at an even faster pace--it believes that growth in the US and Europe will be much lower (and likely downgraded further).

The financial markets and media commentators have not yet really understood that the global centre of economic gravity is rapidly shifting away from the North Atlantic countries towards the emerging world and Asia in particular. Australia is lucky to be situated in this region, and to possess the vital ingredients these high-powered nations require in order to fulfill their industrialisation and urbanisation plans: viz., natural resources, like iron ore, coal and natural gas, for steel and energy.

Already our floating exchange rate is acting like a reflexive ‘shock-absorber’ and relieving pressure on the economy during this time of uncertainty. The seven cents sliced off the Aussie dollar (and counting) will make our export and import-competing industries temporarily more competitive. While this is great news for those sectors, the one drawback is that a depreciating currency means we are likely to import more inflation from China and India (the huge appreciation in the Aussie over the last year had been working in the opposite direction).

As it stands, Australians remain in rude health. The unemployment rate is at its so-called ‘full-employment’ level of just under 5 per cent. Private wages including bonuses grew by 4.1 per cent over the last year. Disposable household incomes rose by even more than this amount. And, if push comes to shove, the RBA can inject enormous stimulus into the economy by cutting home loan rates to as low as 2-3 per cent.

In this context, one surprisingly resilient store of wealth during financial market turmoil tends to be Australian housing.

Compared to shares, this was certainly the case during the 1987, 2002-03, and 2007-08 equity corrections, when local share prices plummeted by 44 per cent, 15 per cent and 50 per cent, respectively and cruelled the retirement plans of so many Australians who were ‘overweight’ this risky asset-class.

It was also true in the 2001 ‘tech-wreck’ when global shares, which have historically attracted about 30 per cent of all Australian super fund money, fell by about 40-50 per cent.

During the recent GFC, the peak-to-trough fall in Australian home values was just 3-4 per cent notwithstanding that an inflation-focussed RBA kept mortgage rates at 9.6 per cent as late as August 2008 (see chart). That’s less than what the Aussie sharemarket lost in a single day last week.

A final test case is the 1991 recession, when despite a spike in the unemployment rate to 11 per cent, and double digit mortgage rates, overall Australian house prices moved sideways.

As regular readers will know, our central case remains that the RBA will hike interest rates once or twice more. This should continue to put mild pressure on the housing market, which has suffered from a combination of the RBA’s de facto double rate hike in November last year and the very “hawkish” expectations of consumers, who have been working on the basis that they would be hit with another 2-3 hikes. If this comes to pass, a modest downward adjustment in dwelling prices should present prospective buyers with attractive investment opportunities before a very robust recovery as the RBA normalises rates over 2012-13.

I should note here that this view is quickly slipping into the minority despite the extraordinarily high ‘core’ inflation readings in the first and second quarters of 2011 (these core estimates strip out unusual events like the floods that affect the ‘headline’ numbers).

After 20 years of uninterrupted growth, many Australians have forgotten what the cost of high and volatile inflation is. Well, I can tell you: high nominal interest rates.

The average home loan rate in Australia between 1980 and 1995 was a scorching 12.6 per cent. That was before the RBA broke the back of inflation during the 1991 recession. Since 1995 the average home loan rate has declined by 42 per cent to be just 7.3 per cent.

The cost of price stability (or low inflation) is occasional periods of higher interest rates when the RBA strives to bring those price pressures back into its target 2-3 per cent per annum band.

Of course, it also pays to remember that inflation is a tax on hard earned savings. That is, it punishes savers and rewards spendthrifts (ie, those with debt). Hence the many net savers out there in the community who have loaded up on cash and fixed-income want to see the RBA do its job properly, even if it means lower growth and higher unemployment in the short-term.

A second major thesis we have been running for a few years now is that housing could be a solid hedge against extreme adversity. The financial markets are currently pricing an incredible six rate cuts within the next year on the basis of the belief that we are going to get a GFC Mark II (see chart).

On the assumption of its ‘peachy’ base-case, the RBA has deliberately sought to crush consumption, retail spending, and the household sectors to make room for the huge amount of private investment that is starting to take place in Australia.

Ordinarily, consumption accounts for 55-60 per cent of all economic growth. Yet there is another $140 billion or so of new private investment that will be commenced in the next two years alone, which amounts to about 11 percentage points of GDP growth. Even if you take an axe to that number and halve it, it remains chunky.

Yet if the China and India urbanisation stories blow-up, and demand for Australian resources disappears, what will the RBA do?

They will slash interest rates (as the financial markets believe they will), and invite the consumer and household sectors to step into the breach left by evaporating resources investments.

And what is the most interest rate sensitive sector of the economy? Housing.

Think about what happened during the GFC. The RBA slashed home loan rates from 9.6 per cent in August 2008 to just 5.75 per cent by April 2009. And, unsurprisingly, Australian house prices soared by a stunning 12.1 per cent in 2009.

Since I believe the world will muddle through this current speed-bump, which is a reflection of the profound structural adjustment taking place in the global economy, I remain of the view that interest rates are more likely to head up than down (although it is possible that a crisis compels the RBA to spin 180 degrees).

This will be especially true if the Australian dollar keeps falling, as this will be equivalent to rate cuts and only exacerbate the RBA’s inflation challenge. In this environment, I would keep my investments in cash and floating-rate fixed-income.

To protect against a downside scenario whereby the RBA is forced to abandon its base-case and radically reduce interest rates—let’s say to zero—the good news is that virtually all Australians have, quite uniquely compared to peers overseas, fully adjustable rate home loans.

If the RBA reduced the cash rate to zero, we would be paying 2.5 per cent mortgage rates. And, in this contingency, housing will likely once again be a very solid store of wealth.