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."

Thursday, July 28, 2011

Higher interest rates good news for net savers!

Yesterday’s inflation data heralds good and bad news for Australian households.

It almost certainly means interest rates are heading higher. Probably at least two more hikes—or half a percentage point in total—are left in the current monetary policy cycle. We may be spared too many more by the strong currency and the fact that the economy’s sensitivity to interest rate changes is much greater than it was in decades past.

While that’s undeniably disappointing news for borrowers, they should remember that even with two more hikes, the ‘market’ (or discounted) mortgage rate in Australia will only be 7.6%. In January 1990 it was over 15%.

And although it is cold comfort for those with big loans, higher interest rates will be terrific news for net savers and Australia’s growing class of retirees, who should be heavily invested in cash-like securities. It means that these folks should be able to generate near-risk free cash or ‘enhanced cash’ returns of 7-8% per annum. That’s easy, safe money.

On the flip side of the coin, further increases to the RBA’s target cash rate mean that we are likely to see a little more softening in house prices before the central bank starts cutting costs again.

It means that the rental market will continue to tighten beyond its already very firm levels with vacancy rates at -time lows. Perversely, it means that Australia’s inflation rate will be propelled higher by robust rental growth as investment in housing supply stagnates. Indeed, we could see gross rental yields heading north of 5% in the apartment sector.

And, unfortunately, it means that Australia’s mortgage default rate, which stands at an internationally-very-low 0.7% today, will probably edge up further

The good news is that potential buyers and investors are going to be presented with more favourable valuation prospects.

The dynamic whereby disposable household incomes in Australia rise solidly while house prices flat-line or decline modestly, which has held for the last year or so, will be reinforced.

As I have argued countless times before, this is not a bad thing. Asset prices cannot always appreciate. Investment is not a one-way bet. Prices will typically fluctuate through the cycle.

In fact, as I showed recently, one in ten Australian property investors lose money when they trade their homes, and that is before accounting for transaction costs. On average, they do well: excluding rents, the compound annual capital growth rate over the last 10, 20 and 30 years has been 7-8%. Including rents, that number is considerably higher.

When you buy a home, you are, on average, making a 7-8 year commitment. So you need to consider what your total post-tax returns will be over this period.

A conservative guide is that asset prices will track disposable incomes through-the-cycle. Historically, disposable incomes have expanded at a 6% per annum pace in Australia. Going forward, a more realistic guide is probably around 4% to 5% per annum.

If you can generate this kind of capital growth (CGT-free if you are an owner-occupier) in concert with net rental yields of 3-4% per annum, you are doing fine. Of course, this is an average outcome. Some will do better, others worse. That’s called risk.

As part of a broader portfolio, housing is a good “diversifier” because its returns tend to be uncorrelated with—or move in a different direction to—most other investment classes.

My own reckoning is that patient folks opportunistically investing in housing over the next 1-2 years are probably going to get the best prices, and valuation fundamentals, that they will have had access to in a long time.

The demand and supply fundamentals underpinning Australia’s housing market are already quite attractive. They are only going to get better over the next 12 months. The one fly in the ointment is interest rates. When the RBA comes to cut them, affordability in this country is likely to be the best we have seen in over a decade, which will help to fuel a very strong recovery (and encourage people to allocate scarce capital to improving supply).

In the heated debate about interest rates, people seem to forget that 90% of Australians have variable rate debt. As we saw during the GFC, it is much easier to cut interest rates, and bequeath instant cash-flow relief to all those households paying off loans, than it is to chase the inflation tiger by the tail.

Trust me, you want our RBA to be vigilant in attacking inflation. You don’t want it to get too far “behind the curve”, which yesterday’s data confirms it is.

If the RBA has to respond belatedly to an entrenched inflation problem the likes of which it struggled with in the decades prior to the 1990s, you will be slugged with much more challenging conditions. You will be dealing with the bad-old-days of double-digit interest rates.

And in the event the RBA does get its monetary policy settings wrong (ie, overcooks the interest rate egg), it will not hesitate to correct the mistake and grant instant relief to everybody with a loan.

Have a little faith.