‘The entire financial market has become a house of cards resting on a “carry trade” mentality that every speculative asset is safe as long as it yields more than Treasury bills do.’
— John Hussman, Hussman Funds (6 June 2016)
Sometimes you just get the feeling that something isn’t right.
But before I let you in on what ails me, the Dow is down 1%, while gold continues to find favour. Global bonds go further into the negative, and the Aussie dollar remains strong, thanks to our ‘high’ interest rates, relatively speaking.
What doesn’t sit well with me?
New York and London have left me with the feeling that there is a disconnect going on in the world.
By ‘normal’ Australian standards (even if you throw Sydney into the mix), the property markets there are decidedly ‘abnormal’.
We are staying in Chelsea — a more expensive (but not the most expensive) area in London — and it is considered normal to see modest two-bedroom apartments with price tags of £2 million (a tad under $4 million). More substantial properties can fetch upwards of £25 million (around $50 million)…and this is not the priciest area in London. The net (after taxes, insurance etc.) rental return on these properties — if the owner is inclined to lease — would be less than 2%.
In addition to paying what I consider to be stupid prices, it seems like every third property is being subjected to a substantial ‘make-over’…what’s another few hundred thousand pounds?
In New York I met with a friend who runs his own family office; he also structures investment deals for himself and other very wealthy families. He’s a very savvy investor. My friend tells me that foreign money is coming into New York in amounts you would not believe. A foreign investor recently paid US$4.3 billion CASH to buy a building yielding (returning) less than 2% BEFORE expenses.
My friend is a native New Yorker — he knows his hometown very well. He personally bid US$4.5 million on an apartment in the East Village — even though he knew the numbers (as in rental returns) did not stack up; but he assures me he likes the area. He told me he was outbid by an offer of US$7.5 million. Even he could not believe an offer of this amount was remotely possible.
He suspects that predominantly foreign money is looking for a perceived safe haven. In a zero bound interest rate world, yield is not important. London and New York property markets are viewed, by some, as being safer than banks.
This is the ‘house of cards’ the central bankers have created with their below-zero interest rate world.
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When I refer to our ‘normal’ property market, it’s only normal on a relative basis. While investors can still eke out a return in excess of 2% on a 12-month term deposit, they will be bound by this ‘risk free’ benchmark when determining the price (which is far different to the value) of a property investment.
If, or most likely when, the RBA decides to sit at the near-zero end of the central banker table, then we too may see our property market (by this I mean Sydney and Melbourne) lumped in with the ‘safe as houses’ trade.
But, then again, the RBA may only respond with much lower rates AFTER the house of cards has collapsed…in a desperate (and futile) effort to reflate the bubble.
It was this extract from John Hussman’s latest letter that converted my gut feeling into something a little more tangible (emphasis mine):
‘An extended period of modest interest rates encourages investors to forget what I often call the “Iron Law of Valuation”: the higher the price an investor pays for a given set of future cash flows, the lower the long-term investment return one can expect. With every increase in price, what was “expected future return” only a moment earlier is immediately transformed into “realized past return,” leaving less and less future return on the table.
‘Investors over-adapt to low short-term interest rates by chasing yields and driving up the valuations of much riskier securities (mortgage securities during the housing bubble, equities, corporate debt, and covenant-lite junk securities in the current episode).
‘The rising asset prices also convince investors that risky assets really aren’t actually risky, and a self-reinforcing bubble results. Ultimately, low interest rates aren’t followed by high investment returns at all. Rather, low interest rates encourage concurrent yield-seeking speculation for a while, but after an extended period of yield-seeking, the overvaluation is followed by awful subsequent outcomes over the completion of the market cycle.’
The perceived ‘safe as houses’ strategy is nothing more than the ‘bigger fool theory’. Provided someone is prepared to pay more than you, this heightens expectation to a level that reaches the mental state of ‘you can’t go wrong buying (insert your bubble asset of choice here)’.
As soon as you start discounting risk from an asset class — any asset class — that’s when it’s most ‘riskiest’ (poor grammar, I know, but it was done intentionally to add a double emphasis to the level of risk being taken).
When my friend told me the story of the commercial building that was purchased on a yield of 2%, it immediately transported me back 25 years to the commercial property bubble in Australia.
Yield was also an afterthought back then. Growth was the name of the game…until the game changed with the ‘recession we had to have’. Suddenly, the only certain investment return that could be relied upon was yield — the income an investment generates.
To show you how destructive a change in investment perceptions, from growth to yield, can be on capital, take the example of an asset purchased for $1 million, yielding a 1% return. The investment income would be $10,000. If investors decide a 2% yield is required, then, unless the tenant can pay double the rent, the capital value must fall to $500,000…a 50% capital loss from a 1% rise in income expectations. What happens if expectations rise to 4%? The value falls to $250,000…a 75% loss.
Nearly everyone is expecting interest rates to stay lower for longer. Perhaps this may be true at the short end (cash, 90-day bills, and short dated treasuries). However, my gut feeling is that we may start to see longer dated fixed interest securities start to rise. Investors may begin pricing in the risk of a fracturing Europe (and the questionable strength of its banks), and once Japan takes centre stage in the economic freak show stakes again.
If the bond market takes the lead on demanding higher returns, then, as John Hussman states, ‘the overvaluation is followed by awful subsequent outcomes over the completion of the market cycle.’
The subsequent outcome translates into bad news for those who pursued a ‘safe as houses’ strategy. As their substantial capital losses begin to mount, they’ll be wishing they’d adopted a ‘safe in the house’ strategy.
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