The ASX 200 has tacked on just over 11.5% in the last eleven trading days. Not a bad little run at all. But it looks to be coming to an end today. And you can blame Glenn Stevens for it!
Actually that’s not fair. Rallies don’t last forever. If you go back to March 6th, the ASX 200 closed at 3,145. It’s up over 1,000 points since then-or 32.5% if you’re trading at home. You’d expect a correction or consolidation at some point. We may be at that point.
But let’s not leave Mr. Stevens out altogether. The Governor of the Reserve Bank of Australia gave a fascinating speech yesterday in Sydney. The market reacted to the speech by pushing up the Aussie dollar. It did so because Mr. Stevens said that Australia’s economy and financial system have, “been travelling rather better” than other industrial economies.
This leads some people to believe the next move for Aussie interest rates is up, which is bullish for the currency (given that interest rate differentials to the U.S dollar and the Japanese yen are currently the big driver for the Aussie). Another way of looking at it is that interest rates are rising because the economy is healthier than we all thought.
We’ll see about that. Stocks are certainly pricing in a profit recovery (about which we have our doubts). But Mr. Stevens also had a bit to say about credit markets and balance sheets, in comments that were not as widely reported as his comments on Australian housing. More on housing in a second.
But what about our claim this week that corporate cash flows are headed back to early 20th century level growth rates because of the burst credit bubble? Does the Governor of Australia’s central bank agree? Judge for yourself.
Stevens writes that, “The pace of global growth, and the easy availability of credit, seen in the period up to 2007 was not the norm. It is unlikely to be seen again any time soon.” So far so good?
“The path to economic health for the major countries of the world will still be a difficult one, because the legacy of the crisis will cast a shadow for some time.” Could he mean that the destruction of bank collateral (commercial and residential real estate loan books) is still a problem restricting the availability of credit, or will restrict future lending?
“Major international banks will remain diminished in stature and balance sheet capability, and will be required to devote more capital to their strategies in the future. If global regulators have their way, the world will be characterised by less leverage and more expensive credit, than in the earlier period. We here in Australia have to accept that fact and accommodate it in our thinking.”
Bravo! We reckon that means that Aussie bank profitability-indeed the profitability of the whole real estate, finance, and insurance sectors-will never again reach the 2007 highs, or not at least for a very, very long time. And if that’s the case, it means that income investors used to counting on dividends from safe bank stocks may need a new game plan.
One other non-housing note from the Governor, this one on debt and the changing nature of global capital markets (due to the massive destruction of global capital). “Government and government-guaranteed debt of one form or another is rapidly increasing globally…Certainly people will worry, longer term, about increases in long-term interest rates potentially ‘crowding out’ private borrowers. To date, though, long-term rates remain historically low for public borrowers, despite the prospect of very large debt issuance.”
The important words in that sentence are “to date.” If historically low interest rates do not stay historically low, the cost of government-guaranteed debt is going to rise along with interest rates. And if the government itself maintains and increases its role as middle-man lender in the capital markets, we can’t see how government borrowing wouldn’t crowd-out borrowing by smaller businesses and even households.
We all know how efficient the government is at spending money and allocating capital to productive enterprise, don’t we? This puts Aussie banks in a tough spot. They can use the government-guarantee to borrow. But who are they going to lend to? Households?
“The prominence of household demand driving the expansion from the mid 1990s to the mid 2000s should not be expected to recur in the next upswing,” Stevens said. “The rise in household leverage, the much lower rate of saving out of current income, and the rise in asset values we saw since the mid 1990s, are far more likely to have been features of a one-time adjustment, albeit a fairly drawn-out one, than of a permanent trend.”
Now that’s a bit of a bomb shell. Stevens describes the whole model of getting rich in the Western world for the last twenty years and says it was a one-off, not to be repeated. But if you can’t borrow, leverage, and spend your way to wealth as your stocks and houses go up in price, how are you going to get rich and retire?
Stevens says that, “The households of the Western world are currently feeling that they can no longer consume as they did, in part because the earlier spending is now seen to have been based on an unrealistic set of assumptions about long-run income and wealth. To that extent, there is no real way around a period of adjustment involving lower consumption for awhile.” What about lower standards of living too? Hmm.
This is remarkably frank talk from a central banker. Stevens paints a picture in which business confidence has recovered. But he also shows that systemic leverage will have to be reduced and that the economy will enter a period where households lower their consumption “for awhile”-even as the government is forced to withdraw its support for “aggregate demand” through cash giveaways s mis-directed stimulus splurges.
All of that leaves us with a question about the Australian economy: who is going to be borrowing and who is going to be spending? What is going to drive the growth? If banks have to repair balance sheets by being more guarded with capital, and if consumers tighten their belts because their real net worth is falling (along with their real wages), why would a business borrow for demand that isn’t there, assuming it could even get a loan from a bank reluctant to lend?
Our guess is that Aussie banks don’t want to lend to businesses because there’s too much risk in that. Besides, Aussie corporations have successfully tapped the equity and bond markets for new capital in last year, leaving the banks out of the loop. But one asset class Aussie banks are keen to lend to is residential housing. Why?
The destruction of bank collateral is what’s behind the shrinking of bank profits and balance sheets. The largest part of Aussie bank collateral is in property, especially residential property. If banks don’t keep lending to the property market to support demand and prices, prices will fall, damaging bank collateral and forcing the banks to tighten credit (housing finance) which leads to even further house price declines. Vicious circle. Feedback loop. Take your pick.
We were discussing just this subject earlier in the week over lunch with Phillip J. Anderson. Phil is the author of a new book called “The Secret Life of Real Estate.” He’s also one of our panellists for this Friday night’s Debt Summit and the State Library of Victoria. He had some forecasts about the Aussie housing and stock markets that some investor might find…surprising.
Incidentally, if you can’t make the Debt Summit, Phil is signing copies of his book tomorrow between noon and 1:30 pm at the Educated Investor Bookshop at 500 Collins Street. We recommend dropping in if you’re in the area. It’s a great book shop. And Phil’s written a book about the real estate cycle that Aussie investors can’t afford to miss.
Glenn Stevens says now is the perfect time to build more houses in Australia and hopes that the “ready availability and low cost of housing finance is translated into more dwellings, not just higher prices.” He seems to be arguing that the Aussie property market could be in strife if someone doesn’t start building more homes ASAP.
“If all we end up with is higher prices and not many more dwellings-then it will be very disappointing, indeed quite disturbing. Not only would it confirm that there are serious supply-side impediments to producing one of the things that previous Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over-leverage and asset price deflation down the track.”
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