How about that? A day after land-mark healthcare legislation passed the U.S. Congress, stocks in New York made a 17-month high. The market likes it when uncertainty is lifted from the horizon. It’s now clearly all down-hill from here.
We jest. Back in Baltimore earlier this month, at dinner, it was argued by one and all that stocks might be a good bet to beat inflation. Or, put another way, if you’re going to beat inflation, you’re more likely to beat it in stocks than cash.
This is not a value-based argument. But it IS an argument for why nominal gains in stock markets are not inconsistent with rampant or even hyper inflation. We’re not saying that’s what’s going on right now. And of course, in our one-two Big Crash dance card, asset deflation precedes the Melt Up.
But it’s hard to call the rally since last March’s lows anything else but a melt-up. Stocks aren’t cheap now. And they are pricing in a lot of future earnings growth. In a world where the private sector and businesses are deleveraging and where credit growth – excepting the public sector – is shrinking, the fuel that generates earnings and income growth is running out.
Not that sovereign bonds are any safer. Another point that came up at our dinner earlier this month is that certain high-quality corporate bonds would be better bets than certain faltering sovereign bonds. Or as Bloomberg reports, “The bond market is saying that it’s safer to lend to Warren Buffett than to Barack Obama.”
If you judge executives by their ability to deliver regular and outstanding returns on equity and capital, the above point is self evident. Buffett has a long track record of delivering high returns on net tangible assets. This partly explains why the yield on two-year notes sold by Berkshire is 3.5 basis points lower than the yield on a two-year U.S. Treasury note.
Buffett generates cash from his assets and borrows sparingly for sensible acquisitions of good businesses which he has meticulously valued (most of the time). The Federal Government is not a corporation. But its chief asset is probably its tax slaves, whom it is currently in the process of flogging for more money to pay for more new programs which the country can’t afford.
The trouble is, as Moody’s points out, when you flog your tax slaves in order to simply pay interest on money you’ve already borrowed, you move “substantially closer” to losing your AAA credit rating. Moody’s predicts that, “the U.S. will spend more on debt service as a percentage of revenue this year than any other top-rated country except the U.K. America will use about 7 percent of taxes for debt payments in 2010 and almost 11 percent in 2013.”
Does this mean short-term capital flows – as Greece plays out in slow motion – will favour dollar-denominated assets that are a) not long-term government bonds, b) are stocks ? We’ll see.
Yesterday we promised to look at how Australia fits into all this. The easy answer is that Australian capital markets remain a yield and risk play. When risk appetite is high, capital flows to Australia’s relatively higher-yield currency and its commodity related stocks. Australia’s stock market has all the upside of an emerging market but without the political risk.
But when investors get nervous and flee home to the U.S. dollar, what happens then? And when U.S. and U.K. banks get into capital self-preservation mode, doesn’t that leave Australia in the vulnerable position of being a capital importer in a world where the cost of capital is going up? Will the Big Four be able to borrow? And in a second credit crunch, will China still want Australia’s resources?
Frankly we don’t have the answers to all those questions, although you know our views on all of them. For now, the whole thing makes us nervous. And if the bulls are happy to rush in where nervous angels fear to tread, more power to them.
And let’s not forget the elephant in the room: property. We’re somewhat shocked with the ferocity of the housing bulls. They have a lot invested – emotionally and literally – in the idea that everyone in Australia is going to be a property millionaire because of immigration and the “supply shortage.”
For a different take on the matter, do yourself a favour and read Tim Colebatch’s article in today’s Age. He makes the simple point that negative gearing encourages investors to take on debt and buy new properties in order to make capital gains which are taxed at a lower rate than income. The net effect of the law has led to a debt boom and the misguided assumption that prices always rise.
“But it won’t happen,” Colebatch writes. “Melbourne house prices have trebled since 1997, not because our incomes trebled, but because we paid those prices by a massive increase in debt. In the 20 years to January 2010, household debt to the banks grew 10 times over, from $118 billion to $1224 billion. As a share of our disposable income, they more than trebled, from 45 per cent of what we earn to 156 per cent.”
“If we want house prices to keep growing at that pace, we’ll have to keep going deeper into debt at that pace – to more than $4 trillion by 2020, or more than three times our income. Any volunteers?” Even with more grant gimmicks and subsidisation of the mortgage backed security market, you’d have trouble expanding debt by that much.
Landlords might not mind taking a net loss on rents if they’re going to clean up on capital gains. But if that’s the case, then it’s clear the Australian housing market is dominated by the idea that buying and selling houses is the best way to get rich quickly in Australia. That leads to speculation, reckless lending and borrowing, and an inevitable bursting of the bubble. You can’t pay infinitely higher prices for what is essentially a consumption asset.
But what would trigger the whole thing? We reckon it’s when the capital dried up – which is largely an external problem. That’s why we spend so much of our time here trying to suss out what’s going in global capital markets.
Locally, the government is still supporting the mortgage market. And maybe it always will, and will go to even greater measures if it has to. But it’s worth noting that the securitisation market – where lenders sell low-doc or higher-risk loans to investors – is still on life support.
True, Lucey Battersby at the Age reports that Macquarie Securitisation managed to sell $500 million worth of low-doc loans via its Prime Masterfund S-8 vehicle. That doesn’t sound dangerous at all, does it? To be fair, according to the article, only 46% of the loans making up the fund have lower approval standards. That means S&P was happy to give the whole bond issue a AAA rating, except for one particular $180 million tranche “for which the rating was not revealed.”
“Right. It’s excellent for the most part, except for the stuff we’d rather not tell you about. Shall I wrap that up for you?”
The buyers were “undisclosed private institutions.” Let’s hope it’s the Future Fund. Or Super funds. With an average loan-to-value ratio of 72%, it’s not quite as worrisome as the LTVs of 90% + that you saw in the States at the height of the boom.
But financial firms are back in the business of selling mortgage debt to investors. All is right with the world again. What could possibly go wrong from here?
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