Olivers Insights

The RBA provided no surprises following its April board meeting leaving the official cash rate on hold at 1.5%.The RBA remains more confident regarding global growth, sees Australian economic growth as moderate, regards the labour market as being mixed, sees a gradual rise in underlying inflation and continues to see conditions in the housing market as varying considerably across the country, but sees recent regulatory measures as reducing the risks associated with high and rising household debt. This note looks at the outlook for the cash rate, the impact of bank rate hikes and the implications for investors.

RBA likely on hold well into 2018

Our assessment is the cash rate has probably hit bottom after falling from 4.75% in 2011 to a record low of 1.5% last year and that the next move will be a rate hike but not until second half 2018. Another rate cut looks unlikely because:

• economic growth is okay – having bounced back in the December quarter after a temporary slump;

• national income is up from its lows thanks to higher commodity prices;

• the RBA expects underlying inflation will gradually rise; and

• the Sydney and Melbourne residential property markets are uncomfortably hot with prices up 19% and 16% respectively over the last year and 75% and 50% respectively over the last five years posing financial stability risks if prices and household debt continue to rise.

By the same token it’s too early to be thinking about hikes as:

• unemployment and underemployment (ie. labour underutilisation) at over 14% are way too high;

• this is maintaining downwards pressure on wages growth which is at record low of 1.9% year on year (in terms of the historical record for the Wage Price Index);

Source: ABS, Bloomberg

• the $A remains too high and is up from January last year;

• underlying inflation risks staying below target for longer – reflecting low wages, the rise in the $A and competition;

• there are risks around economic growth as the contribution to growth from home building is likely to slow this year and retail sales growth is weak at a time when mining investment is still falling; and

• bank “out of cycle” mortgage rate hikes have delivered a (“modest”) de facto monetary tightening any way.

The RBA has to set interest rates for the average of Australia so raising interest rates just to slow the hot Sydney and Melbourne property markets would be complete madness at a time when overall growth is still fragile, underlying inflation is well below target and property price growth elsewhere is benign or weak. The best way to deal with the hot Sydney and Melbourne property markets and excessive growth in property investor lending into those markets is through tightening lending standards, which APRA has just moved again to do.

By the second half of 2018 the drag on growth from falling mining investment is likely to have ended, stronger global growth should have started to help Australian growth and stronger employment growth should have started to benefit full time jobs and wages and the threat around below target underlying inflation should have subsided. All of which should allow the RBA to start raising interest rates. But on current indications it’s hard to justify RBA rate hikes before then.

But what about bank out of cycle rate hikes?

The banks have recently raised rates for property investors and on interest only loans by around 0.25% and for principal and interest owner occupier loans by around 0.03%. The stated drivers were higher funding costs (presumably following the back up in global bond yields over the last six months) and regulatory pressure to slow lending to investors and higher risk borrowers. More moves may lie ahead if global borrowing costs rise further but again would be focussed on investors & interest only mortgages and in the absence of RBA rate hikes are likely to be small as only 20-30% of bank funding is sourced globally. But it’s worth putting “out of cycle” moves in context:

• The RBA is still in control. “Out of cycle” bank moves have been a regular occurrence since the GFC and yet this did not stop mortgage rates falling to record lows in response to RBA rate cuts. As can be seen in the chart below the virtually fixed 1.8% gap between the standard variable mortgage rate and the cash rate only applied from 1997 to 2007, prior to that the relationship was far less stable so “out of cycle” moves are nothing new. The chart shows that changes in the cash rate remain the main driver of mortgage rates. If the RBA wants to lower mortgage rates again it can just cut the cash rate till it gets the mortgage rates it wants.

Source: RBA, AMP Capital

• So far the changes in owner occupier rates are unlikely to have much economic impact because 3 basis points is trivial compared to the 200 basis point rise in mortgage rates that occurred in the 2009-10 monetary tightening cycle. So don’t expect much impact on consumer spending albeit there is negative psychological impact.

• Changes in investor rates have less impact on spending in the economy because they are tax deductible and investors are less sensitive to rate moves. That said investor rates have gone up by around 0.52% compared to owner occupier rates since 2015 and this will eventually have some dampening impact on investor demand.

House prices

While strong population growth means that underlying property demand remains strong, the threats to the hot Sydney and Melbourne property markets are building: more macro-prudential measures to slow lending to investors and to more risky borrowers have been announced; the banks are raising rates out of cycle particularly for investors; the May budget is likely to see a reduction in the capital gains tax discount; all at a time when the supply of units is surging; and home prices are ridiculous. Taken together these moves are likely to result in a significant dampening impact on home price growth.

Source: CoreLogic, AMP Capital

We continue to expect a significant cooling in price growth in Sydney and Melbourne this year followed by 5-10% price falls commencing sometime in 2018 after the RBA starts to hike rates. By contrast Perth and Darwin are getting close to bottoming (as the mining investment slumps nears its low) and other capital cities are likely to see continued moderate growth. Unit prices are most at risk given the increasing supply of units.

Will rate hikes crash the economy?

There seems to be a view that household debt is now so high that any hike in interest rates will cause mass defaults and crash the economy. This is nonsense. Yes household debt is up but not dramatically since the GFC and interest payments as a share of household disposable income are at their lowest since 2003. Mortgage rates would need to rise by nearly 2% to get the interest servicing ratio back to its most recent 2011 high – which slowed but did not crash the economy. And most Australians are ahead on their debt payments.

Source: RBA, AMP Capital

Finally, the RBA will move gradually when it does start to raise rates and knows households are now more sensitive to rate moves and so it probably won’t have to hike rates as much as in the past to cool any overheating in the economy.

Implications for investors

There are several implications for investors. First, bank term deposit rates are set to remain very low. As a result, there is an ongoing need to consider alternative sources of income. Second, be cautious of the Sydney and Melbourne property markets, particularly units. Third, remain a little bit wary of the $A as an on hold RBA at a time when the Fed is likely to hike rates another two or three times this year could put downwards pressure on the $A. So retain some exposure to unhedged global shares. Finally, with low interest rates growth assets providing decent yields will remain attractive. This includes unlisted commercial property and infrastructure but also Australian shares which continue to offer much higher income yields relative to bank term deposits.

Source: RBA, Bloomberg, AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

The basics of successful investing are timeless and some investors (often the best) have a knack of encapsulating these into a sentence or two that brings them to life in a way that’s easy to understand. Over the last few years I have written two insights on investment quotes I find useful (see “21 great investment quotes”, Oliver’s Insights, April 2014 and “Another 21 great investment quotes”, Oliver’s Insights, February 2015). Here are some more. Just considering them helps bring us back to the basics of investing which is critical at a time when we are being increasingly bombarded by noise around the next best thing or the next disaster about to hit investment markets.

Having a goal

“If you don’t know where you’re going any road will take you there.” Lewis Carroll paraphrased, George Harrison song “Any road”

The first thing to do when embarking on investing is to work out what your financial goals are, how much risk you are prepared to take, your desire for income versus capital growth, how active you want to be in managing your investments, etc. This may entail seeking advice. But if you don’t work out these things you will be vulnerable to all sorts of distractions which will take you a long way from your goals.

“Saving is a great habit, but without investing and tracking it just sleeps.” Manoj Arora

There is a big difference between saving and investing with the former often implying putting money aside in a bank deposit. This may be fine for short term spending requirements and rainy days but it won’t grow your wealth for which the more deliberate and considered process of investing is required.

The market

“Investing is the intersection of economics and psychology.” Seth Klarman

The point is that asset prices rarely reflect some rational fundamental value. Instead, the influence of various behavioural biases on thousands and millions of investors will often act to push prices well away from fundamentally justified levels.

“Sometimes [Mr Market’s] idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.” Benjamin Graham

In other words, the market can be like a manic depressive. Several insights flow from the Mr Market metaphor for financial markets. First, avoid getting sucked in during good times and spat out during bad. Second, it’s the manic swings that create opportunities. Third, make sure that you respect the market as the silly prices it throws up can sometimes linger longer than you can remain solvent (to borrow from John Maynard Keynes).

Contrarian investing

“Nearly every time I have strayed from the herd, I’ve made a lot of money. Wandering away from the action is the way to find the new action.” Jim Rogers

In the roller coaster of investor emotion that characterises investor psychology through a share market cycle the best financial opportunities are found after a period of sharp falls when shares have become undervalued and under loved by the investing crowd, ie, when investors are depressed. And vice versa for when shares are overvalued and investors euphoric.

The roller coaster of investor emotion

Source: Russell Investments, AMP Capital

“Generally the greater the stigma or revulsion, the better the bargain.” Seth Klarman

The more an asset has fallen out of favour to the point where no one will touch it with a barge poll is usually the point its value and return potential is probably the greatest.

“Cash combined with courage in a time of crisis is priceless.” Warren Buffett

To take advantage of the buying opportunities thrown up by a sharp fall in markets requires not only spare cash but a lot of courage because this is invariably the time when the news flow is at its worst – with talk of economic crisis, falling profits, high unemployment, etc – but also when the crowd around you is convinced that it’s a crazy time to invest.

Pessimism

“Pessimistic visions about anything usually strike the public as more erudite than optimistic ones.” Joseph Schumpeter

The evolution of the human brain through the Pleistocene era when the key was to avoid being eaten by a sabre tooth tiger or squashed by a woolly mammoth has left us hard wired to be on the lookout for risks. So bad news sells and a financial loss is felt more distastefully than the beneficial impact of the same sized gain. Consequently, prognosticators of doom are more likely to be revered as deep thinkers than optimists. Therefore, we seem to be perpetually bombarded with warnings about the next disaster to hit investment markets. But when it comes to investing, giving too much attention to pessimists doesn’t pay. Historically, since 1900 shares have had positive returns seven years out of 10 in the US and eight years out of 10 in Australia.

Process

“Investing is simple. It’s the financial industry that works hard to make it complex!” Robert Rolih

Unfortunately, there is an element of truth in this, although in the industry’s’ defence often the complexity arises from the desire to protect against a particular risk (eg, options) or make it easier to gain access to a certain exposure and remove others (eg, hedging currency risk from global exposures). But frequently this leads to unnecessary complexity and at times the industry itself has not properly understood what it has created (eg, the risks around sub-prime debt in the US prior to the GFC). Maybe it’s just human nature to want to make the simple complex. But the bottom line is: don’t overcomplicate your investments. Avoid investments you don’t understand and keep your investment process relatively simple and commensurate with the amount of effort you want to put in.

“Trying to pick the stocks that outperform the average is like trying to find a needle in a haystack.” Robert Rolih

Jack Bogle (the founder of Vanguard) says just buy the haystack. The point is that trying to pick stocks that will outperform the market is not easy and requires a lot of effort. The key to growing wealth over time is to get a broad exposure to the market and let compound interest do its job.

“If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.” Benjamin Graham

If you are trying to pick stocks to outperform the market the key is to look for value rather than glamour.

“The individual investor should act consistently as an investor and not as a speculator. This means,,,that she should be able to justify every purchase she makes and each price she pays by impersonal, objective reasoning that satisfies that she is getting more than her money’s worth for her purchase.” Benjamin Graham

In other words you need a process that filters stocks & enables you to assemble a portfolio as opposed to just taking a punt.

“Good investing is boring.” George Soros

Successful investing can take discipline and time and sometimes it can take years to pay off. This can be boring. If you want bright lights, excitement and instant riches (or more likely, losses) the casino is the place to go.

“It is remarkable how much long term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Charlie Munger

This is very important. You don’t need a super high IQ to be a successful investor. In fact, Charles Ellis wisely related investing to a “losers game” like amateur tennis or boxing after several rounds where you win by not trying to be smart but by not making stupid mistakes. In other words you win by not losing.

Knowledge, wisdom and noise

“Information is not knowledge, knowledge is not wisdom.” Frank Zappa (and maybe some others)

The information revolution and particularly the explosion of social media has made available to us a wealth of information and opinion around investments. But we need to recognise that much of this is ill-informed and that there is a big difference between information and wisdom when it comes to investing.

“An investment in knowledge pays the best interest.” Benjamin Franklin

There is not much to add to this. You have to do research and analysis before making investment making decisions. And with knowledge will come the wisdom to be able to screen out what doesn’t matter from the noise that surrounds us.

“When an investor focuses on short term investments, he or she is observing the variability of the portfolio, not the returns – in short being fooled by randomness.” Nassim Nicholas Taleb

Focussing on short term fluctuations in investment markets can be very distracting and risks blowing you off course from your strategy. Much of it is just random noise. On a day to day basis its pretty much a coin toss as to whether you will get good news or bad from share markets but the longer the time horizon you take the greater the probability of a positive return. On a calendar year basis its around 70-80% and on a decade by decade basis its actually 100% for Australian shares. In other words, time is on your side and the more you have of it the better. So turn down the day to day noise and avoid looking at your investments too frequently to avoid being disappointed.

Daily and monthly data from 1995, data for years and decades from 1900. Source: Global Financial Data, AMP Capital

Right mindset

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Mark Twain

If you want to be a successful investor you have to check your ego at the door and be humble.

Another perspective

“Always borrow money from a pessimist – she doesn’t expect to be paid back.” Anon

Or just make sure you don’t take on too much debt such that you lose control over your investments just at the wrong time.

“Money is not the most important thing in the world. Love is. Fortunately, I love money.” Jackie Mason

The Beatles wisely realised that “money can’t buy me love” and in the end the love you take is equal to the love you make.

“Money, if it does not bring you happiness, will at least help you be miserable in comfort.” Helen Gurley Brown

Well I guess that’s a good second best!

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

“It’s not what you own that gets you into trouble, but what you owe.”

Excessive debt tends to be at the centre of most scare stories regarding the investment outlook – whether they relate to China, public debt in developed countries, corporate debt in the US or Australian household debt. The standard debt related scare story runs something along the lines of “we have lived beyond our means. Any attempt to prevent a debt implosion won’t work or will just delay the inevitable. Divine retribution will get us in the end!” One big debt scare that gets wheeled out is that total global debt outstanding has reached a new record high of nearly $US200 trillion and either that on its own or in combination with any significant rise in global interest rates will trigger the next crisis. To be sure problems with debt or a desire to reduce it are part and parcel of most financial crises and economic downturns. And total global debt has indeed reached record levels. But that’s not the same as saying another financial crisis is imminent. This note looks at the main issues.

Global debt – first some facts

Excluding the debt of financial companies like banks (to avoid double counting) total gross world public and private debt is around $US170 trillion. That is a record high big scary number but it’s meaningless unless it’s compared to something. An obvious comparison is to income levels and the best guide to that at an economy wide level is GDP. Again new records have been reached with gross world public and private non-financial debt rising to a record of 235% of global GDP.

Since the global financial crisis (GFC) the climb in overall debt has been due to rising public debt in the developed world (DM) and rising private debt in the emerging world (EM). The rise in developed world public debt reflects GFC related stimulus programs and the failure to turn budget deficits into budget surpluses post the GFC.

Source: IMF, Haver Analytics, BIS, Ned Davis Research, AMP Capital

The next table compares total debt for various countries.

Total gross non-financial debt outstanding, % GDP

Source: IMF, Haver Analytics, BIS, Ned Davis Research, AMP Capital

There are some qualifications to the table. For example, because of public investments in debt via sovereign wealth funds, central bank reserves, etc, net public debt is usually well below gross debt. In Norway net public debt is -274% of GDP and in Japan its 128% of GDP. So gross debt data exaggerates the total level of debt. But as an overview:

• Japan, Belgium, Portugal and Greece have relatively high total debt levels;

• Germany, Brazil, India and Russia have relatively low debt;

• Australia does not rank highly in total debt – it has very high household debt but its offset by low public & corporate debt;

• Emerging countries tend to have relatively lower debt, but China is an exception given a high level of corporate debt.

But the bottom line is that global debt is at record levels even adjusted for GDP. As a result some fear that any rise in interest rates will immediately derail global growth. Excessive debt can also be associated with slower growth and a higher risk of a financial crisis. Of course it’s not that simple.

Debt, savings and income dynamics

Firstly, the relationship between income, savings and debt is more complicated that often portrayed. The Global Investment Strategy service of Bank Credit Analyst Research (a Canadian research house) recently illustrated this using some simple examples. Suppose there is an island with 100 people, each producing 100 coconuts a year. Here are three possibilities.

Case 1: Output is 10,000 coconuts with each person consuming 100. Saving and investment are zero and no debt is created.

Case 2: Each person consumes only 75 coconuts a year, selling the remainder to a plantation who buys them with a bank loan and plants them resulting in 2500 new coconut trees. Consumption is 7500 coconuts. Savings and investment are 2500 and debt has gone up by 2500 coconuts.

Case 3: Each person consumes 125 coconuts, by importing 25 each. Consumption is now 12,500 coconuts, savings is -2500 coconuts, investment is zero and the current account deficit is 2500. External debt goes up by 2500. This is arguably more risky if foreign islands decide they want their coconuts back!

The point is that debt can rise in an economy even if it lives within its means and invests for the future as Case 2 illustrates. No need for divine retribution here!

Reasons not to be too alarmed about record debt

There are several reasons not to be too alarmed by the rise to record debt levels.

First, the level of debt has been rising ever since debt was invented. This partly reflects greater ease of access to debt over time. But it also reflects the fact that the level of debt is a stock while income is a flow. Suppose an economy starts with $100 of debt and $100 in assets and in year 1 produces $100 of income and in each year it grows by 5%, consumes 80% of its income and saves 20% which is recycled as debt. At the end of year 1 its debt to income ratio will be 120%, but by the end of year 5 it will be 173%. But assuming its assets rise in line with debt its debt to asset ratio will remain flat at 100%. So the very act of saving and investing creates debt and rising debt to income ratios.

Second, China has led the surge higher in private debt in recent years but is an example of Case 2 where it borrows from itself. The main problem in China is that it has a very high savings ratio of nearly 50% of GDP and this saving is largely recycled through the banking system (partly because of a less developed share market) and this results in strong debt growth. But not much of this has gone into the Chinese property market (household debt is low) – rather it finds its way into corporate debt and investment. But this is largely matched by an expansion in productive assets and is really a reflection of fiscal policy and is subject to government support if there’s a problem.

Third, the rise in private debt in the emerging world is not that concerning as they, like younger workers, have a higher growth potential going forward than developed countries. Of course the main problem emerging countries face is that they borrow too much in US dollars and either a sharp rise in the $US or a loss of confidence by foreign investors causes a problem. But there are no signs of the latter and emerging countries seem to have weathered the rise in the $US since 2014 pretty well.

Fourth, debt interest burdens are low and in many cases still falling as more expensive long maturity older debt rolls off. For example despite the recent rise in bond yields US public debt interest payments are less than 3% of US GDP – well down from 4.5% in 1991. And given the long maturity of much debt in advanced countries it will take time for higher bond yields to feed through into actual interest payments. In Australia, interest payments as a share of household disposable income are at their lowest since 2003, and are down by more than a third from their 2008 high. See the next chart. Moreover there is no sign of significant debt servicing problems globally or in Australia – unlike in relation to US sub-prime debt just prior to the GFC.

Source: RBA, AMP Capital

Fifth, most of the debt increase in recent years in developed countries has come from public debt and governments can tax and print if worse comes to worse. Japan is perhaps most at risk here given its very high level of public debt but it has borrowed from itself (Case 2 again) and Japan remains one of the world’s biggest creditor nations. And even if Japanese interest rates do rise sharply (which is unlikely with the BoJ maintaining zero 10 year bond yields) 40% of Japanese Government bonds are held by the BoJ so higher interest payments to it will simply be paid back to the Government.

Sixth, when it comes time to raise interest rates central banks will adopt a gradual approach knowing that in an environment of higher debt they don’t need to raise rates as much to have an impact on inflation or growth as had been the case in the past. The gradual approach is currently evident at the Fed.

Finally, increased debt of itself is rarely the source of a shock to economies. Some sort of trigger is required – usually much higher interest rates or rising defaults as economies sour or after a big deterioration in lending standards – as was evident in the US sub-prime crisis. At present these seem unlikely.

Concluding comment and investment implications

None of this is to say there’s nothing to worry about. History tells us that the next major crisis will involve debt problems of some sort. But just because global debt is at record levels and that global bond yields have moved higher does not mean a crisis is imminent. For investors, debt levels are something to keep an eye on – particularly if there is a broad based surge in debt in the context of surging asset prices. At present, apart from pockets of concern (eg, Sydney & Melbourne property markets) there is no sign of this on a generalised basis globally.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

The cooling in the Sydney and Melbourne property markets evident in late 2015 in response to macro prudential tightening deployed by APRA has proved ephemeral. Price gains have reaccelerated and auction clearance rates & lending to property investors have rebounded. Over the last five years Sydney dwelling prices have risen a ridiculous 73% and Melbourne prices are up 47%. As a result the Australian housing market continues to cause much angst around poor affordability and high household debt. This note looks at the main issues.

Source: CoreLogic, AMP Capital

Is Australian housing overvalued?

On most measures Australian housing is overvalued:

• On the basis of the ratio of house prices to rents adjusted for inflation relative to its long term average Australian houses are 39% overvalued and units 13% overvalued.

• According to the 2017 Demographia Housing Affordability Survey the median multiple of house prices in cities over 1 million people to household income is 6.6 times in Australia versus 3.9 in the US and 4.5 in the UK. In Sydney it’s 12.2 times and Melbourne is 9.5 times.

• The ratios of house prices to incomes and rents are at the high end of OECD countries.

Source: OECD, AMP Capital

Why is it so expensive and household debt so high?

There are two main drivers of the surge in Australian home prices over the last two decades. First, the shift from high to low interest rates has boosted borrowing and hence buying power. This has taken Australia’s household debt to income ratio from the low end of OECD countries 25 years ago to the top end. Second, there has been an inadequate supply response to demand. The following chart shows a cumulative shortfall relative to underlying demand had built up by 2014 and is still yet to be worked off despite record construction lately.

Source: ABS, AMP Capital

Consistent with this, while vacancy rates have increased they have only increased to around average long term levels. In Sydney vacancy rates are below average.

What about investors and foreign buyers?

A range of additional factors may be playing a role in accentuating demand beyond that implied by population growth. These include negative gearing and the capital gains tax discount, foreign buying and SMSF buying. Negative gearing is just part of the normal operation of the Australian tax system. However, the interaction with the capital gains tax discount by enhancing the after tax return available to property investment may be resulting in higher investment activity than would otherwise be the case. This may particularly be the case when past property price gains have been strong encouraging investors to think future gains will be too. While commitments to lend to property investors slowed in 2015 after APRA tightened macro prudential controls, this has since worn off.

Source: ABS, AMP Capital

Foreign buying is likely also impacting – with indications that it is around 10-15% of demand – but it is also concentrated in particular areas and SMSF buying appears to be relatively small. But like lower interest rates, all of these should have a less lasting impact if the supply response was stronger.

Is a crash likely?

The surge in prices and debt has led many to conclude a crash is imminent. But we have heard that lots of times over the last 10-15 years. In 2004, The Economist magazine described Australia as “America’s ugly sister” thanks in part to a “borrowing binge” and soaring property prices. Most recently the OECD has warned of the risks of a property crash. However, the situation is not so simple:

• Firstly, we have not seen a generalised oversupply and at the current rate we won’t go into oversupply until 2018 and in any case approvals suggest supply will peak this year.

• Secondly, mortgage stress is relatively low and debt interest payments relative to income are around 2003-04 levels.

• Thirdly, lending standards have not deteriorated like they did in other countries prior to the GFC. In recent years there has been a reduction in loans with high loan to valuation ratios and interest only loans are down from their peak.

• Finally, generalising is dangerous. While prices have surged in Sydney and Melbourne, they have fallen in Perth to 2007 levels and seen only moderate growth in other capitals.

To see a general property crash – say a 20% plus average price fall – we need to see one or more of the following: a recession – which looks unlikely; a surge in interest rates – but rate hikes are unlikely until 2018 and the RBA will take account of the greater sensitivity of households to higher rates; and property oversupply – this would require the current construction boom to continue for several years. However, the risks on the supply front are high in relation to apartments.

What can be done to fix it?

Recent RBA commentary strongly hints that more macro prudential measures to tighten lending standards are on the way. These could include a further lowering in the 10% growth cap on the stock of lending to investors and tougher debt serviceability tests. This is in part about reducing the risks to financial stability when it’s too early to consider raising rates.

More fundamentally, policies to help address poor housing affordability should focus on boosting new supply, particularly of standalone homes which have lagged. This includes relaxing land use restrictions, releasing land faster, speeding up approval processes and encouraging greater decentralisation. This is largely a state issue. Policies designed to make better use of the existing housing stock (eg, by relaxing constraints on empty nesters downsizing) could also help.

Policies that are unlikely to be successful include increased first home owner grants (as in periods of high demand they just result in higher prices) and allowing first home buyers to access to their super (again this will just result in even higher prices unless supply is fixed before and will mean less in retirement).

Tax reform should ideally be part of the package and include replacing stamp duty with land tax (again a state issue), removing the capital gains tax discount that is a distortion in the tax system and lower income tax rates to discourage use of negative gearing as a tax avoidance strategy. Piecemeal cuts to stamp duty targeted at FHBs will just result in higher home prices. Abolishing negative gearing would just inject another distortion in the tax system and could adversely affect supply (although I can see a case to cap excessive benefits).

What is the outlook?

Generalised price falls are unlikely until the RBA starts to raise interest rates again and this is unlikely until later in 2018, which after a few hikes will likely trigger a 5-10% pullback in property prices as was seen in the 2009 & 2011 cycles:

• Sydney & Melbourne having seen big gains are most at risk.

• Prices are likely to fall further in Perth and Darwin this year, but they are close to bottoming and should rise next year.

• The other capitals are likely to see continued moderate growth this year and a less severe down cycle around 2019.

• But units are at much greater risk given surging supply and this could see unit prices in parts of Sydney & Melbourne fall by 15-20% as investor interest fades as rents falls.

What are the risks to the economy?

Slowing momentum in building approvals points to a slowdown in the dwelling construction cycle ahead. This combined with a slowing wealth affect from rising home prices means that the contribution to growth from the housing will slow. However, as this is likely to coincide with a fading in the detraction from growth due to falling mining investment and higher commodity prices it’s unlikely to drive a slowing in the economy. However, a likely decline in rents (as the supply of units hits) will constraint inflation helping keep interest rates low for longer.

Source: REIA, AMP Capital

A property crash would have bigger impact given the exposure of banks, but as noted above such a development is unlikely.

Implications for investors

• While there is a strong long term role for residential property in investors’ portfolios at present their remains a case for caution. It is expensive on all metrics and offers very low net income (rental) yields of 2% or less. This leaves investors highly dependent on capital growth.

• But it is dangerous to generalise. Apartments in parts of Sydney and Melbourne are probably least attractive. Best to focus on areas that have lagged behind.

• Finally, investors need to allow for the fact that they likely already have a high exposure to Australian housing. As a share of household wealth it’s nearly 60%.

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Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

The long running soap opera around whether the Eurozone will break up is now into its eighth year! In 2015 all the focus was on the latest Greek tantrum and last year the big fear was that the populist/nationalist Brexit vote and Trump victory would lead to a surge in support for populist parties across Europe and drive a Eurozone break up. There was no sign of this in Spanish and Austrian elections, but this will be put to the test again with elections this year in the Netherlands, France, Germany and maybe in Italy. The fear is that a Eurozone break up will plunge the world’s third biggest economic region into recession and financial chaos, which would adversely affect the global economy and Australia. Such a fear may be exaggerated – the UK hardly imploded after Brexit – but that’s the worry.

The big picture

There are several reasons why Europe differs to the UK and US. Firstly, it doesn’t have the issues with inequality that drove the anti-establishment backlash in the US and UK. The Gini coefficient which measures income inequality is below average.

After taxes and transfers. Source: OECD, AMP Capital

Secondly, Eurozone break up risk may have peaked with the high point of the Eurozone debt crisis – when unemployment & fiscal austerity were at their peak in 2013. But unemployment has now fallen and fiscal austerity has ended. An abatement of the migration crisis may help too with sea arrivals slowing from over 200,000 a month in October 2015 to around 5000 recently.

Thirdly, despite the media frenzy the Eurozone populist parties are not really doing any better than a few years ago (mostly anyway). See below in relation to Marine Le Pen in France.

Further, leaving the Euro is not as simple as leaving the European Union as it would entail currency redenomination, the anticipation of which would drive a likely exit of foreign investors fearful of getting paid back in depreciated currency.

Finally, support for the Euro remains high in the Eurozone at around 70%. So to attain power the populists invariably have to renounce their anti-Euro policies as Syriza did in Greece.

Source: Eurobarometer, AMP Capital

But a chain is only as strong as its weakest link and there are risks at the individual country level, to which we now turn.

The Netherlands (parliamentary election March 15)

There are 28 parties contesting the parliamentary elections and 14 could enter parliament. Gert Wilders’ populist Eurosceptic Freedom Party may get a greater share of the vote and more seats than any other party but support has slipped from around 20% of the vote and seats to around 17% in recent polls. It won’t be able to form government, which will ultimately come from a group of centrist parties (which have rejected working with Wilders). Support for the Euro is very high at around 77%.

France (presidential elections on April 23 and May 7 and parliamentary elections on June 11 and 18)

The presidential election is a two round contest with the two highest placed candidates in the first round on April 23 then facing a run-off on May 7. Polling indicates that Marine Le Pen of the National Front (whose policy is to reinstate the Franc for domestic purposes, redenominate public debt into the Franc, allow the Bank of France to finance budget deficits and undertake a big round of public spending) is likely to “win” the first round (in the sense of getting more votes than anyone else with polls running around 26% support compared to around 24% for her nearest rival, Emmanuel Macron). And her chances of winning the second round have been boosted by allegations the Republican Party’s candidate Francois Fillon used public money to pay his family when he was a parliamentarian for fake work and rioting in the Paris suburb of Aulnay-sous-Bois.

However, several considerations work against a Le Pen victory in the second round. Firstly, support for Le Pen actually peaked several years ago and has since fallen back to around 26%. This suggests that the real issue is not the rise of Le Pen, but weakness in the conventional parties, ie the Socialists thanks to President Hollande and the Republican’s problems with Fillon. Le Pen also has similar allegations against her to those against Fillon, although so far this isn’t having much impact.

Source: IPSOS, AMP Capital

Secondly, French support for the Euro is relatively strong at 67%, whereas Le Pen advocates an exit from the Euro.

Thirdly, while Fillon is in trouble, former economy minister now running as an independent, Emmanuel Macron has been seeing increased poll support and on some recent polls has been running just ahead of Le Pen for the first round. What counts though is the final round. Polling currently shows that if the second round is between Macron and Le Pen – which looks most likely – then Macron will win by around 20 to 25%. If it’s between Fillon and Le Pen then Fillon is ahead by around 14%. And these margins are much wider than was the case in relation to opinion polls at the same point ahead of the US election when it was around 3% in favour of Clinton.

The bottom line is that current polling indicates Le Pen will not win the second round. However, France is not without risk. For example, more race related rioting in French suburbs or a major terrorist attack would play into the hands of Le Pen. The leaking of Russian hacks into Macron’s campaign may also do the same – as Russia stands to benefit from a Le Pen win.

However, even in the event of a Le Pen victory, it’s doubtful she would be able to implement her policies in relation to the Euro because her National Front is very unlikely to win a majority in the June parliamentary elections and leaving the Euro would require an act of parliament. In any case a panic in the French bond market upon a Le Pen victory (as investors fear getting paid back in devalued Francs) would likely force Le Pen to back down much as occurred with Syriza in Greece.

Finally, note that Macron (and Fillon) is pro Euro and economic reform oriented, which is just what France needs. So a Macron victory by either would be positive for France.

Germany (election September 24)

German Chancellor Angela Merkel is at some risk of losing to the centre-left Social Democrat Party whose new leader Martin Schulz is polling well. But while there may be a bit of market angst if Merkel is defeated, this would soon be forgotten as Schulz is more pro Europe than Merkel so even if he does win it could actually mean a stronger Eurozone as he and the SPD are likely to undertake German fiscal reflation (which could help countries like Italy). The populist Alternative for Deutschland is stuck at around 10% support, reflecting Germans’ 80% support for the Euro. So Germany is not really an issue.

Italy (possible election around September)

Perhaps the country at greatest risk is Italy. The next election is not due to 2018, but Matteo Renzi who is still the leader of the governing Democratic Party (PD) is keen on having it earlier – possibly September – given the ongoing softness of the Italian economy. However, there is a high risk that the Eurosceptic Five State Movement (5SM) will win. Eurosceptic parties are polling in line with establishment parties in Italy, support for the Euro in Italy has fallen to around 53% and a possible split in the governing PD party will add to support for Eurosceptic parties. However, even if the 5SM “wins” in the next election and successfully forms a coalition government (it’s unlikely to win a majority in parliament) a move towards an exit from the Euro (Itexit) would likely drive a market panic leading to sharply higher Italian bond yields which in turn would adversely affect the Italian economy and most likely cause 5SM to backdown.

Greece

Greece remains a risk given the state of its economy and tough negotiations with its creditors. But there is no longer a populist Eurosceptic party for the Greeks to turn too. In fact if there were an early election the pro-Euro New Democracy party would win.

Spain – Catalonia

Finally, the Catalonia region of Spain looks likely to have another independence referendum around September. But for most Catalonians this seems to be more about more autonomy from Spain than actually wanting independence. Turnout is likely to be low again and without recognition from Spain (or EU support) it’s unlikely to go anywhere even if “yes” wins again.

Risks

Our base case is that the Eurozone stays together, but there are two main risks around this. Firstly, if the migration crisis ramps up again or terrorist attacks escalate which could drive broader based support for populists. Secondly, weak centrist coalition governments risk turning the populist Eurosceptics into the main opposition and leave their countries vulnerable to a populist take over the next time there is a significant economic downturn. Alternatively, if the European economy continues to recover – and gripes around immigration and EU bureaucracy are dealt with – support for the populists may decline over time.

Key implications for investors

There are several implications for investors. Firstly, various elections will no doubt keep Eurozone break-up fears alive causing periodic short term investment market volatility.

Second, while the Eurozone economy looks stronger political risk maintains pressure on the European Central Bank to keep its quantitative easing program going out to year end, delay announcing any “tapering” in it and remain dovish. This will maintain downwards pressure on the Euro.

Finally, if we are right and the Eurozone continues to hang together then bouts of financial turmoil triggered by break-up fears are buying opportunities – just as we have seen since the Eurozone debt crisis began in 2010.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

For the last few years we have heard constant predictions of a recession in Australia as the mining boom turned to bust and a housing bust was seen to follow. Some even went so far as to say that an imminent recession was “unavoidable”. Those fears intensified after the September quarter GDP data showed the economy going backwards. But a 1.1% rebound in December quarter growth highlights that yet again it hasn’t happened. The December quarter rebound was on the back of stronger consumer spending, housing investment, business investment, public demand and export volumes. So where to from here?

Source: ABS, AMP Capital

The Australian worry list

To be sure, aside from global threats, Australia has its own worry list. The key threats and constraints are as follows:

• Business investment plans point to mining investment continuing to fall at the rate of 30% or so a year.

• Housing construction activity is likely to peak this year, a large supply of apartments will hit various cities, affordability is poor and household debt levels are very high.

• The Australian dollar arguably remains too high and has risen more than 10% from early last year. (That said most countries want a lower currency these days.)

• Unemployment and underemployment at a combined 14% are high. The combination in the US is 9.4%.

• Inflation is too low and risks staying below the 2-3% target for longer reflecting record low wages growth, a rising $A, competitive pressures and weak rents as new supply hits.

• Our political leaders seem collectively incapable of undertaking productivity enhancing economic reforms

That said, most of these concerns are not new and have been discussed endlessly. Endless whinging about them is distracting from the good news.

Reasons to be upbeat on the outlook for Australia

In fact, there remains good reason to be upbeat on Australia.

• Firstly, at now 102 quarters without a recession, Australia is on track to take out the Netherland’s record of 103 quarters without a recession. This owes a bit to statistical luck, but it also reflects the benefits of the economic reforms of the 1980s and 1990s that made the economy more flexible and sensible macro-economic management that meant that when the mining boom ended it enabled other sectors of the economy to take over in driving growth. This included housing and services exports like tourism and higher education.

Source: ABS, AMP Capital

• Secondly, reflecting this, the south eastern states of NSW, Victoria and ACT are continuing to perform strongly in reversal of the so-called two speed economy.

• Thirdly, while mining investment is continuing to decline, it’s now a smaller share of the economy so its decline is having a diminishing impact and it’s nearing the bottom anyway. At its peak in 2012 it was 7% of GDP whereas its now less than half that so a 30% annual decline is having half the impact on the economy. What’s more mining investment intentions indicate that by mid next year it will have fallen back to around its long term norm of about 1.5% of GDP. Engineering construction – which has been dominated by mining activity – has already fallen back to its long term trend. This means a slowing in housing investment is less of a threat because it will be offset by a lessening in the detraction by falling mining investment.

Source: ABS, AMP Capital

• Fourthly, we are continuing to benefit from the third phase of last decade’s mining boom, which is the surge in resource export volumes as new projects complete – notably gas projects this year.

• Fifthly, the blow to national income from the slump in commodity prices has reversed as prices for iron ore, metals and energy have rebounded. While a new commodity price boom is a long way away the rebound is pushing up national income. Amongst other things, this along with booming export volumes is leading to a dramatic shrinkage in Australia’s current account deficit which could soon be in surplus for the first time since the 1970s and the associated surge in resource company profits could knock $8-10bn pa off the Federal budget deficit.

• Sixthly, public infrastructure investment is ramping up strongly, in response to state infrastructure spending particularly in NSW and the ACT much of which is financed from the privatisation of existing public assets.

• Finally, there are signs of life in non-mining investment. In terms of fundamental drivers borrowing costs have been low for some time but business confidence is reasonably high, profits for non-resource companies are growing around 5% per annum and capacity utilisation is up from its lows. While mining investment plans for the financial year ahead are around 30% below such plans a year ago, plans for non-mining investment are actually up 7%.

Source: National Australia Bank, Westpac/MI, AMP Capital

Overall, recession is likely to continue to be avoided and economic growth is likely on its way back to near 3% this year.

Interest rates on hold

There remains a case for another RBA interest rate cut: the $A remains too high, slowing housing investment at a time when mining investment is still falling risks slower economic growth, banks are under pressure to raise rates out of cycle and inflation risks staying lower for longer as wages growth remains weak. But against this, growth has bounced back nicely in the December quarter, national income is up and RBA concerns about the threat to household financial stability that may flow from more rate cuts imply a high hurdle to cutting rates again. As a result we are removing the rate cut we had expected for May and now expect rates to be on hold this year. That said if the RBA is to do anything on rates this year a cut is more likely than a hike. A rate hike is unlikely until later next year.

Profit growth goes back to positive

The Australian December half profit reporting season confirmed a very strong return to profit growth. However, this dramatic turnaround has been driven by resources stocks with more modest growth for the rest of the market. In terms of some key statistics: 45% of companies results have exceeded earnings expectations which is around the long term norm, 59% of companies have seen profits up from a year ago with a median gain of 4% year on year and the focus has remained on dividends with 80% of companies either increasing or maintaining their dividends which is a positive sign of corporate confidence in the outlook.

Consensus profit expectations for the overall market for this financial year were revised up by around 2% through the reporting season to a strong 19%. The upgrade has all been driven by resources companies which are on track for a rise in profit of 150% this financial year reflecting the benefits of higher commodity prices and volumes on a tighter cost base. Profit growth across the rest of the market is likely to be around 5% with mixed bank results and constrained revenue growth for industrials. Outlook comments have generally been positive and as a result the proportion of companies seeing earnings upgrades has been greater than normal. While the bounce in resource profits will slow, profit growth for industrials is likely to pick up reflecting stronger economic growth.

Source: UBS, AMP Capital

Implications for investors

A return to reasonable growth underpinning reasonable profit growth is positive for Australian assets. With Australian shares up 12% since the US election and trading on a forward price to earnings multiple of 15.5 times which is above the long term average, the market is vulnerable to a further short term consolidation or correction. However, the improvement in profits – which is likely to broaden to industrials – should underpin a rising trend in the market on a 6-12 month horizon.

Source: AMP Capital 2 March 2017

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.