‘The seeds of disaster are sown in boom, not recession…it takes two generations to forget the lessons of the last recession.’
And so it ends pretty much the way it began. With an empty desk, an empty brain, a keyboard, a modem, and a pressing date with happy hour. Almost nine years later, today’s Daily Reckoning has the exact same task as the first Daily Reckoning I wrote in Australia on December 20th, 2005: to try and figure things out with a lot of thinking and a bit of humour.
Once more into the breach, dear friends, once more! Let us fill up the page with our financial dread. Yesterday, I promised I’d discuss whether commercial property is a bigger threat to the Australian economy than a residential house price crash. It is.
But first, an update on the crumbling state of the federal government’s finances. This year’s deficit will blow out to $48.5 billion, according to Treasurer Joe Hockey. That’s six years in a row of red ink from Canberra. It adds up to $240 billion in debt you and your kids get to pay interest on, never mind the principal.
Not only does Australia have a spending problem, but it also has a revenue problem. Tax revenues fell by $1.2 billion during the year. The company tax and superannuation failed to deliver what was expected. That’s what happens in a recession.
But shush! Recession is the economic cycle that dare not speak its name in Australia.
Now, let’s get back to the housing bubble. Do you think house prices will come off the boil if the Reserve Bank of Australia (RBA) and the Australian Prudential Regulatory Authority (APRA) set a maximum loan-to-value ratio (LVR) for new housing loans? RBA Governor Glenn Stevens got himself into trouble for saying he’s open to the idea of using ‘macro-prudential’ tools like LVRs to let some air out of the bubbles currently enclosing Melbourne and Sydney.
The trouble is, capping LVRs has already been tried in New Zealand, and didn’t work. Cashed up investors usually don’t have a problem putting up more equity for a home loan. It’s the new buyers and owner occupiers who get locked out of the market with limits on LVRs. And even if you cap the loan size as well, you simply move investors into the market for lower-priced units and homes, where they’ll be competing with first-time buyers.
If the Reserve Bank of Australia is really worried that lenders and borrowers are acting like maniacs, it can raise interest rates. For other economic reasons, of course, it can’t do that. That means the boom will likely end in a titanic bust. More on that below from Trevor Sykes.
Let’s not forget commercial property, though. This could be the real canary in the property mine. APRA’s statistics show that Authorised Deposit-taking Institutions (ADSIs) have $230 billion in commercial property on their books. They hold nearly a trillion dollars more in residential property. On the surface, it looks like a small risk. But the RBA wrote the following in its Financial Stability Review. Emphasis added is mine:
The dynamics in the housing market are also relevant in considering risks in commercial property markets. This area of Australian business activity has strengthened over the past couple of years, unlike most other parts of the business sector. Amid the global search for yield, Australian commercial property has attracted strong investor demand, both domestic and foreign. This has boosted prices and widened the disparity between movements in prices and rents for both CBD office and industrial property. Any significant reversal of this demand could expose the market to a sharp repricing. At this stage, however, the broader risks to financial stability from this source remain modest, because banks’ commercial property exposures are a smaller share of banks’ total assets than prior to the crisis.
That all sounds sensible. Yes, global investors have pumped up commercial property prices. And yes, if the Australian dollar falls and/or yields on property developers plummet, the market could be sharply repriced. But everything in the economy will be fine because the banks have lower exposure to commercial property now than before the GFC. Carry on.
Not so fast, RBA!
Here are two other interesting angles to look at. The A-REITS and property developers. If the Big Four aren’t at risk, what about the A-REITS? These high-yield real estate funds have been a hot-spot for foreign capital. They certainly have exposure to a ‘sharp repricing’ in commercial property values. And what about property developers like Lend Lease (ASX:LLC), Mirvac (ASX:MGR), and Stockland (ASX:SGP)? Or Westfield (ASX:WFD), Goodman (ASX:GMG), and Scentre Group Limited (ASX:SCG)?
The second angle is the Aussie dollar. The Bureau of Resource and Energy Economics (BREE) published new research yesterday revising its forecast of for the average iron ore price in 2015. It revised it down from $119 per tonne to $94 per tonne. That’s a 21% downward revision. And even that may be optimistic, considering the price is about $81/tonne now.
The Aussie dollar is not reacting well to falling iron ore prices. The Terms of Trade have been falling for over two years now. The dollar is just catching up with the fact that the glory days are over. The risk now is that a much weaker dollar triggers a sell-off in the A-REITS and property developers.
That’s a risk to some investors, anyway. It’s still legal to make money shorting stocks, as far as I know. If you’re inclined to believe there’s a big fall coming in the commercial property sector, there’s no reason you can’t try to profit from it.
And speaking of commodity prices and profit, let’s get back to BREE’s report. Kris Sayce and I grabbed a bite to eat yesterday to discuss what the world’s most hated investments are at the moment. We agreed on dirty black coal. You have a surplus of supply and a deficit of demand. The charts below tell the story.
Thermal coal is coal you burn to generate electric power. Let’s remember that about electric cars, by the way. They have to get their batteries charged from somewhere. That ‘somewhere’ usually involves burning a fossil fuel. But as the charts show, the Dow Jones Coal Index is making, arguably, a double bottom on the atrocious news coming out of coal stocks and the coal market.
If you have a single contrarian neuron in your brain, a chart like that will fire it up like the New Year’s Eve ball drop in Times Square. Sure, there could be a lot more pain ahead. But if you want to know what’s cheap, start with what’s out of favour. Coal is out of favour. Even if we don’t like it (I don’t like it either), we’re going to need it. Take this nugget from BREE’s report:
‘The National Development and Reform Commission has proposed a set of standards that restrict the consumption of thermal coal with high ash and sulphur content. The standards are scheduled to apply from 1 January 2015. The proposed coal standard restrictions are not expected to reduce China’s coal consumption, particularly given its electricity needs and plans for new coal-fired capacity.’
Electricity use and GDP growth are correlated. Growth needs power, just as a body needs calories. If China’s going to grow, it will need more power.
And if it isn’t going to burn its own brown coal, it will have to get higher-quality thermal coal from somewhere. Kris and I agreed it’s a development worth keeping a close eye on, especially if you’re looking to hedge your bets on the ‘Australia is doomed’ scenario I’ve been yammering about for years now.
If I’m yammering about the risks, at least I have some good company. My research on the damage commercial property busts can do to ordinary Australians took me to Two Centuries of Panic, the brilliant book written in 1988 by former journalist Trevor Sykes. Here’s how he described the scene in 1974:
‘While the mining share market was collapsing in the early 1970s, much of the money switched into a new boom area: property. Then the property boom, too, came to a shuddering halt. In four months, Australia saw five major failures:
July 1974, Home Units Australia
August 1974, Mainline Corporation
September 1974, Cambridge Credit Corporation
October 1974, Landall
October 1974, Keith Morris
‘The rapacity of the developers would have been bridled if they had not access to the funds of some of Australia’s largest finance companies. In some cases, the banks which controlled the financiers, being curbed by the Reserve Bank restrictions from investing in property on their own account, deliberately fostered their financiers’ activities. When the day of reckoning arrived, it was often masked from shareholders and creditors by a cover-up…
‘The accountancy and valuing professions could take no pride in the episode. In every instance of a company that collapsed — and in several that narrowly missed — property assets were shown in the books at high valuations. These values were attested by valuers, stated by accountants and checked as true and fair by auditors…
‘When the overextended companies collapsed the results were painful. Ordinary Australians, who had put their faith in the statements made my directors of purportedly respectable institutions and in balance sheets endorsed by accountants from the nation’s best known firms, suddenly discovered they would not have been much worse off in the hairiest mining stocks. Thousands of Australian investors lost their money or had it frozen for years in seemingly eternal receiverships or liquidations.
‘A few months after Cambridge Credit collapsed, an elderly woman rang the Melbourne office of the Financial Review. She had retired the previous year and sunk her life savings — $20,000 — into Cambridge. She asked what the prospects were. When I told her she would have to wait years to get anything back, and would probably never be repaid in full, she said: ‘Oh well, I’ve got a heart conditions, so I don’t suppose I’ll last that long anyway.’
You could repeat that passage today and hardly change a word. But the main difference is that today, the finance for developers is coming from two places: foreign investors and superannuation funds. A day of reckoning is still to come.
For the foreign investors, the falling dollar may make existing real estate more desirable. But new developments? Not so much. For superannuation funds loaded up on commercial property, it’s going to take a very good PR person to explain to members how so much money can be lost so quickly.
But enough of the risks of a whole nation overinvesting in an unproductive asset class.
For The Daily Reckoning Australia