Australia’s Housing Frankenstein

australian real-estate development
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Global markets staged a recovery on Friday but the Aussie market is set for a lacklustre start. It follows an ordinary day on Friday where local stocks tried to rally early but ended the day down.

There’s a lot of nervousness around. While the ASX 200 continues to hold on above important support at the 5,000 level, it looks like succumbing at some point soon. Increased selling meets every rally, which keeps the pressure on prices.

Why do I think the market will fall below support at 5,000 points? Well, Australia’s bellwether stock, the Commonwealth Bank [ASX:CBA], made a new weekly low on Friday, closing the week at $71.44. That’s the lowest close since July 2013.

CBA is the biggest stock on the ASX. The banks led the bull market on the way up and they are now leading the market on the way down. The fact that the biggest and best bank just made a new low is a bearish sign.

What is it telling you? Why are shareholders deserting the stock? Clearly, the market thinks the slowing economy and tougher regulatory regime around capital levels will hurt profits and dividends per share. Rising bad debts will do more damage.

What about the housing market? Does the fall in bank shares across the board reflect concern about the great Australian house price bubble?

Well, bank stocks all fell hard on Friday. They were down around 1.4% in an overall market that fell 0.6%. It may have been this report from the Financial Review:

A senior Treasury official has confirmed the Turnbull government is looking at the tax breaks on capital gains and superannuation.

Paul Tilley, head of the personal and retirement income division, told a parliamentary inquiry into home ownership on Friday that Treasury had spent a lot of time looking at capital gains tax exemptions on investment properties.

“The new prime minister and new treasurer have indicated they’re areas, together with superannuation, that we’ll look at,” Mr Tilley said.

Mr Tilley said the focus of Treasury thinking on tax and investment properties, and the extent to which they might drive property prices, was on the 50 per cent capital gains tax discount. He said there was no consideration of taxing the family home.

One of the good things to come out of the recent change of leadership is the realisation that Australia has a tax system that rewards speculation over hard work. Not that Malcolm Turnbull said that directly. But his intention is to improve Australia’s productivity. That means encouraging capital to flow into business and innovation…not just houses.

If bank investors are concerned about the potential for these future tax changes, property investors don’t seem to care.

Clearance rates were still pretty strong in the bubble cities of Sydney and Melbourne on the weekend, despite a large amount of properties for sale. Still, the industry seems unduly neurotic about the future course of property prices.

After going crazy for the past few years (in what could be the blow-off top in a 25 year bull market) this seems like a panicked rush to sell before prices return to some semblance of normality…or go bust.

But weekend clearance rates hovering around 73% suggests the market is still rising, albeit not as stupidly as a few months ago.

You’ll want to see clearance rates at least fall into the 60% range before worrying (or rejoicing) about the market dropping. I think such a fall is coming.

That’s what falling bank share prices are warning about.

Maybe that has something to do with a higher cost of debt? As I’ve pointed out before, Australian households hold gross debt of $1.8 trillion. Much of that sits on the balance sheets of the big four banks. They, in turn, need to borrow a large chunk of this debt from offshore.

But if global risk appetite starts to wane, and lenders want more compensation for the risk of lending their funds, then Australian households will suffer. As the Wall Street Journal reports, US corporates are already starting to feel the effects of this increased risk aversion:

The U.S. corporate-bond market is starting to flash caution signals about the broader economy.

The difference in yield, called the “spread,” between bonds from America’s strongest companies and ultrasafe U.S. Treasury securities has been steadily increasing, a trend that in the past has foreshadowed economic problems. Wider spreads mean that investors want more yield relative to Treasurys to own bonds from U.S. companies. It can signal that investors are less confident about companies’ business prospects and financial health, though other factors likely also are at play.’

The US economy is relatively healthy. The Aussie economy is slowing down and has few prospects of putting in a strong recovery. If global investors are starting to discern a slowdown in the US, that’s going to translate into higher borrowing costs for our banks and household sector.

Combined that with an economy that might stop growing in the next 12 months, and we could be in a spot of bother, to put it mildly.

Consider this. With gross household debt of $1.8 trillion, the interest bill (assuming an average borrowing cost of 4%) is $72 billion a year. On a net basis it’s lower than that, let’s assume around $40 billion.

In other words households have a net interest expense of around $40 billion per year. With the economy growing, servicing that debt is relatively easy. But as it slows down, the debt burden becomes harder to manage.

Australia’s $1.5 trillion economy growing at 2% expands by $30 billion per year. That’s not quite enough to cover our interest bill but it’s not the end of the world. That said, a stagnant economy and a rising interest bill would not be good news.

With economic output flat, we would need to find perhaps $50 billion per year to service our debts. That would see the current account deficit blow out and our dollar continue to fall. This in turn would freak out foreign borrowers even more, causing another increase in borrowing costs.

It’s a negative feedback loop we’re at risk of getting caught up in. Unless something is done very soon, the housing monster is at risk of eating Australia whole.

Regards,

Greg Canavan

Editor, The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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