Why the Big Four Banks will Dictate Where Property Prices Go Next

Illustration of australian real-estate development

Trading was mixed in global markets overnight. European stocks remained under pressure, with the Euro Stoxx 50 index falling 1.8%. Financial stocks on the continent were the worst performers.

This weakness initially dragged US stocks down but, after European markets closed, the Fed released minutes from their last interest rate meeting telling everyone what they already knew; that is, that interest rates would remain on hold. As a result, US stocks recovered.

The Dow Jones index finished the session up 0.44%, while the S&P 500 jumped 0.54%.

The Fed minutes related to the 14–15 June interest rates meeting, which was held a week prior to the Brexit referendum. Apparently, Fed officials were getting cold feet about further interest rate rises before they even knew Britain would leave the EU.

The excuses given? The Fed was concerned about the US economy and a faltering labour market. This just confirms the trap US policymakers have gotten into. They don’t raise rates when employment growth is strong, and won’t raise them on any sign of weakness.

The Fed missed the window they had for raising rates and the market knows it. They are now on hold for some time. That’s partly the reason why gold (and silver) continue to rise relentlessly higher.

The other reason is the weakness of the pound. The UK’s decision to leave the EU has taken the pound out of contention as one of the world’s major currencies. Gold is in some way filling the void, helped by a prone Federal Reserve, who has gone from a tightening bias, to neutral at best, in a matter of weeks.

The weakness of the pound is emblematic of a number of problems beginning to develop in UK capital markets. That is, capital wants out of the country.  Specifically, it wants out of commercial property.

As Bloomberg reports:

Four more U.K. property funds froze withdrawals as investors sought to dump real estate holdings in the aftermath of Britain’s vote to leave the European Union.

Investors are pulling money from U.K. property funds as analysts warn that London office values could fall by as much as 20 percent within three years of the country leaving the EU. During the financial crisis of 2007 and 2008, real-estate funds were similarly hit by redemptions and forced to halt withdrawals, contributing to a slump in property prices that saw values drop more than 40 percent from their peak in Britain.

But according to our resident property cycles guru, Phil Anderson, you shouldn’t worry about this too much. It’s not going to have an effect on the long term cycle.

Phil reckons the cycle has another 10 years to run. That doesn’t mean you wont see a slowdown or pullback during this time — and Brexit could be a good excuse for a pullback — but it isn’t the end of the cycle.

As Phil wrote in a recent update for Cycles, Trends and Forecasts subscribers:

I am continually staggered by the lack of people prepared to accept the fact that economic cycles exist, let alone make an effort to understand the cause—the enclosure of the economic rent.

This is a tricky concept for many people to understand. Economic rent refers to the fact that land values capture all the benefits of economic growth. Society must pay this ‘rent’ to use the land. The better the land, the higher the rent.

And because land is privately owned (and can be bought and sold like any other commodity), this rent is ‘enclosed’ in a competitive marketplace.

As a result, there will always be competition for prime property because landlords want to collect this rent. The rent then capitalises into land values, and prices go up.

A broad based land tax would remove the incentive to bid crazy prices for land. It would return the economic rent to society (where it belongs) and enable the lowering of taxes on production and labour. But that’s another issue…

The way the system is, cheap availability of credit simply increases the competitive bidding for a chance to get the economic rent. And by the end of the cycle the bidding becomes so crazy that prices collapse.

According to Phil, we’re not at the end of the cycle yet. And Brexit will not bring it about any earlier.

The UK leaving the EU will have little effect on this process in the long run. In fact, it will have no effect at all. Can you see why?

Because the economic rent will still generate, regardless of whether the UK is in the EU or not. And the ‘Brexit’ doesn’t change who collects it.

The entire ‘Brexit’ is merely ‘fluff’ within the wider context of the real estate cycle.

Having said that, London house prices have had a huge run over the last five years (as forecast.) They are due a slowdown. Remember, history says the largest land price gains happen in the second half of the cycle.

So Brexit will cause a slowdown, but not a crash, in UK property prices.

What’s in store for Australia?

Well, a slowdown might be upon us here as well, if the performance of the banks is any guide. The share prices of all the Big Four banks are very close to major lows. If this support level gives way in the weeks ahead, expect to see further large falls. The chart of the Commonwealth Bank [ASX:CBA] is a good example:

Source: BigCharts
[Click to enlarge]

Given the fact that Aussie interest rates are at record lows, and the market is expecting another rate cut in the next few months, the lack of response from bank shares is concerning.

It’s perhaps a sign that Aussie households are maxed out, and don’t have much more capacity to take on debt. Banks survive on debt growth; without it, they cannot grow. So the continual weakness in bank shares is a concern given record low interest rates.

Whether this translates into a flat or falling property market remains to be seen.

Where’s the money-making opportunity in all this?

As I wrote to subscribers of Crisis & Opportunity yesterday, it appears as though financials are no longer responding to monetary stimulus. But real assets are.

In the short term, I think the precious metals horse has already bolted. Of the five gold stocks in the Crisis & Opportunity portfolio, three are up triple-digits, while the other two aren’t far off that.

A big chunk of those gains came in the past two months. So I think the party for gold is in full swing. It’s a bit late to be rocking up now.

But the commodity complex is only just starting to stir. If you’re interested in what’s going on there, and where the opportunities might be, click here.


Greg Canavan,
For The Daily Reckoning

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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