The Iron Ore Bust into a Housing Boom

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Irony is thick on the ground this morning as we head into a shortened Easter trading week. Just as Sydney property prices go absolutely bonkers, the iron price crashes.

Of course, revenue from the great iron ore boom helped to fuel the housing bonfire, along with regular petrol douses from RBA boss Glenn Stevens. But now, with iron ore crashing, property prices continue to detach from reality. It’s a cheap money driven boom if there ever was one.

In case you missed it, the benchmark iron ore price finished trading on Friday down US$2.22 to US$53.14, a new low. It was another dose of irony that probably knocked the price lower.

Last week, Fortescue Metals [ASX:FMG] Chairman and major stakeholder Andrew Forrest implicitly called on iron ore miners to form a cartel to control the price (and save his company from a slow death). Rio Tinto [ASX:RIO] boss Sam Walsh replied with scorn, which the market interpreted to mean that Rio will continue to dig up as much red dirt as it can. Hence the price crack on Friday.

The comments from Forrest indicate just how much damage the iron ore bear market is having on marginal cost producers. Aussie juniors won’t survive this price rout. It’s just a matter of time before they fold.

Fortescue’s cost curve is a little better than the juniors, but at current prices my guess is the company is barely making a profit. When you have a heavy debt load, that’s a dangerous situation to be in.

If Fortescue isn’t making a profit at these levels (after interest repayments), then it begs the question why it’s equity value is still around $6 billion. Clearly, the market thinks the low iron ore price environment won’t be sustained and that Fortescue will return to profitability.

That’s quite an assumption given the current state of the iron ore market. The biggest, lowest cost producers all have expansion plans in the works over the next few years. This wall of new supply hits at a time of waning demand. As The Australian reports this morning:

The unprecedented growth in Chinese steel production that underpinned Australia’s iron ore boom of the past decade could be over, with early signs this year’s production will fall for the first time in three decades.’

That’s right folks. China’s steel demand is set to fall as its credit bubble unwinds. Who would’ve thought!

Not the iron ore miners. They all consistently said China’s steel output would grow to over 1 billion tonnes per annum by 2030 and plateau at these high levels. Instead, it looks like steel output peaked in 2014 at around 840 million tonnes.

Fortescue CEO Nev Power is still flogging that lame horse — Chinese urbanisation — to talk up the prospects for iron ore demand. He’s at the Boao Forum in China and latched onto comments that there is still another 300 million Chinese awaiting ‘urbanisation’. The Australian quoted Nev as saying:

There’s a massive amount of steel required in the coming decades. I think the only question is how quickly that steel and infrastructure will be built, which will determine the amount of steel per year.

Not quick enough, Nev. Not quick enough…

Iron ore’s renewed woes helped to end the mini-rally that was underway in the Aussie dollar last week. As I mentioned though, much of that rally had to do with ‘short-covering’ (traders buying back positions) following a surprise interest rate announcement from the US Fed. Now reality is coming back into the market…the Aussie is back down to around US$0.775.

Meanwhile, reality is nowhere to be seen in the Sydney property market after another strong weekend of auctions. Dr Andrew Wilson, ‘senior economist’ with the Domain Group (Fairfax’s property listings site), saidthat, ‘This could not have been rationally predicted — the highest clearance rate on the biggest auction day ever. This is the hottest of hot auction markets ever."

So at a time when the price of Australia’s prime export is imploding, taking national income growth to near zero, speculation in the country’s largest property market detaches from reality. It’s all limbic brain in action…the neocortex isn’t getting a say.

In other words, it’s all getting very emotional. Crazy, almost.

On Friday, Domain published an article by Lindsay David, a noted bear on housing and the Aussie economy. His analysis is mostly driven by the neocortex, the rational/reasoning part of the brain.

He hit the nail on the head in the first paragraph:

By all accounts, Australia is experiencing what is one of the greatest credit-fuelled real estate bubbles in modern times. On the back of a collapsing mining sector, we can thank the RBA, APRA, ASIC and the political elite in Canberra for creating a flawed household wealth-creation strategy that shares all the hallmarks of a predictable economic disaster.’

This is the real nub of the issue. The political and regulatory class have created a flawed household wealth creation strategy that will do untold damage to the Aussie economy in the years ahead.

Higher houses prices — driven by ever increasing amounts of debt — do not create wealth. It creates a redistribution of wealth from non-homeowners to homeowners and from the young who take on debt to the older generation who sell an inflated asset. It’s wealth redistribution, not wealth creation.

Take a recent high profile sale in Sydney. A San Souci red brick waterfront home sold on the weekend for $6 million. Sans Souci is in Southern Sydney. It may be waterfront, but it’s not Sydney Harbour…it’s where the George’s river flows into Botany Bay.

So $6 million is quite of chunk of cash, especially because the house is 73 years old and will likely be knocked down.

Was there wealth created here? There certainly was for the vendor, who no doubt did well out of the sale. But did that wealth come at the expense of the buyer?

The only way to make the purchase an economic one (assuming it’s partially debt funded) is to build a bunch of luxury apartments on the site and sell them or rent them out at a very high price.

More than likely, the rent wouldn’t cover the cost. But that’s okay. Who buys a property for income returns these days? Thanks to negative gearing and concessional capital gains tax treatment, you buy to get a tax break and make a capital gain.

Whether renting or on-selling, both options would involve another round of debt and wealth transfer. In the case of the renters, a large sum of money would go towards housing expenses each week, taking away disposable income that could be spent elsewhere.

As Lindsay points out in his article on the expense of servicing debts now on a median house price in Sydney:

Based on median multiples, new home buyers in Sydney will spend the better part of 6.54 years savings (using 30 per cent of their income) for a 20 per cent deposit to buy a median-priced home.

When it comes to servicing the first 12 months of a 25-year/80 per cent LVR mortgage, it will cost roughly 65 per cent to 70 per cent of household income to service that debt at current record-low mortgage rates. Melbourne is not too far behind.

65-70% of household income to repay housing debt on a median priced house is astonishing. No wonder the rest of the economy is struggling. After debt repayments and essentials, there isn’t anything left to spare.

As my colleague Phil Anderson likes to say, land values capture the wealth created by society. But it also captures the value of the debt that society takes on to speculate in land.

Mistaking this debt capture as wealth is a fatal flaw for any society to make. We’re making it right now. And it will be to our detriment.

Greg Canavan+,
for The Daily Reckoning Australia

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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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6 Comments on "The Iron Ore Bust into a Housing Boom"

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slewie the pi-rat
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good rant. oh, hell: a great rant! “The political and regulatory class have created a flawed household wealth creation strategy that will do untold damage to the Aussie economy in the years ahead.” well, the ARE the RULING class! and they hafta protect THEIR interests in YOUR wealth, do they not? “they” are also “only” following the “examples” of their “allies”, anyhow, are they not? the idea that any of those who RULE actually care about anybody else [especially those with no-to-low-to-middling “net worth”] is getting pretty quaint, even in Oz, isn’t it? we have been locked out of our… Read more »
Ray
Guest

“we have been locked out of our own political processes” That is the crux of the matter. The entire idea of the “political process” is to lock someone out and delegate him to serfdom. Once you’ve conceded that the “political process” is the correct way to settle the matter of a man’s rights you’ve lost the game. Thanks for playing mate and stop whining like a sore loser!

HB
Guest

It’s been idiotic economic bubble management for a long time. Maybe this iron ore bust will pop it this time. But maybe it will be an excuse for ZIRP, to keep it going further yet to the further benefit of the land owning majority.

Jason Hall
Guest
Ok, I understand what is being stated & that in the end it will be biting many (if not all) of us on the boney bums, BUT I’m now confused as to what us individual homeowners should do about it. Should those who owner a home (with a mortgage of course)be looking to sell & capitalise on the high prices, or sit tight?? If gets out of the coming crisis & sells, then we are facing those exorbitant rents you were talking about. But if one sits tight then you run the risk of either higher interest rates &/or the… Read more »
Raoul Duke
Guest

Welcome to the country of tax apartheid.

kim
Guest

Terrifying stuff. Who’s going to stop the flow of easy credit? No one wants to trigger a recession. The RBA will probably keep cutting interest rates. The liberal party will probably do whatever they can to keep prices high until they get booted out in 2017.

When we do have the inevitable recession, so many people who’ve bought houses recently, esp the young home buyers are going to see their savings wiped out when their house values plummet. Paying 65% to 70% of their income on a massive loan for a house that isn’t worth nearly as much.

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