Mortgage Bubble and More at Stake Between Australia and China

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A quick note on yesterday’s invitation to the “Australia in the Red” summit, to be held in Melbourne on Friday, July 31st from 7pm to 11pm at the State Library of Victoria. We’re still accepting requests to be put on the list to buy tickets. We can’t guarantee you a ticket (only available on a first come, first serve basis). But according to our web wizards, there are still a few spots open. We also received more than a few requests to host a similar event in Sydney. We’re on the case!

And now back to the financial markets….

Go you little Aussie mortgage bubble! The value of new mortgages grew in May by 2.2%, according to the Australian Bureau of Statistics. For the month, investors boosted their demand for new mortgages at a faster clip than people who intend to live in the house (owner occupiers). That doesn’t sound like a bubble at all does it?

Two other items of note in yesterday’s housing numbers. The First Home Buyer’s consolidated their position as the most important group propping up Australian house prices. First home buyers increased their percentage of total owner-occupied mortgage demand from 28.6% in April to 29.5% in May. Nearly a third of all demand for new mortgages is coming from new buyers sucked in by the grant. Hmmn.

One final note. The average loan size for the first home buyer was $281,000. That was actually a $3,400 fall from the month before. But it’s still $14,400 higher-or about 5%–than what the average loan size of all the other borrowers in May ($266,900). Max out your borrowing at the low point of the interest rate cycle. Hmmn.

Moody’s economist Matt Robinson told a reporter that, “The policy stimulus from the Federal Government and the central bank has helped boost the housing market, offsetting the deterioration in the labour market conditions that would otherwise subdue the willingness of people to purchase houses…This is a ‘prime example” of monetary and fiscal policy working.”

That statement seems like a ‘prime example’ of getting the analysis absolutely wrong. We’ll explain why in a moment. But first, a word about abductions.

What the heck is going on in Shanghai? Chinese police have detained Rio Tinto iron ore executive Stern Hu on suspicion of “espionage and stealing state secrets,” according to Bloomberg. Hu hasn’t been charged with a crime yet. Three other Rio workers who are also Chinese nationals are being held.

Incidentally, the Age’s Matthew Murphy is reporting that Chinese steelmakers have agreed to a 33% cut in iron ore fine prices and 44% for lumps. “The deal would break a tense nine months of negotiations between the Australians and the Chinese, which had allowed the June 30 deadline to pass while refusing to budge on their demand for a price cut of up to 45 per cent,” Murphy says.

Let’s recap. In late March, Treasurer Wayne Swan knocked back China Minmetals’ bid for 100% of Oz Minerals based on the proximity of Oz’s Prominent Hill gold and copper mine to the Woomera weapons testing range in South Australia. Then in early June, Rio Tinto abandoned its offer to sell an 18% equity stake to Chinalco and instead raised the money from shareholders and a joint venture with BHP Billiton. And finally, the Aussie ore producers refused to give Chinese steel makers a larger discount this year than customers in Korea and Japan got.

So perhaps there’s some hardball going on now? There are more than just business interests at stake in the relationship between Australia and China. There is national interest too. Interesting times, eh?

Let’s quickly get back to that nonsense from the Moody’s economist about policy stimulus ‘working’ by supporting the housing market. It could be a simple case of diagnostic failure. He said the policies are, “offsetting the deterioration in the labour market conditions that would otherwise subdue the willingness of people to purchase houses.” But is this true? And if so, is it something to celebrate?

First off, throwing money at people to buy a house when they are at risk of losing their job doesn’t seem like a good policy at all. It seems reckless. It also seems like the height of stupidity. But the larger issue is whether you can correct a problem if you don’t really understand its causes.

The correct answer would be, “no.” The policy responses inspired by John Maynard Keynes call for the government to run a deficit and spend money that households and businesses will not. But this response assumes that aggregate demand (household and business spending) has fallen for no good reason at all and that all the government has to do is restore confidence (by stimulating the appearance of health) and everything will be fine.

Balderdash! The problem isn’t that demand has fallen unreasonably. It’s that credit rose too much. The economy needs to walk itself back to more production (creating value) and less credit-financed consumption. Recessions aren’t caused by too little spending. They’re caused by spending gone wrong in a credit boom (mis-allocated capital).

In his latest Gloom, Boom, and Doom Report Dr. Marc Faber says, “This is where I have the greatest problem with US economic policy makers [ed note. We’d add Australian policy makers to the mix]. I don’t think they have ever recognised that the excessive, credit-driven expansion of the US economy was unsustainable in the long run and that, sooner or later, the current crisis was inevitable. But not only that!”

“Now that we all know that the monetary policies implemented after the Nasdaq bubble burst in 2000 led to the current crisis, US economic policy makers are attempting to restore economic growth through essentially the same policies; the difference, this time, being that gigantic fiscal deficits are also being created.”

To be fair, not ALL Aussie policy makers are making the same mistakes. As we reported yesterday, Glenn Stevens seems to know that in a balance sheet recession, the way back to recovery is to patiently rebuild the balance sheet on a foundation of solid assets and reduced debt. That’s the course he encouraged businesses to take.

It’s Australia’s government that has us worried, and it’s both parties frankly. The worse the recession gets (it IS a recession and it will probably get worse, we reckon) the more tempted (and forced) the government of the day will be to borrow more and more and run the deficit higher and higher. This won’t be good for confidence in Aussie assets.

Speaking of which, Faber also had something to say about the on-going feud between inflation and deflation. “Asset markets,” he wrote “are buffeted by recurring waves of inflationary and deflationary expectations and I’m afraid we might now run again into a bout of deflationary fears. But unlike the deflationists, I don’t expect new interest rate lows in this cycle.”

“The interesting part about all this is how the various asset classes relate to each other. Equities and commodities seem to move up at the same time (driven by rising inflationary expectations and growth expectations), while bonds and the US dollar move down (the pattern since March 2009). But, when deflationary expectations increase, the US dollar and bonds strengthen while commodities and stocks decline (the patter of 2008).”

If Faber right and the deflationistas have the upper psychological hand, bond prices and the U.S. dollar go up and stocks and commodities will go down. For Australia, you’d probably see a weaker Aussie dollar versus the greenback and lower stock prices too. Meanwhile, the government will try to restore growth by running large fiscal deficits which may stabilise the economy a bit, but a lower level of output (as businesses stay on the sidelines with investment spending).

So how much lower could stocks go? Faber thinks it will be a few years before stocks make new lows (below the 2003 levels, we assume). He says stocks were oversold in March but overbought in June. Stocks are now priced for an economic recovery that looks increasingly illusory.

Two other things from the good Doctor. He expects to see rebounding corporate profits as businesses begin to reap the earnings benefits of cost-cutting and deleveraging. They will be coming off a low base anyway. So he may be right to consider the dismal upcoming profit season as a contrarian nadir.

The other interesting observation is that there is still a large cash position in the market. In fact, according to The Bank Credit Analyst, cash as a percentage of the Wilshire 5000 (the broadest index of U.S. stocks) is at its highest level ever. It’s a veritable mountain of cash.

If we’ve done our maths correctly and the Wilshire has a total market capitalisation of nearly US$9 trillion, that means there’s about $8 trillion in cash, money market funds, and savings waiting to hit the road. Where will it go?

It doesn’t look like investors are buying the “green shoots” line being peddled by Ben Bernanke. That means the cash may not be going anywhere. Or-again using the Faber thesis-it could go into U.S. bonds. Faber also says that on a price-to-book basis emerging market stocks look a lot more attractive than U.S. stocks.

We reckon U.S. investors are still scorched from the last two years and would be reluctant to get back into the market with authority via emerging market stocks. That alone might make emerging market stocks good value for money. It doesn’t really tell us where all the cash might go, though, does it? We can think of a few places and will have more to say about it tomorrow. Until then!

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Regarding Mr Hu there are a number of contextual issues.

    First of all the Chinese Government are very good at their own espionage. When I travelled to Beijing several years ago, I was told to assume that every room is bugged and it was. Before you go you have the hard disk of your laptop scrubbed down just to make sure. Speaking to American Embassy staff in a compound for happy hour drinks the bugging issue was regarded at a bit of a joke – we even had one way conversations with the concealed State Security guys in the tall building next door. Long distance listening devices are used to eavesdrop everything. Over the road from one of the embassies is a stake house at which the tables are bugged. Locally engaged Chinese staff at all the western embassies are debriefed (metaphorically) by State Security on a monthly basis.

    Second Issue: The substance of 99% of the espionage from the Chinese side has absolutely nothing to do with cold war military type issues. Its all about industrial // commercial-in-confidence type stuff. Trade secrets!

    Thirdly issue: Hu is an ethnic Chinese name. This means that State Security may treat him more as one of their own. In any case, as a RIO rep he is not afforded the privileges of an official or semi-official passport from a western government.

    Fourth Issue is PAYBACK. If the Chinese RIO deal had gone through you could be absolutely sure that these arrests would not have happened. Dan D was wondering several weeks ago what the payback would be and now we know.

    The Chinese well know that those who live in glass houses should not throw stones and on this basis the eventual outcome for Mr Hu is likely to be release and expulsion. Any dirt they may or may not have on Mr Hu is in fact irrelevant to the final outcome though obviously State Security believe they have some dirt. I can’t predict what will happen to Mr Hu’s Chinese National colleagues, except to say they will be under extreme (and I mean extreme) pressure to tell the investigators what the investigators want to hear.

    The message to the world is that if you want a long term partnership with China, don’t abuse the relationship or treat them as patsies. China holds an upper hand. As for the impact of this on RIO’s positioning in China I can’t guess.

    Coffee Addict
    July 9, 2009
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  2. CA, let’s wait and see. Smith blew smoke early and then quickly toned it down. This means he might not be one of ours but might well be one of someone elses. Hu is a Chinese. The ring in their words when describing themselves like this is one that claims “species”. It sounds likely he has dual nationality due to the carefull wording in the reports. In that case he is on a hiding to nothing anyway. This is not good for us but I think the idea of crude payback underestimates the Chinese. I think the underlying tension is that they want us to go further and quicker than we feel it is safe for us to go. I’m pretty sure they know we won’t sell them mountains like they have been allowed to do in South America or we have been allowed to do in Africa. We also don’t want their USD cash, better that we keep the value in the ground than having to revert to brinkmanship with export taxation on foreign owned local assets. When visiting you do get a little more attention and even dare I say it respect from the Chinese when you have some intent to hide. And that’s from someone who enjoys their company and most of their sensibilities.

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  3. I read with interest your analysis of recent trends in household finance applications and mortgage indebtedness, particularly the inference to a potential housing market bubble some commentators are calling. The emergence of a bubble may well be true—residential property prices are up 5% this year in Sydney, at a time when house prices are capitulating in a number of other developed economies.

    But I don’t understand your criticism of the comments attributed to the Moody’s economist by a reporter (re: “[t]his is a prime example of monetary and fiscal policy working”). Granted, most reporters take comments out of context and/or publish them selectively to fit their own story. But regardless, you would be hard pressed convincing anyone that the recent rise in housing finance applications and building approvals are anything other than a result of the dramatic interest rate reductions by the central bank and subsidies offered by federal and state governments encouraging activity in the housing sector. It certainly isn’t a result of rising incomes, or buoyant consumer confidence, or because Australian house prices are undervalued relative to other asset classes. They aren’t. And, so, the recent increase in housing finance and building approvals is, unequivocally, an example of monetary and fiscal policy working.

    Whether or not you support the use of monetary and fiscal policy in this way is a completely separate matter. There are many commentators worried by the recent policy-induced increase in household indebtedness of the most vulnerable to losing their job. There are probably even more commentators worried about the use of government funds to (temporarily) support a sector that may in all likelihood need to go through some form of correction just like nearly every other asset class has in the past 12 months. And I’m certain there are more than enough commentators willing to argue against the merits of debt-fuelled fiscal stimulus to support aggregate demand. But it doesn’t change the fact that the government has chosen this path and that, rightly or wrongly, the government appears to be achieving its desired goal if one looks at rising housing finance applications and building approvals in recent months.

    Housing Market Watcher
    July 9, 2009
    Reply
  4. Initially the 20% deposit system is providing a buffer to ensure that the banks are not over-leveraged in any individual property transaction. But the flip-side is that individual home-owners must commit many years savings (plus equity from their parents abode usually) into a first-home purchase. If either the property market cools and prices subside (likely once the first home-buyers grant bubble bursts) or the first home-buyer finds themselves unable to service mortgage costs either because interest rates rise or income falls (both likely) then both the savings of the offspring and the equity of the parents will be wiped out.

    Bear in mind that many middle-class, established families have climbed the property ladder in recent years. They’ve used rising home prices to extract increased equity from their existing home which in turn they used to leverage into much larger home investments (initial 20% deposit plus $n,000 increase in equity = 20% deposit on much larger principle sum). If home prices stagnate then this ladder-climbing activity will stop dead, there’ll be no-one around in the sub-million dollar market and the market will collapse. And parents will stop lending to junior because they’ve not got the equity they once had. Middle-class home-owners are going to get absolutely clobbered and it’s the 20% rule that will force it.

    Current government policy, therefore, is trying to support house-prices at all levels by stimulating the bottom rung of the ladder. But it’s just serving to bring the bubble to the boil and cause much more pain when the bubble finally collapses. Watch out!

    TrickiDicki
    July 13, 2009
    Reply
  5. Useful warning, Dan! But that cash will head to the best investments and those will not be in paper! 3Bn people want western standards of living, that’s a lot of minerals and coal!

    Pat Donnelly
    July 30, 2009
    Reply

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