The Property Cycle Keeps on Going

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Aussie stocks are set to take a breather today as German banking giant Deutsche Bank resumed its fall in the US overnight. In addition, healthy economic data out of the US increased the odds of a US rate hike this year.

Stocks don’t like the prospect of tighter money; hence the selloff. The Dow and the S&P 500 both fell around 0.3%. Oil continued its rally, while gold fell to around US$1,312 an ounce.

Keep an eye on the Deutsche Bank story, dear reader. It’s one you’ve heard many times before, and will hear plenty of times again. But it’s always interesting to see how it unfolds in real time, without the benefit of hindsight.

The bank is clearly in trouble. The market knows it, and the bank knows it, too. Yet it will still go through the charade of pretending to be solvent, and in strong financial health, or whatever.

Banking is always about trust. When highly leveraged institutions like banks lose the market’s trust, they are as good as dead. Deutsche Bank is in the process of losing the market’s trust. You’re witnessing it happen.

The only question is: How does the bank die? Or will it be kept on life support for as long as it takes? Yes it will…although I’m not sure what that means exactly, or what kind of damage it will do to the European and global banking systems.

Markets have been conditioned to believe that banks cannot fail. That’s why you’re not seeing too much stress in equity markets over Deutsche’s issues. But if the central planners managing and massaging global markets get this one wrong…look out!

Not that I think a sinking Deutsche Bank will kick off a GFC Mark II. But it will cause a nasty short term panic that could quickly wipe 20% of the value of global equity markets.

Now that we’re in the month that brought us the panic of 1907, the crash of 1929, and the infamous Black Monday of 1987, there would certainly be some symmetry to another October panic.

But don’t worry, the Fed will be there, ready to buy shares and prop up markets should things get out of hand.

That’s right. While the market is preparing for an interest rate rise from the Fed, last week, boss Janet Yellen raised the possibility of the Fed buying equities if need be. As reported by Reuters on Friday:

The Federal Reserve might be able to help the U.S. economy in a future downturn if it could buy stocks and corporate bonds, Fed Chair Janet Yellen said on Thursday.

Speaking via video conference with bankers in Kansas City, Yellen said the issue was not a pressing one right now and pointed out the U.S. central bank is currently barred by law from buying corporate assets.

But the Fed’s current toolkit might be insufficient in a downturn if it were to “reach the limits in terms of purchasing safe assets like longer-term government bonds.”

“It could be useful to be able to intervene directly in assets where the prices have a more direct link to spending decisions,” she said, adding that buying equities and corporate bonds could have costs and benefits.

Just when you thought that the failure of QE would lead to a rethink of the Fed’s policies…you get this!

The Fed obviously thinks that it hasn’t done enough. It knows that, when the next downturn hits, it will not have enough interest rate ammunition to fight it. Moreover, it will not be able to launch another big round of QE (buying US Treasuries) because it will screw up the market’s ‘plumbing’.

That is, it will take too many treasury assets out of the market — assets that the market needs as collateral.

So why not buy stocks instead? Because higher stock prices will, of course, get people to spend more money. I mean, record stock prices in the US are obviously the driving force behind the resurgent US economy, and not the other way around.

As dangerous as this type of thinking sounds, it’s exactly the type of growth model promoted by our own central bank. For the past few years, the RBA’s strategy has been to cut interest rates, push house prices higher, and watch spending increase due to the magic of the ‘wealth effect’.

I’m not sure how much longer this growth model has to run. The latest national accounts showed household spending growth at the slowest quarterly rate since 2013.

August’s interest rate cut might give households another short term boost in the September quarter, but that remains to be seen. The fact of the matter is that, despite record high house prices, household spending growth is slowing. This just goes to show how focusing on the ‘wealth effect’ is an unsustainable growth model.

While the RBA is likely to keep rates on hold today, you can bet that they will continue to cut rates in the future if need be. It’s the only tool they have.

And if you’re thinking that house prices can’t keep rising, I’m sorry to say that our property cycle expert Phil Anderson doesn’t agree. Phil called the start of this cycle years ago, and he expects it to run its course for years to come.

If you haven’t seen Phil’s work before, you can check it out here. If you’re interested in the property market at all, you simply need to see his unique and uncannily accurate take on the Aussie property cycle.

Cheers,

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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