Thoughts through the cycle: W4 July ’20

Share on facebook
Share on twitter
Share on linkedin

Top of the warning to you

  • Perhaps one of the reasons why history seems to repeat itself is that there are only so many things that can actually happen. In ‘Anna Karenina’, Tolstoy writes that, “all happy families are alike; each unhappy family is unhappy in its own way.” The equivalent in financial markets is the “this time it’s different” argument, yet in reality all too often events follow the same old predictable path. Down under in Australia, the housing market is wobbling, but Prime Minister Scott Morrison has recently been quoted as saying,

“I think one of the problems about the commentary about the housing market is too often the analysis has appropriated the conditions of other places and applied them to Australia, and that application has been completely misguided.”

  • This is a classic case of claiming exceptionalism. Australia has gone for 30 years without a recession, and avoided the worst of the global financial crisis (GFC) due to its fortunate position as exporter-in-chief of metallic ores and coal to China. Things are however looking bleak – the flow of immigrants into the country has stopped, and the boost this provided to the housing market (especially rentals) has gone into reverse. Tensions with China are on the rise, and Australia finds itself having to choose between economic reliance on China and political alliance with America during the open stages of what could become a new cold war between the two countries. The Australian banks stand in the middle of this. Are there any precedents that should guide investors about how the Australian situation plays out?
  • The answer is yes, and it didn’t end well. The story of Ireland during the GFC offers some unfortunate parallels to the story playing out in Australia, albeit currently at very early stages. Ireland went into the crisis with a remarkably low government debt to GDP ratio of 24% but with an epic housing bubble, and with a small number of domestically-focused banks with notable concentration risk in the commercial and residential mortgage sector. Low interest rates resulting from the adoption of the euro had created a property boom, especially for investment rather than owner-occupied housing. With the credit crunch, the boom came to a shuddering halt. In what was possibly the most cavalier gesture in the history of bailouts, the Irish government not only back-stopped deposits but the whole asset-base of the banking system. Arguably, this made the state insolvent in an instant. Government debt-to-GDP peaked in 2012 at 120%. Without the ability to devalue its currency, Ireland suffered a period of internal devaluation and austerity which severely strained its relations with Brussels and the other European member states.
  • The set-up in Australia is remarkably similar. Government debt-to-GDP heading into 2020 was 42%. According to data from the Bank of International Settlement (BIS), household debt-to-GDP started the year at a staggering 120% (down from a high of 127% in 2016). For reference, this ratio for the US entering the GFC was 99% (this has fallen to 76%), and for Ireland it was 117% (now 44%). Currently the global average is 72%. Australia sits in second place behind Switzerland, but the concentration of debt in housing – especially investment housing – makes US subprime look positively conservative. It has even generated its own set of terminology, notably the idea of ‘negative gearing’; a property investment which is loss-making in terms of cashflows (rent, mortgage, taxes etc) but where an overall gain is expected due to capital appreciation. As the Aussie tourist board advertisement from 2006 asked, “where the bloody hell are you?”. Soon to be under water it seems.
  • The pandemic and lockdown has hit Australia much in the way it has elsewhere. The Reserve Bank of Australia (RBA) has cut its cash rate to 0.25% from 0.75% pre-crisis, as well as initiating quantitative easing (QE) but with the addition of yield curve controls – the RBA is targeting a 3-year yield of around 0.25%. This has created an upwardly-sloping yield curve as can be seen from the graph below (the current Australian sovereign yield curve in green, year-end 2019 in yellow). All else equal, a pleasantly upward-sloping yield curve ought to be good for banks as this ought to allow them to borrow short and lend long in a profitable manner. Profitable lending is not the issue at hand.

Source: Bloomberg, 20th July 2020

  • Along with extraordinary monetary measures, the pandemic saw governments globally allow ‘mortgage holidays’ for borrowers. These were not targeted at those who had lost their jobs. They appear for the most part not to have been targeted at all. With respect to deferred loans, data from the Australian financial regulator (the APRA, Australian Prudential Regulatory Authority) at the end of May 2020 showed 11% of all housing loans are currently not being serviced (this is despite the official unemployment level having only risen from 5% to 7%). Of these deferred loans, 34% are for investment properties, and 14% are interest only. Clearly this shows the speculative buy-to-let part of the market being hit first and hardest.
  • At low interest rates, servicing mortgages is made more manageable. A problem occurs when unemployment rises as household cashflows fall. While the headline unemployment rate is 7.1%, Treasurer Josh Frydenberg has recently been quoted as saying the effective rate is nearer 13.3% due to the limbo that many find themselves in from furlough arrangements. Job-keeper allowances were due to expire on 27th September, but have been extended, albeit with a tapering of payment amounts over time. In any case, pressure is starting to appear in terms of falling property rental prices, more sale listings, lower prices being accepted to clear at auction and so on. That all this is happening at very low rates and with ample bank liquidity stands in sharp contrast to the backdrop of the credit crunch that Ireland found itself in during 2007.
  • The effect on banks is clearly making itself felt. The graph below shows a basket of the big four Australian banks (Westpac, Australian & New Zealand, National Australia Bank, Commonwealth Bank of Australia) in yellow, the ASX 200 Australian Equity Index (blue), and the MSCI World Index (red). Amidst a global equity market rally of exceptional ferocity, the drag of the Aussie banks on the overall index is clear to see. It is worth noting too that the dividends paid by the banks (now largely suspended) were a major contributor to Australian income funds. Those who remember Ireland’s travails during the GFC will remember bank equity largely being wiped out as well as a bad bank (NAMA – National Asset Management Agency).

Source: Bloomberg, 20th July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Looking more closely at the Australian banks, the context is an industry already under pressure following a Royal Commission into loan mis-selling. Westpac is also being investigated for money-laundering and the financing of terrorism. In general, the banks’ capital position is better than that of the Irish banks in 2007. At Q1 2020 results, National Australia Bank (NAB) had a core tier 1 (CET1) of 10.4%, while in 2007 Allied Irish was at 5.7% and Bank of Ireland was at 5.2%. The profitability problem though is clear: in Q1, NAB’s net operating profit after tax (NOPAT) fell 51%, the dividend was cut to AUD 0.30 from AUD 0.83 while expenses rose 1.8%. Given the potential vulnerability of the housing market, the real worry is that provisions only rose AUD 1.262b to AUD 5.228b – this is only 1.2% of risk-weighted assets (RWA’s), with a worst-case loss modelled at just AUD 3.8b. An Irish-like crash would clearly see these losses increase incrementally. The banks are already tightening lending criteria, almost ensuring that the property market continues to perform weakly.
  • The pivot is of course the state of the global economy. If the recovery loses steam as the bond market is predicting, then the immediate future looks deflationary, clearly a bad situation for the housing market. Melbourne in Victoria has again moved into lockdown (this state is 25% of Australian GDP). Property crashes are slow as the transaction process is a protracted one. The danger is that the asset-side of the banks’ balance-sheets becomes compromised, and that write-downs will necessitate government bailouts – the likelihood of bailouts happening should circumstances warrant is extremely high given how important the housing market is to the Australian economy and to the Australian psyche in general.
  • If Australian government debt following a bail-out were to start to follow Ireland’s exponential path higher in the GFC, one would assume that the Australian dollar would start to wobble. (While the euro did depreciate against the dollar during the Eurozone crisis, the move would have been dramatically higher had the Irish still had the punt – the Icelandic krona halved during this period.) Australian foreign liabilities have fallen to a 21-year low of 40% of GDP, but there is a potential balance-of-payments issue given the growing conflict with China. China has already restricted imports of beef. It is not inconceivable that these could be extended to coal, iron and copper. The growing tension between Australia and China will become a key vector for Australia’s economy and currency from here.
  • The graph below shows the Australian dollar (yellow) against copper (blue). Despite the obvious issues in the Australian banks and the property market, the Aussie dollar has rallied as part of the general global re-leverage-cum-reflation move. Copper is clearly in the same boat, helped by supply issues in Chile due to the Covid-19 virus. Australia is obviously a major copper producer and exporter, so there is some logic to this correlation.

Source: Bloomberg, 20th July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • If the world suffers a double-dip recession and a more extended period of deflation, the housing market and banks will be vulnerable – the US banks reported last week and were flattered by credit-trading profits. Loan loss provisions continue to rise there. Given the size of their residential property market, the problem for Australia is more profound. The concentration of risk amongst the big four banks is more substantial. The risk to the currency as a result is great, and made greater by the context of the burgeoning cold war with Australia’s key trading partner, China. Unlike Ireland which found itself within the cold embrace of the European economic archipelago, Australia would find itself increasingly isolated like the Galapagos. Good luck, mate.

Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 23rd July 2020.

The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.

RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.

This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.

RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.

Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.

The information transmitted is intended only for the person or entity to which it has been given and may contain confidential and/or privileged material. In accepting receipt of the information transmitted you agree that you and/or your affiliates, partners, directors, officers and employees, as applicable, will keep all information strictly confidential. Any review, retransmission, dissemination or other use of, or taking of any action in reliance upon, this information is prohibited. The information contained herein is confidential and is intended for the exclusive use of the intended recipient(s) to which this document has been provided. Any distribution or reproduction of this document is not authorised and is prohibited without the express written consent of RWC or any of its affiliates.

Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.

AIFMD and Distribution in the European Economic Area (“EEA”)

The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.

In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).

Information Required for Distribution of Foreign Collective Investment Schemes to Qualified Investors in Switzerland

The representative and paying agent of the RWC-managed funds in Switzerland (the “Representative in Switzerland”) is Société Générale, Paris, Zurich Branch, Talacker 50,

P.O. Box 5070, CH-8021 Zurich. In respect of the units of the RWC-managed funds distributed in Switzerland, the place of performance and jurisdiction is at the registered office of the Representative in Switzerland.

Explore more

INVESTOR TYPE SELECTOR

Please confirm your investor type

Professional

Non-professional

By clicking Submit, you agree that you have read and accepted the terms and conditions detailed in the DISCLAIMER

This website uses cookies. A cookie is a small data file placed on your computer which captures information about your choices which allows us to improve your experience of the website, for example, by remembering your country of residence. By continuing to access this website, you agree to be bound by our Cookie Policy. You can accept and/or block at any time by changing your browser settings.

SELECT YOUR REGION

Where are you located?

Europe

Asia-Pacific

Rest of world

By clicking Submit, you agree that you have read and accepted the terms and conditions detailed in the DISCLAIMER

INVESTOR TYPE SELECTOR

What type of investor are you?

Professional

Non-professional

By clicking Submit, you agree that you have read and accepted the terms and conditions detailed in the DISCLAIMER