Thoughts through the cycle: W4 July ’20

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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.

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