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Interest Rates and Financial CrisisBy Roger Montgomery
In an environment of low interest rates (that will eventually rise), and record high asset prices (that will eventually decline), now is the time to instruct to your adviser to investigate alternative strategies such as market neutral funds. After reading today's column you may be asking your adviser or the team at the family office team to 'speed it up'.
Back in February this year I wrote; "Drop a pebble in a pond and eventually everything in the pond experiences the change in conditions as the waves radiate from the point of impact…The waves emanating from China's 'dropped pebble' have already hit Australia's west coast. One suspects that as those waves hit landfall their velocity slows, but it looks like the east coast of Australia is still going to get wet."
Today, the downturn in Perth is being described as the worst in 40 years, with 500 people leaving WA each month - according to Bank-West’s chief economist Alan Langford - and geologists with 10-years experience driving for Uber. Meanwhile, West Australia’s state net debt has grown to $27 billion from $3.6 billion just eight years ago. Keep that debt in mind. We’ll return to debt in just a moment.
Meanwhile Corelogic notes that Perth’s median house price has fallen slightly more than 10% since 2014 and commercial vacancies are higher than at any time since 1995.
Living on the east coast of Australia you wouldn’t know there’s a problem, but like beachgoers unaware of a tsunami hurtling towards them, all of Australia might soon be engulfed in something far direr than leveraged property speculators in Sydney, Melbourne and Brisbane would like to believe.
Carmen Reinhart and Kenneth Rogoff wrote the New York Times Bestseller This time is different – Eight centuries of financial folly.
The book provides a quantitative history of financial crises and their basic message is simple:
There is always, and without exception, one common theme to the vast number of crises the world has experienced. That commonality is excessive debt accumulation, irrespective of whether it is by the government, banks, businesses or consumers. And the accumulation of debt almost always poses greater systemic risks than it seems during the boom, while the injection of cash makes the economic growth that results look more sustainable than it really is.
Reinhart and Rogoff show that throughout history private sector borrowing binges have inflated housing and stock prices, while simultaneously making banks seem far more stable and profitable that they really are.
Sounds ominous doesn't it?
According to the authors, the study of eight centuries of financial crises reveals a standard and repeating set of leading indicators to a financial crisis.
- Asset price inflation, particularly real estate,
- Rising household leverage,
- outsized borrowing from abroad and reflected in a sequence of gaping current account and trade balance deficits, and
- Slowing economic output.
Each of these pre-conditions now exist in Australia.
We have written extensively about bubble-like conditions in Australian property and repeatedly warned investors to eschew leveraging to buy property, particularly apartments which will soon be in oversupply.
Australia residential real estate is some of the most expensive in the world on a House-price-to-income ratio basis and yet supply is increasing rapidly further into oversupply as high rise construction activity rises exponentially. These two conditions simply cannot coexist for very long.
Returning to debt and the expansion of WA’s debt from $3.6 billion to $27 billion under Premier Collin Barnett’s watch is only one of the many interesting revelations about Australia's profligacy.
The history of financial crises reveals that borrowing binges precede the crisis. Prior to the GFC, US policy makers should have noted that the rise in asset prices was being fuelled by a relentless increase in the ratio of household debt to GDP. This ratio had been stable at 80% of personal income until 1993 before jumping to 120% in 2003 and 130% in 2006. In Australia today, household debt to GDP is rising inexorably and has hit 130%. Over two decades, Australia’s household debt has increased more rapidly than household income. In 1990 household debt to income was 56%, by 2002 it had reached 125%. By April of 2014 it reached 177%. And according to the OECD it now sits at 206% and is only exceeded by four countries including Ireland and Norway.
According to Reinhart and Rogoff, empirical work conducted by Bordo and Jeanne (2002) and the Bank of International Settlements (2005) confirms that when housing booms are accompanied by sharp rises in debt, the risk of crisis is significantly elevated.
Since 2011 a declining percentage of disposable income has been required to pay the debt. This is a direct result of consistent declines in interest rates despite increasing levels of debt. According to the ABS, interest payable was 7.49% of disposable income in 2014. It seems insignificant except that it has not been declining as fast as interest rates, which suggests that debt has increased.
Australians have simply debt-funded more expensive houses and now have less money to pay for it all, especially if interest rates rise. When interest rates on mortgages do increase, borrowers will have more debt to service and less capacity to repay.
In the United States, prior to the subprime crisis, US Federal Reserve Chairman Alan Greenspan branded as alarmists those who worried excessively about the burgeoning US Current Account deficit which reached 6.5 percent of GDP. In 2015, Australia recorded a Current Account deficit of 4.60 percent of the country's Gross Domestic Product, compared to an average of 3.24 percent since 1960.
Those who might suggest 'this-time-is-different' will point to globalization, for the rising Current Account deficit, that allows much larger surpluses and deficits to be carried.
Investors should remember however that a Current Account deficit simply means revenue from exports are insufficient to meet the cost of imports.
An examination of all 19 bank-centered crises since WWII reveals that the average current account deficit increases from 1% of GDP four years before the crisis to 3% of GDP in the year prior to the crisis.
The final ingredient that precedes a financial crisis is a slowing economy.
The Australian economy is currently growing at 3% per annum and has been expanding without interruption for 25 years. Most recently growth has been fuelled by immigration and mining exports, but these are masking an erosion of living standards which are better illustrated by the record high in underemeployment of 8.7% - measuring the number of people who have jobs but would like to work more - and weak real income growth.
Globally, The International Monetary Fund has cut its forecast for growth, warning that a "precarious" outlook amid rising protectionism and a lack of commitment to economic reform could bring further growth forecast downgrades next year.
As WA is now demonstrating that Australia is not immune to the impact of a slowing world or a slowing major trade partner. The East Coast of our country appears to be blissfully unaware of WA's tribulations and yet, when apartment oversupply eventually causes the residential construction boom to end, Australia may find itself looking for sources of growth that don't exist.
And then the fourth and final ingredient required to precede a crisis will be in place.
Investors buying assets at today’s generally elevated prices are looking in their rear view mirror believing, for example, that the recent and rapid rises in property will be repeated in the future. Remember the simply investing fact; the higher the price you pay, the lower your return.
Cash is most valuable when nobody else has any and while it earns very little today it represents an option over lower asset prices in the future.
So what are we suggesting? Speak to your adviser of course and consider what we are doing; We have gradually been building our cash reserves, retaining the flexibility to take advantage of lower prices in the future, if and when they transpire.
Interest rates are at historic lows but this will not be permanent and those who describe these conditions as the 'new normal' are, perhaps unwittingly, saying 'this time is different'. It never is.
What we are doing is building cash in The Montgomery Fund, The Montgomery [Private] Fund and the Montgomery Global Fund to take advantage of future bargains if they emerge. We have also launched long/short (Montaka Global Fund) and market neutral funds (Montgomery Alpha Plus Fund) that can profit from declining asset prices and we are seeing rapidly increasing interest in these funds from professional investors, advisers and research houses.
The encouraging thing about all of our strategies at Montgomery, is that if the above scenarios fail to materialise, we are securely invested in very high quality businesses growing strongly and with sustainable competitive advantages. Each year these businesses become more valuable irrespective of what markets, economies and prices do.
Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!