What housing elephant?

A few weeks ago I wrote about how the Australian housing market has diverged wildly from the typical boom/bust cycle.  Today I want to address the elephant in the room that seems to be ignored by most in the media:

Is the Australian government really pinning it's economic growth hopes on trying get the world's second most indebted consumer to borrow even more?

It is a (morbidly?) fascinating economic experiment that the government has launched, seemingly in concert with the regulators. 

We know from examples in numerous countries over history that housing booms can occur when the regulators are asleep at the wheel but there aren't many examples we can look at where the government are actively encouraging over-leveraged consumers to borrow more and the regulators to stay out of the way.  

At the moment the plan has four parts, the first being relatively simple: target the main group that isn’t already geared to the eyeballs (first home buyers) and encourage them to borrow up to 95% of the value of a house.

The second part is more complicated. The royal commission into banking deemed the banks were breaching responsible lending rules and APRA (the regulator in charge) was pilloried for being too close to the banks and allowing banks to set their own standards. This slowed the meteoric rise in debt and saw house prices tumble. The current government’s response has been:

• Three days after the election APRA announced it was looking at loosening credit conditions and letting the banks calculate their own risk.
• The head of APRA for the period in which the banks were deemed to be lending irresponsibly was given a new five-year term.
• The assistant Treasurer recently told The Australian Financial Review that he will press financial regulators to review their restrictions on bank lending to help ease a credit squeeze and to “get credit flowing” to home borrowers.

A cynical observer might think the current government’s plan is to encourage banks to resume lending irresponsibly. 

The third part of the plan is subtle. The Reserve Bank of Australia has been publicly begging the government to spend money on productive infrastructure in order to boost jobs and get wages to grow. The government is refusing, which effectively leaves the Reserve Bank no option but to continue to cut interest rates, and lower interest rates will presumably encourage Australia’s indebted consumer to become even more indebted.

The fourth part is back to simple. When your existing citizens are too indebted to borrow more, you need to get some new citizens:

Maybe everything will work out fine. History suggests otherwise.

The real question for asset allocation is what to do in the meantime. The current government has at least three years in power, plenty of scope to increase government debt to support the housing sector in novel ways and apparently no compunctions about trying to exhort Australian consumers to borrow even more.

Blowing the property bubble meaningfully larger is probably beyond the Australian government, but arresting the fall in prices seems likely.

The risk is some sort of global shock or broader economic downturn. Australia has already “broken glass in case of emergency” to prop up the housing market and many of the policies that could be employed in a crisis have already been employed – meaning that in the event of a genuine crisis the downside is going to be more pronounced.

Asset allocation

Which leaves a measure of conflict in asset allocation – do you try to ride a short term stabilisation in the Australian economy and run the risk that any global crisis is likely to be more devastating than it may have otherwise been? 

Valuations have made the decision easier, with the Australian market looking increasingly expensive.

So where does an asset allocator turn? In 2018 with a slowing Australian economy, stagnant wage growth and 10-year government bond yields of 2.8% we felt being overweight bonds was an easy decision for investors in our tactical or superannuation funds (investors make money on bonds when yields fall). 

At the time we were one of the only voices expecting rate cuts in Australia. Now the first two rate cuts have occurred and further cuts are a consensus opinion. While we were expecting Australian 10-year bond yields to fall to these levels (1.4%), we weren’t expecting them to fall so quickly – the last six months has been dramatic.

Keep in mind that the Reserve Bank of Australia has an inflation target of 2-3%. At current yields, the bond market is suggesting that it will not meet that mandate for the next 10 years. Which, in the context of the European and Japanese examples, anemic wage growth, world-leading private indebtedness and an overvalued housing market, is probably a reasonable assumption – unless something changes.

We are of the view that stagnant growth is going to be on the menu until we see governments spending money. And probably “helicopter” money. Given the current state of economics, that will probably take some sort of reasonably large economic crisis. Until then we expect more of the same – slow growth and a grind lower.

As the bond yields have fallen we have been taking profits, although we remain overweight.

The low yields present an asset allocation quandary. I was hoping that by this stage we would have seen equity prices that were more reasonable, giving us the opportunity to switch out of our bonds and into equities. But equities are looking expensive. Not irrationally expensive, but certainly more expensive than we would have thought given the uncertain and low growth outlook. So we are holding lots of cash, looking for the right opportunity.