Intro
While there is always something to discuss each quarter, markets are dishing up more conversation topics than usual. We provide our usual economic and investment commentary, with a focus on property, mounting risks in China and potential for ‘The Great Resignation’.
Our investment views remain aligned to those outlined last quarter, despite investment risk sentiment appearing to have increased. We share some out of favour views on cryptocurrencies and finish up this quarterly edition with some insurance industry specific news.
Economic Commentary - A lot is happening!
Brits are queuing for petrol. The Chinese Communist Party (CCP) dumped (AUD) $96billion into its banking system. Janet Yellen, and six former treasury secretaries, have written to leading members of the Republican Party imploring them to increase the debt ceiling – which is happening. An energy crisis is gripping Europe and China. In China, streetlights are being turned off and they’ve resumed buying coal from Australia… things must be bad. Energy prices are likely to remain high through to next year and a variety of Central Banks are actively reviewing monetary settings.
What happens next?... A lot of guessing is going on.
As property developer Evergrande fails, questions surround how much of the Chinese economy sinks with it? The CCP’s $96billion shoring up of the banking system tells us two things.
1. The CCP is concerned about the economy.
2. They remain intent on preventing contagion.
Three more Chinese developers appear to have defaulted on debt. It’s a near certainty there are more to come. This will be further exacerbated by a CCP corruption probe into financial markets. Bankers under a CCP spotlight now fear for their personal safety if they miscalculate risks, leading to a reduced willingness to make further risky loans.
In the US, Biden’s threat of removing the filibuster saw an immediate compromise from Mitch McConnell. The debt ceiling negotiation has been pushed till December. A default on US government debt would be apocalyptic for markets.
In Norway, Norse Bank raised interest rates, the first rate rise from a G10 Central Bank. The Reserve Bank of New Zealand followed suit on October 6th, indicating more rate rises to come. Stronger hawkish sentiment is emerging, notably from the Bank of England and Federal Reserve. The Bank of England may even raise rates before the year is out. The developing world is ahead of the curve. Hungary (1.5%), Brazil (5.25%), Turkey (19%) and Pakistan (7.25%), all having raised interest rates this year.
“Interest rates are the price signal that links today’s economy with tomorrow’s, and links savers with investors. To make sense, rates should be substantially positive in real terms, reflecting the time-value of money” – Stephen Grenville (former RBA deputy governor).
Central Bank policy settings have been negative in real terms. Irrational capital allocations have followed. Interest rates remain the elephant in global markets. As rate setting sentiment shifts, concerns are emerging that interest rates may have been too low for too long.
Property
A biproduct of negative real rates has been an explosion is some asset prices. An often-used justification for not being overly concerned with escalating asset prices is the ‘wealth effect’. Appreciating asset prices, particularly home values (an almost global phenomenon), are viewed favourably as asset owners are buoyed to consume more as they grow wealthier. This leads to consumption growth, supporting an economic recovery.
We believe the ‘wealth effect’ is invalidated when asset prices disconnect from wages, which they appear to be doing now.
Wealth Effect or Inequality Drag?
As already wealthy people get wealthier, there is a marginal impact on consumption. Wealthy people tend to be older with established lifestyles and although they might feel emboldened to spend a little more, how many extra coffees or handbags will they really buy?
As asset prices, particularly housing, disconnect from wages, emerging generations sacrifice consumption and innovation activity, like not becoming entrepreneurs, to retain access to appreciating assets, particularly housing. The widespread reduction in consumption from emerging generations is unlikely to be offset by the extra spending from older and already wealthy people. In fact, the emergence of the ‘bank of mum and dad’ suggests stretched house prices place pressure on parents, concerned about shoring up their children’s futures, therefore reducing their discretional spending. The bank of mum and dad is one of Australia’s leading lenders.
Central Bankers are at pains to disconnect themselves from asset prices. This has allowed financial system risks to creep in. It also demonstrates, we believe, central banks misunderstanding of longer-term inequality drags on consumption, innovation, and the resulting sustained decline in productivity that supresses economic expansion.
We see this in practice. Over-extended first home buyers, some with debt-to-income ratios above 10, are cutting back to threadbare budgets. Debt-to-income ratios of 5 or 6 are accepted as prudent upper limits. We have seen family financing, where the older generation redraws from existing bank financing to prop up a deposit for the next generation, who then access further bank lending. Both banks are unaware of the intergenerational servicing obligation that the younger generation have servicing their parents borrowed deposit.
We do not believe regulators fully grasp embedded risks creeping into the system. Or, if they do, they are presenting a composed poker face. A temporary handbrake on escalating credit risks has been the low volume of housing stock for sale, subdued through COVID. As economies open, confidence to sell increases, and as a result more homes will be listed for sale. Therefore this handbrake will ease, and credit expansion may increase significantly.
Although general consumption is likely to rebound strongly as pent-up demand flows into a reopened economy, household consumption’s contribution to GDP in Australia looks likely to continue on its downward trend.
Unless there is a productivity boom or substantial and sustained wage growth, we expect increasingly leveraged households to keep economic growth subdued over the medium to long term.
China
The most obvious example of an ‘inequality drag’ is in China. House prices are 40x household income in tier 1 cities. Australia’s housing market looks tame by comparison. China really is another world.
The fierce disconnect between house prices and incomes within China has exposed the country to vast financial system risks. Younger generations have been sacrificing the lion’s share of income, lifestyle and consumption activity (often begging/borrowing from family for the 30% deposit) to acquire a property. The substantial growth in household wealth has not led to ‘wealth effect’ benefits. In fact, the opposite has happened.
Graphs from PolyMatter showing low and reduced consumption within China
The contribution of household consumption to GDP in China is very low by global standards. Contrary to expectations, as China got wealthier, consumption as a proportion of GDP fell. A range of factors are at play, like an aging population and somewhat fixed lifestyle habits. The disconnect between house prices and wages is a likely important contributor.
The CCP’s push for economic growth at all costs, and China’s local government’s reliance on housing demand to finance infrastructure investment, has seen regulators turn a blind eye to growing financial system risks. The Chinese economy is now fragile, with a trifecta of challenges from water security, inflated housing to aging population demographics. China’s role as the global engine for economic growth looks under threat.
Australian Policy Response
Australia can learn from both China and New Zealand’s challenge in addressing housing market risks. That is, as house prices and wages disconnect, early intervention is a positive for both the economy and society. Incidentally, New Zealand’s runaway market is so hot that a wide range of interventions appear to have come too late. The New Zealand Reserve Bank has been forced to begin raising interest rates.
In Australia, APRA intervened on October 6. An increase in servicing buffers will apply from November. This is like trying to extinguish a bomb-fire with a squirt gun. It has taken cajoling from major bank CEO’s, the RBA, IMF and most recently, treasurer Josh Frydenberg publicly calling for APRA intervention. It’s as if political protection was required for the ‘independent’ regulator to act. We expect further interventions as current measures look inadequate.
No such policy response looks likely from central banks. Monetary policy settings are, as Governor Lowe is at pains to stress, not targeted at house prices: “While it is true that higher interest rates would, all else equal, see lower housing prices, they would also mean fewer jobs and lower wages growth. This is a poor trade-off in the current circumstances”.
We disagree with the RBA’s logic. Although generally true that lower cost of funding is supportive to the economy, it is not the cost of funds preventing wage growth or business investment.
“Profits have been consistently high while the cost of borrowing, even long-term, has been historically low, without this triggering an investment boom. Whatever is holding investment back, it is not the cost of funds.” – Stephen Grenville (Former RBA Governor)
A return to real rates does not appear likely to negatively impact jobs or business investment, but it would be effective at rationalising capital allocation. This would in turn improve long term household consumption, entrepreneurialism, and lower financial system risks.
The Great Resignation
One biproduct of the pandemic disruption is a rethink of values. House prices disconnecting from wages will contribute to renewed labour migration. Ben Hamer from PWC recently had some interesting comments on labour markets:
“Between 40 to 50 per cent of the labour market are looking to leave their employer in the next 12 months and, with 100,000 more jobs in Australia than pre-COVID alongside record high vacancies and historically low unemployment, we are on the precipice of The Great Resignation,” Hamer said. “We are about to see a massive exodus of workers ... And there is no going back to the way things were.”
With migration presently stalled from international labour markets, employment looks set to undergo a disruptive period. Wage growth might arise sooner than expected, and with more acute disconnects between wages and house prices, most starkly seen in major cities, this could translate into a renewed increase in migration to regional centres.
Employment turnover in a competitive labour market is indicative of wage growth upside. Higher wages, excess leverage risks and with signs of asset price speculation, it is improbable that interest rates remain at 0.10% through to 2024, as Philip Lowe keeps forecasting. In the battle between Philip Lowe and the market, who are pricing a much earlier rate rise, we side with the market.
Investment Commentary
If this graph doesn’t catch your attention, nothing will. It’s not just property markets that have skyrocketed. Some stocks are trading at phenomenal prices.
Cryptocurrency
The cryptocurrency market is reputedly worth another $2trillion (USD). That store of ‘value’ is artificial and generates no income. Cryptocurrency has similarities with both Tulip Mania and the subprime mortgage collapse. Some more obvious similarities are;
Totally speculative - neither Tulip’s nor cryptocurrency generate income
Growth in jargon and complexity – NFT’s, tokens and digital wallets are reminiscent of CDO’s, Synthetic CDO’s and credit default swaps.
But the surest sign of a bubble is a flood of well-healed salespeople rushing to spruik the wonders of a new ‘asset class’, both sellers and buyers all share a commonality in thinking.
The promise of free money is alluring and attracting a growing pool of retail and institutional investors alike.
If we lump that $2trillion onto the $4.5trillion of stretched Price to Sales Ratio (P/S) companies, it shows just how large the influence of sustained negative real interest rates and QE programs are. We are either amid a bubble, and it certainly appears to be in some asset sectors, or a new paradigm of investing. Crypto believers argue the latter, often with religious zeal. While people continue making money from cryptocurrency, the market dictates them right and our thinking wrong… However, to the disappointment of those true believers, I don’t anticipate uttering shibboleth any time soon.
Portfolio positioning
As suggested in our economic commentary, the prospect of tightening central bank policies and excessive leverage appears to be coming to a head. The disconnect between the real economy, investment markets and the artificial world of ‘digital assets’ makes it challenging to interpret where capital should be allocated. Are Central Bankers responding to the real economy or the market?
“If you’re not a little confused about what’s going on, you don’t understand it”- says Charlie Munger.
In our last quarterly, we discussed the hunt for a good defensive portfolio. Bonds are at historic lows (as in a thousand years of history low), stocks appear stretched in many markets and cash delivers real negative returns.
We saw some limited protection for Australian investors via unhedged investments in reasonably valued overseas businesses. This has proven effective through the last quarter as a reduced risk sentiment emerged, commodity weakness led to a drop in AUD, and the FX movements partially offset a decline in asset prices. Active management has been incredibly important to achieve results.
With the US dollar’s supreme status under threat due to partisan politics, even unhedged US dollars aren’t safe! Options are thinning out for good defensive investments.
Energy stocks, only recently recovering from COVID uncertainties, often prove resilient in inflationary markets. However, they are also volatile. Infrastructure, although sensitive to interest rates, can at least pass on higher cost inputs to their customers. With so much debt in households and businesses, interest rates are unlikely to move all the way back to trend. Infrastructure assets, energy stocks and floating rate credit, as well as reasonably valued price-setting businesses, if you can find them, continue to be the shrinking pool of options for sensible capital management.
Private investments, like unlisted assets and private equity remain relatively attractive for those who are lucky enough to access these opportunities.
Investors with nearer term funding needs should resign themselves to holding cash.
It is often said, more money is lost being out of the market in the lead up to the bubble bursting, than is lost in the burst itself. It could be years before interest rates normalise. So, for investors, keeping capital allocated, but doing so in a manner that remains rational is all one can do.
Our thinking is not particularly novel, and investment positioning represents no real change to last quarter.
Other news
Income protection insurance in its normal form has now been removed from the marketplace. Having lost $5b over the last 5 years, there was only so long this sort of unsustainable insurance offering could be tolerated by APRA (insurer regulator).
The enforced removal of contracts and a forced redesign to a new (and less generous) product for consumers has led to a last-minute push to get insurance policies in place, particularly across high skilled professional clients. The window has now closed.
For those with existing income protection policies, these are now more valuable than ever! For anyone else, it will take some time for new policy structures to settle into an accepted market structure.