House Prices Rise Again...

Christopher Joye

Coolabah Capital

This week I write that the housing party is just getting started (click on that link to read the column or AFR subs can click here). Recall we forecast the end of the boom in April 2017 when prices were still climbing, and called a 10% peak-to-trough decline. Well we got almost exactly that: CoreLogic's 8 capital city index has fallen 10% from its September 2017 peak (the 5 capital city index is off 10.7%). In April 2019 when prices were still falling we declared the correction over and forecast that national house prices would increase 5% to 10% in the 12 months following the RBA's second cut. Now it looks like CoreLogic is going to report that both Sydney and Melbourne house prices actually appreciated in June 2019 for the first time since mid to late 2017 (the final index numbers will be published on Monday). When I wrote my column on Friday it appeared that Melbourne prices had increased in June ever so slightly while Sydney prices had almost stopped declining (off -0.1%). But the month was not over, and it now looks like Sydney will actually grind out a similarly modest capital gain in June. No matter which way you slice or dice it, my chart below shows that the great Aussie housing correction in our two largest conurbations is over. And this is also confirmed by the auction clearance rate data, which was strong again over the weekend with CoreLogic's preliminary estimates at 72% in Sydney (on 354 auctions) and 71% in Melbourne (on 442 auctions) compared to 49.7% and 57.2% 12 months ago (see the second image enclosed noting that the preliminary numbers tend to revise down somewhat). In my column this week I discuss these dynamics, the likelihood that the banks will pass on only 10-15bps of the next RBA rate cut, which should be in July or August, the intensifying search for yield impulse, and the stunning success of my mates Rob Luciano and Doug Tynan at VGI, who recently listed their business. Excerpt enclosed:

The big four in particular face tremendous pressures on their net interest margins and returns on equity via numerous headwinds, including: the inability to cut deposit rates below zero; a permanent increase in their regulatory and compliance costs; ongoing customer remediation payments; opportunistic class action litigation; a huge hike in the equity capital they are required to hold in their New Zealand subsidiaries; a new levy on their New Zealand deposits; intense competition from Chinese, Japanese and European banks in business lending, and from lightly regulated non-banks in residential finance; and, finally, the spectre of APRA eventually introducing a total loss absorbing capacity (TLAC) regime that could materially raise their funding costs. (There is, of course, also Scott Morrison’s unprecedented big bank levy of 0.06 per cent annually on the value of their wholesale liabilities.)

Back in 2015 we argued that the steady-state returns on equity for the major banks should decline from their 16 to 18 per cent levels at that juncture to around 10 to 12 per cent, which is about where they have landed today. The concern will be if these returns start shrinking below the banks’ cost of equity, which would imply they should be trading in share price terms at less than 1 times book value.

If it was difficult to make the economic case for banks to pass through more than 15 basis points of the RBA’s first 25 basis point cut, one would be hard pressed to imagine them passing along much more than 10 to 15 basis points in July or August.

After the generous “gimme” of near-full-pass-through in June, the banks have to start behaving like profit maximisers and defend the sustainability of their business models, which frankly could rationalise pass-through of less than 10 basis points after the next RBA move.

It is, as a result, plausible that the RBA gets less than two-thirds of the lending rate reductions it would normally expect from a brace of standard cuts. This is not nearly enough to give it confidence that monetary policy will stimulate the economy toward its new full employment target, which is a jobless rate of less than 4.5 per cent (compared to today’s 5.2 per cent level).

That immediately introduces the need for a third cut, which may be why financial markets are pricing one in by the end of the year. The problem, of course, is that the RBA will get even less pass-through at that time, perhaps as little as 5 to 10 basis points.

Finally, there is the nontrivial complication that the US Federal Reserve is likely to slash its own cash rate, which will put upward pressure on the Aussie dollar and directly detract from the RBA’s attempts to stimulate the economy.

This presumably explains why RBA governor Phil Lowe is suddenly talking about the “limits of monetary policy” and expressing a desire to see fiscal policy furnish more support. The problem with this logic is that Scott Morrison and Josh Frydenberg were elected on the basis they would balance the books and deliver a string of surpluses. The only thing likely to stop them doing this is the threat of a full-blown recession.

When you think through this decision-making tree, all roads inevitably lead to the RBA sensibly expanding its monetary policy tool-kit to target a wider range of interest rates than just the conventional overnight cash rate. This should include longer-term risk-free rates and the spreads over these benchmarks that determine bank funding costs and hence the practical savings and loan rates they set for depositors and borrowers. If the RBA wants to, it could quite easily link its wider interest rate targeting program to changes in both bank funding costs and the rates they charge customers...

And while investors may be worried about superficially low interest rates, if yields and credit spreads keep compressing, total returns can be very large indeed. Over the last 12 months, a portfolio of 7 year AAA rated government bonds yielding, on average, only 2.1 per cent delivered a stunning total return of 11.4 per cent. This is because the expected return from these bonds collapsed from 2.4 per cent a year ago to 1.2 per cent today. The price of the bond has therefore jumped to reflect the fact investors are now happy to accept much lower yields. The point is that one can capture enormous returns from ostensibly low yielding investments if the required yield drops sharply. The trick is to find those investments that still appear cheap in a world where most asset-classes look heinously expensive.

One team that has proven especially adept at hunting out such bargains is the high profile long-short duo, Rob Luciano and Doug Tynan, of VGI Partners. I first met Rob and Doug when I profiled them for this column way back in 2013. Alongside the likes of AMB Capital’s Todd Bennett, superstar adviser Chris Garnaut, and myself, Rob and Doug helped sergeant Harry Moffitt establish the Wanderers Education Program, which has raised millions of dollars to fund education scholarships for currently serving soldiers in the Special Air Services Regiment. This is the first time in the world that a private philanthropy has been set up to educate active (as opposed to retired) special forces soldiers.

While Rob can be as idiosyncratic (euphemistically put) as the next exceptional fund manager, I love the guy and admire his unparalleled intensity. This son of a piano player is almost as tough as one of his mentors, master water-boarder Russell Aboud (trust me, I’ve been subject to the latter's torture many times first hand).

Luciano’s protégé, Doug Tynan, is no less impressive and the perfect foil for his curmudgeonly, yet also incredibly generous, boss. These guys go to extraordinary lengths on behalf of their investors, and some time ago sent their entire team to the US to be trained by former CIA interrogators.

Read the full column here.

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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