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Minor miracle: bursting the bubble during the boom

Christopher Joye

Coolabah Capital

Today I write (very short excerpt only): "Amidst the daily market chaos we can state a few things with certainty. First, the volatility of volatility (or the volatility of the VIX index in the US) is at a record high as investors struggle to figure out where fair value for equities lies in a world where there is tremendous uncertainty about what the right long-term interest rate, or equilibrium discount rate, is to price assets (click on that link to read the full AFR column or AFR subs can click here)...

The second thing we know is that this uncertainty is being amplified by two other forces: the unwinding of the US Federal Reserve’s unprecedented policy of quantitative easing, or purchases of government bonds, to artificially depress the underlying price of money; and markets falling out of love—it’s a love/hate relationship—with the most capricious US President of all time, Donald Trump...

The final thing we know is that the incoming stream of economic data that defines activity in the world’s largest economy is incredibly strong and does not lend any weight at all to the much-mooted idea that will shortly head into a recession...

Deutsche Bank economist Torsten Slok rightly asks, “Where is this recession the market is so worried about?” We’ve both argued that the current cycle will likely elongate for many years.

“The long duration and measures of slack such as a tight labor market suggest the cycle is late,” he explains. “But all other fundamental indicators, ranging from inflation or cost pressures generated by the limited slack, the cyclical components of demand (housing; durables; and investment spending), confidence, corporate and household leverage, delinquencies and default rates, bank lending standards and earnings, all suggest mid- or in some cases even early cycle.”

Indeed, Standard & Poor’s says that default rates on US high yield bonds are decreasing on the back of benign economic conditions notwithstanding large recent increases in their credit spreads...

I am often asked about our views on Aussie housing, which is tracking in line with our early 2017 forecast of a 10 per cent decline in national prices. My response is that this correction is the best thing that could happen to Australia in economic terms because it is removing our single biggest financial stability risk.

We are incredibly lucky to have had APRA engineer this downturn through the application of a series of unprecedented constraints on credit creation at a time when economic growth is robust, the budget is in balance, and the jobless rate has fallen to its full employment level. This is, in fact, one reason why S&P recently upgraded Australia’s sovereign rating to AAA “stable” and why it has flagged it may upgrade the big banks’ senior bond, subordinated bond, and hybrid ratings.

On Thursday night, the RBA’s Guy Debelle echoed these sentiments, commenting that “what we haven't seen anywhere in the world is a decent fall in house prices in two capital cities at the same time unemployment is going down and the economy is growing at a reasonable pace”.

To APRA’s immense credit, it has managed to pull off a minor miracle: bursting the bubble during the boom.

Debelle has previously noted that there was no evidence of a wealth effect, or positive feedback loop into consumption, during the upswing when Melbourne and Sydney house prices surged 50 per cent and 75 per cent respectively over 2012 to 2017. On this basis, we should not expect a negative wealth effect simply because we are giving back a small share of that capital appreciation.

Make no mistake, the housing correction is terrible news for certain sub-sectors of the economy. It is awful for residential developers, builders, property speculators, and anyone who has crazily bought residential mortgage-backed securities (RMBS) in the last 12 months. But the housing construction industry only represents about 5 per cent of economic activity and employment, and is not, therefore, likely to move the dial. 

Read the full column here.

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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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