There’s no question Australia’s economy has enjoyed a stellar run. The trouble is, it’s largely been a consumer-based, credit-fuelled growth story. And the Bank of International Settlements (BIS) reckons it could soon come to a shuddering halt.
Every year, BIS, based in Basel, delivers its Annual Report on the state of the global economy. It is always worth reading and typically full of a number of really important insights for investors.
One such insight is the difference between those advanced economies that have de-leveraged since the Global Financial Crisis (GFC), and those that have not. Tucked away on page 44 of the 2017 Annual Report are a couple of charts on credit and house price trends. These show (i) the cumulative change in annual private non-financial credit relative to gross domestic product (GDP); and (ii) the cumulative change in real property prices – both over the most recent 11 year period.
The charts are worth a look. They clearly show a significant cumulative build up in private, non-financial credit in countries like Australia, New Zealand and Canada – as well as emerging market economies.
The charts also contrast the recent experience of these countries with the experience of major advanced economies: US, Europe, UK and Japan. The difference is stark! Since the GFC, major advanced economies have undertaken a multi-year deleveraging process; while smaller advanced economies (including Australia) have done the opposite.
And what has been a by-product of this difference in leverage profiles? In the major advanced economies, property prices reset downwards. In the smaller economies, property prices have continued to inflate – significantly. Indeed, the smaller advanced economies are no different to emerging market economies, including China, on these metrics.
In the US economy, the ratio of household debt to GDP peaked at around 125 per cent, at the onset of the GFC. Today, that same ratio in Australia is north of 180 per cent. Some have asserted that Australia did not so much survive the last recession: its recession is simply still to come.
And what does the BIS have to say about build-ups in household debt? Well, skip down to page 48 of its 2017 Annual Report and you will see an outline of a forthcoming research paper that finds that: “an increase in the household debt-to-GDP ratio acts as a drag on consumption with a lag of several years.”
The BIS confirms this finding based on a study of 54 advanced and emerging market economies over the period of 1990-2015: “Rising household indebtedness boosts consumption and GDP growth in the short run, but not in the longer run.” The simple intuition is that, while borrowing allows households to bring forward consumption, it also creates a higher debt-service burden in the future. Sounding familiar?
The Australian economy is now in a somewhat precarious position. Significant consumption has been brought forward through the significant growth in household debt over recent years. The renovations to the house, some new furniture, a couple of new flat screen TVs – all justified given the recent run-up in house prices and resulting boost to home-equity levels. Consumption of this nature has been fuelling a strong Australian economy for many years now. It seems as if the best case scenario for the Australian economy is for growth to simply slow.
And a worst-case scenario? An increase in the cost of financing could lead to household debt-service burdens becoming unbearable – which could crush consumption. And remember, Australia’s banking system is largely financed offshore – therefore, our cost of financing is arguably governed more by the Federal Reserve and less by the RBA.
The Australian economy has a noose around its neck. It is not to say that a recession is imminent, but the risks have not been this high for quite some time.
The Bank of International Settlements Annual Report is available here.
Andrew is responsible for managing the Montgomery Global Fund, ASX-listed Montgomery Global Equities Fund (ASX:MOGL) and global equity long/short strategy, Montaka Global Fund. Andrew oversees $500m in FUM.