Asset Allocation

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.




Comments

Please sign in to comment on this wire.

Jonathan Rochford

A well written piece Damien. Rather than doing the right but hard thing (tax reform and productivity reform) it's back to the same old story of credit growth and population growth to juice the economy.

Asad Khan

I am a bit colour challenged, it seems IMF debt chart has two groups, Aus, Can, UK, and US and then the republics. Looking at banking balance sheets also paints complementary picture, the first group notably US, UK, and Aus have the most stretched balance sheets. With this level of financial stress on citizens, it's an unstable system which can survive and may be even prosper but with a string of miraculous events.

Ian

It's like you were putting my thoughts into words Damien! Unfortunately, I've come to much the same conclusion, although I'm not so certain that cash will hold it's value either..... Gold maybe???

Geoff Walduck

An extremely well written and concise piece. I just hope some politicians treasurers read it. The only concern I have is that you are all too correct. Modern Monetary Theory seems to have the ascendency in policy circles at the moment. Governments both State and Federal have learned to their cost that they must be seen to give more and are punished at the ballot box for any perceived brake on growth in credit. I do not see this changing any time soon.

David Yabsley

I guess it's too much to ask that the Reserve Bank go on strike and refuse to lower rates again until the actual people responsible, the Government, act responsibly. But given the salaries and perks of the Board and CEO that question answers itself.

Andrew Smith

Population growth and/or 'immigration' has been overstated since 2006 when the UNPD NOM definition (used only by Australia, UK and maybe NZ) was expanded. This was done through conflation of (12/16+ month) temporary churn over or 'froth' including students, backpackers, NZ'ers and temp workers, but often misrepresented as permanent immigrants (minority gain PR). For population growth to increase, and be maintained, would require international education to expand significantly, when it has already experienced significant growth in an uncertain economic environment. Meanwhile our permanent population base is stagnant while the oldies and now baby boomers are downsizing etc., hence spending less but maybe releasing funds for younger generations?

raymond wang

Thanks for sharing your thoughts, Damien. I have always had a question in my mind that whether our superannuation savings offset somehow our household debt. I think most other OECD nations don't have as high retirement savings as we do. If we compare the net amounts (household debt -retirement savings), then the comparison may not be as stark. However, it is just my 5 cent worth of observation. I'd be interested in other your view on this. Cheer

Peter Hooker

I like your style Damien, and your conclusions too.

Harry

Why is it that we always want government to help. This "helicopter money" is one of the major sources of the problem. Now they are encouraging more helicopter money in Europe and the US. No one today seems to accept the fact that there are recessions and depressions which are usually in the past the result of ridiculous lending practices (viz Bank of New South Wales debacle), booming speculative real estate markets encouraged by lending practices, governments trying to come to the rescue and the population never accepting the fact that they have borrowed far too much and never consider the loss of their job. If the US had let the markets FAIL previously we wouldn’t be in this position. Job losses, company failures, loss of houses is nothing new but may appear so in the last 20 years. Interest rates will rise, job losses will occur, the housing market will crash and like previous history the government can do nothing about it. This addiction to growth is like all addictions…destructive.

S Leung

Well a cynical person would think this govt would withhold infrastructure spend in more to force lower rates to come about- in order to deliver paper wealth for the wealthy from artificially low rates and higher asset prices. This would be a means of rewarding their voting base.

Will Dunlop

There’s an unwritten contract in Australia between voters, Government and immigrants, and it’s been in place for a long time: voters work as stable, corporate employees to pay off debt for 20+ years, pay taxes, and in return expect to be financially compensated via housing price appreciation and high employment levels. Immigrants arrive and do the jobs voters don’t want to do, or aren’t skilled to do, so that their children can enjoy Australia’s relatively open society that voters tacitly provide. Australians again renewed the contract at this year’s Election, despite a more logical and ideal alternative. To wish for optimal economic management ignores the political contract. To suggest that things should change ignores what Australia is. Might as well found a new country. Does a global economic crisis upend the political contract? Aren’t global central bankers, politicians and corporate talking all the time in order to support it? Investing for a break-down in order is folly, unless the how and when can be identified. Otherwise buy stocks, property and bonds and pin your ears back.