Bears, the Dragon and Australia in 2012

Close to the top of the list of things I want to achieve in 2012 is to secure development funding for a 4 townhouse joint venture project I’m doing in Northcote.

So I have been watching the gyrations of the global markets for the last months of 2011 with a lot of interest, searching for a better understanding to these three questions:

  1. How bad will it get globally this time around?
  2. To what extent will the Eurozone and US financial woes impact China’s growth?
  3. How will this all impact the Aussie banking system and their appetite for housing finance…?

To find answers to the first question I’ve been looking to the big hitters, people like Nouriel Roubini, Jeremy Grantham, Bill Gross and Joe Stiglitz…and they are all bearish on the global economy in the short to medium term.

Nouriel Roubini in “Fragile & Unbalanced in 2012” typically pulls no punches…

“The outlook for the global economy in 2012 is clear, but it isn’t pretty: recession in Europe, anemic growth at best in the United States, and a sharp slowdown in China and in most emerging-market economies. Asian economies are exposed to China. Latin America is exposed to lower commodity prices (as both China and the advanced economies slow). Central and Eastern Europe are exposed to the eurozone. And turmoil in the Middle East is causing serious economic risks – both there and elsewhere – as geopolitical risk remains high and thus high oil prices will constrain global growth.

Flaws in China’s growth model are becoming obvious. Falling property prices are starting a chain reaction that will have a negative effect on developers, investment, and government revenue. The construction boom is starting to stall, just as net exports have become a drag on growth, owing to weakening US and especially eurozone demand. Having sought to cool the property market by reining in runaway prices, Chinese leaders will be hard put to restart growth.

They are not alone. On the policy side, the US, Europe, and Japan, too, have been postponing the serious economic, fiscal, and financial reforms that are needed to restore sustainable and balanced growth.”

Roubini also points out that policymakers (all over the world) are running out of options:

  • Currency devaluation is a zero-sum game, because not all countries can depreciate and improve net exports at the same time.
  • Monetary policy will be eased as inflation becomes a non-issue in advanced economies (and a lesser issue in emerging markets). But monetary policy is increasingly ineffective in advanced economies, where the problems stem from insolvency – and thus creditworthiness – rather than liquidity.
  • Fiscal policy is constrained by the rise of deficits and debts, bond vigilantes, and new fiscal rules in Europe.
  • Backstopping and bailing out financial institutions is politically unpopular, while near-insolvent governments don’t have the money to do so.

Perhaps most worryingly, Roubini also points out that there is pervading political paralysis that reduce the chances of concerted actions to resolve the global economies ills…

“the promise of the G-20 has given way to the reality of the G-0: weak governments find it increasingly difficult to implement international policy coordination, as the worldviews, goals, and interests of advanced economies and emerging markets come into conflict.”

Bill Gross from PIMCO heralds “Paranormal economic activity” being the new normal from 2012 versus the old normal we have witnessed since 1971. His conclusion…

“for 2012, in the face of a deleveraging zero-bound interest rate world, investors must lower return expectations. 2–5 per cent for stocks, bonds and commodities are expected long-term returns for global financial markets that have been pushed to the zero bound, a world where substantial real price appreciation is getting close to mathematically improbable. Adjust your expectations, prepare for bimodal outcomes. It is different this time and will continue to be for a number of years. The New Normal is ‘Sub’, ‘Ab’, ‘Para’ and then some. The financial markets and global economies are at great risk.”

While the events in Europe stole most of the headlines last year, and made for gripping reading, of most interest to me is China.

When in 2008 the US sub-prime mortgage fiasco triggered GFC I one of the most popular terms at the time in Australia was the term “de-coupling”. The theory being that Australia had de-coupled from the US economy to the extent that we would be relatively immune from its economic malaise. This time around though, I’m not sure Australia can de-couple from Europe and in particular, from China.

The Year of the Dragon – will the Dragon run out of puff…?

In the last quarter of 2011, the Chinese government tried to turn China’s heated property market into something more equitable for middle-class home buyers and as a result, forced home prices down in at least 33 cities. There are various reports of just how far property prices have fallen in different cities. But just how successfully the Chinese government can manufacture a soft landing, as Robert Gottliebsen says, “is Australia’s frontline”

In “China’s epic hangover begins” Ambrose Evans-Pritchard, international business editor at the Telegraph writes

“the economy is badly out of kilter. Consumption has fallen from 48pc to 36pc of GDP since the late 1990s. Investment has risen to 50pc of GDP. This is off the charts, even by the standards of Japan, Korea or Tawian during their catch-up spurts. Nothing like it has been seen before in modern times.

A fire-sale is under way in coastal cities, with Shanghai developers slashing prices 25pc in November – much to the fury of earlier buyers, who expect refunds. This is spreading. Property sales have fallen 70pc in the inland city of Changsa. Prices have reportedly dropped 70pc in the “ghost city” of Ordos in Inner Mongolia. China Real Estate Index reports that prices dropped by just 0.3pc in the top 100 cities last month, but this looks like a lagging indicator. Meanwhile, the slowdown is creeping into core industries. Steel output has buckled.

The International Monetary Fund’s Zhu Min says loans have doubled to almost 200pc of GDP over the last five years, including off-books lending. This is roughly twice the intensity of credit growth in the five years preceeding Japan’s Nikkei bubble in the late 1980s or the US housing bubble from 2002 to 2007. Each of these booms saw loan growth of near 50 percentage points of GDP.

The IMF said in November that lenders face a “steady build-up of financial sector vulnerabilities”, warning if hit with multiple shocks, “the banking system could be severely impacted”.

Mark Williams from Capital Economics said the great hope was that China would use its credit spree after 2008 to buy time, switching from chronic over-investment to consumer-led growth. “It hasn’t work out as planned. The next few weeks are likely to reveal how little progress has been made. China may ride out the storm over the next few months, but the dangers of over-capacity and bad debt will only intensify“.”

These last comments reiterate those made by Nouriel Roubini earlier last year. Back in April he wrote a piece called “China’s bad growth bet” where he predicted that China’s economic growth model was now unsustainable and would start stalling in 2013. Perhaps his prediction was 1 year out…? In that article he noted that

“When net exports collapsed in 2008-2009 from 11% of GDP to 5%, China’s leader reacted by further increasing the fixed-investment share of GDP from 42% to 47%.

Thus, China did not suffer a severe recession – as occurred in Japan, Germany, and elsewhere in emerging Asia in 2009 – only because fixed investment exploded. And the fixed-investment share of GDP has increased further in 2010-2011, to almost 50%.

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

Commercial and high-end residential investment has been excessive, automobile capacity has outstripped even the recent surge in sales, and overcapacity in steel, cement, and other manufacturing sectors is increasing further. In the short run, the investment boom will fuel inflation, owing to the highly resource-intensive character of growth. But overcapacity will lead inevitably to serious deflationary pressures, starting with the manufacturing and real-estate sectors.

Eventually, most likely after 2013, China will suffer a hard landing. All historical episodes of excessive investment – including East Asia in the 1990’s – have ended with a financial crisis and/or a long period of slow growth. To avoid this fate, China needs to save less, reduce fixed investment, cut net exports as a share of GDP, and boost the share of consumption.

The trouble is that the reasons the Chinese save so much and consume so little are structural. It will take two decades of reforms to change the incentive to overinvest.

But boosting the share of income that goes to the household sector could be hugely disruptive, as it could bankrupt a large number of SOEs, export-oriented firms, and provincial governments, all of which are politically powerful. As a result, China will invest even more under the current Five-Year Plan.”

Yikes.

But what does all this mean for Australia and in particular for the Australian housing market?

For me what happens in the short term is intimately related to how the big four banks respond to GFC II…and it seems that despite all the rhetoric from the banks, the situation is not as bad as one would think…

In “A wake up call for Australian banks” by Robert Gottliebsen in Business Spectator Robert writes that

“Australian banks have been money-making machines because they have paid low rates to bank depositors and supplemented their consequent low Australian deposit base by borrowing between 40 and 50 per cent of their funding requirements from the global wholesale market. (It’s currently around 40 per cent). The banks have then used their fund avalanche not so much to support businesses, but to fund houses. Australian dwellings have become among the most expensive in the world because of the widespread availability of bank credit.”

Gottliebsen asserts though that time is up on this funding strategy because

“of the deep problems in the European and US banking communities, plus the demand for funds in Asia, massive wholesale bank borrowing to fund housing markets will not be available unless you are prepared to pay much higher rates of interest.”

The good news…?

However, the good news seems to be, that despite the fact though the wholesale banking market is frozen in a replay of GFC I, the Australian banks seem to be in a reasonably good position (compared with the rest of the developed world) because

“most of the large Australian banks have borrowed over three years so they will be impacted gradually. When wholesale funds become due for rollover next year, the impact will be minimised because demand for funding from businesses is low and housing is not buoyant the banks know that in the superannuation movement there are substantial funds which could be tapped with higher rates if necessary. And if all that proves to be insufficient, there is the Reserve Bank as a back-up.

The International Monetary Fund’s Zhu Min says loans have doubled to almost 200pc of GDP over the last five years, including off-books lending.
This is roughly twice the intensity of credit growth in the five years preceeding Japan’s Nikkei bubble in the late 1980s or the US housing bubble from 2002 to 2007. Each of these booms saw loan growth of near 50 percentage points of GDP.
The IMF said in November that lenders face a “steady build-up of financial sector vulnerabilities”, warning if hit with multiple shocks, “the banking system could be severely impacted”.
Mark Williams from Capital Economics said the great hope was that China would use its credit spree after 2008 to buy time, switching from chronic over-investment to consumer-led growth. “It hasn’t work out as planned. The next few weeks are likely to reveal how little progress has been made. China may ride out the storm over the next few months, but the dangers of over-capacity and bad debt will only intensify”.

In “Spotting the big four’s euro bonus” Karen Maley concludes that for the short-term at least, the outlook for the big banks isn’t nearly as dire as they’d have you believe.

“Although the banks’ wholesale borrowing costs are edging up, wholesale funds now only account for around 40 per cent of total bank funding. When it comes to retail deposits, which now represent a more important source of funding, the banks are doing extremely well. This strong rise in local deposits has kept the banks very liquid.

Australians looking for a home for their money would be hard pressed to find a better option than the big local banks, which enjoy an enviable credit rating. And growing financial market stress means that Australian companies are increasingly opting for safety, and parking their surplus funds with the local banks. As a result of this strong inflow of retail funds, the banks’ overall funding costs are not rising nearly as sharply as some suggest.

Even if the European debt crisis caused global capital markets to shut down completely, local banks would not be starved of cash. The Reserve Bank would ensure that the local banking system remained liquid. Banks would be able to borrow from the Reserve Bank, pledging high quality assets as security.”

This last point is perhaps the most salient one for me. Ian Verrender in the SMH came to the same conclusion as Maley in December in “Psst … want to know the banks’ secret plan to cap funding costs?” in the SMH…

“Ready? If Europe implodes and the faecal matter really hits the fan, four crucial phone calls will be made within quick succession.

In no pre-determined order, Gail, Cameron, Ian (not me) and Mike will pick up the phone. They each will dial a number at a Canberra address.

A conversation along the following lines will ensue: ”Wayne, [insert appropriate name here] calling. How wonderful to speak with you. How was Christmas? Umm, any chance you could bring back those taxpayer-backed guarantees on offshore loans, you know the ones you instituted a few years ago after that nasty Lehman Bros collapse?

”Tell you what, if we could borrow using the Commonwealth AAA credit rating, it would be a damn sight cheaper for us and for our customers. Be forever grateful too, you know. No, seriously, I would. No, no, I really mean it.”

That’s it in a nutshell.

Should the need arise, however, Australia’s AAA credit rating has become highly valuable.

One reason the Aussie dollar has maintained its strength during a period of such volatility is that foreign governments have seen us as a safe haven.

That’s a major turnaround. During the first round of the financial crisis three years ago, the Aussie dollar sank like a stone as commodity prices plummeted. Not this time.

This time it has bounced around at parity with the US dollar, within cooee of its record high. The reason is that Australian government bonds – backed by that AAA rating – are seen as a safe bet by foreign governments and big global investors. They pay well, too.

And let’s face it, there are not many choices when it comes to gold-plated credit ratings these days. The Europeans are in danger of losing theirs early in the new year. America, the world’s biggest economy with the global reserve currency, has already suffered a downgrade.

The price of raising money offshore might have risen sharply in recent months. But in Australia it has dropped.

Strong demand for Australian 10-year government bonds resulted in yields falling to 3.78 per cent, down from 5.55 per cent at the beginning of the year.”

It seems then that from a funding perspective, if the downside risks in the global economy materialise, the big four should still be able to continue to keep on lending. Which will be critical to how well the market performs this year. But that’s not to say it won’t be a tough year for the Australian property market, with unemployment ticking up and in Melbourne at least, around 47% more stock on the market as at the same time last year.

So when I meet with my bankers later this month to start working towards formal offers for my development, I will be in a cautiously optimistic frame of mind. I know from my discussions last year that they are chasing business because the appetite for lending has faded. Particularly amongst their business customers. So while the funding is there, good quality, low risk projects (our project is in the inner north, is architecturally designed and has 4 joint venture partners so all the townhouses are effectively “pre-sold”) should attract competitive financing…

In a tough market my focus for this year and the next few years will be on adding or creating value/equity to properties. For me this means focusing on developing small townhouse or unit developments in the inner city.

I remember reading this interview a while ago with Scott Keck founder of Charter Keck Cramer where he discussed how he would invest $1m…

Q) So if someone gave you $1 million Scott, what would you buy and where?

A) I’d buy two townhouses for $500,000 each in the inner suburbs and the reason for that is if you can’t afford a house, and most people can’t now and you have to opt of some other form of housing, would you rather have a townhouse or flat? And…you’d rather have a townhouse…the next best alternative to a house is a townhouse.”

So houses having got too expensive, the demand will now shift to townhouses. And for the next four or five years in Melbourne, particularly in the inner suburbs both east and west, the lowest risk, most assured investment you could have would be to buy a townhouse, a residential townhouse.

Q) What does the townhouse look like?

A) It’s two stories, it is two bedrooms with a study. It’s about 125 to 130 square metres. It’s been built in the last eight to 10 years and is probably one of up to 10 in the particular development.

Q) So we’ll expect to see more of those being built?

That’s where the really savvy developers are focusing their attention. There’s a lot of very good quality, smaller number, boutique scale developments coming on and they’ll meet with very strong demand. People don’t live in houses anymore, they can’t afford them. They’re living in townhouses, they’re not fully embracing apartments yet. A lot of tenants are but owner/occupiers are saying okay I can’t afford a house but I’m not going to buy a bloody flat, I’ll buy a townhouse.

Q) And what’s happening to houses then?

Well houses are supported by a market of people who are in the upper socio-economic profile these days, whether it’s due to income or capital. A good house in the inner suburbs these days costs you $800,000 to $900,000, if not $1 million. But in the same suburbs where houses cost you $1 million, you can buy townhouses for probably 50-60% of that value.

Now I’m not sure in the time since this interview was published whether Scott would change his advice. But I think his logic is sound and still holds. I do think you’d be hard pressed to find many quality inner city townhouses for $500k though, and personally from what I’m seeing I think there is still demand to the $700k range… as does CBRE…

“Well-located properties with good access to public transport and amenities continue to be the most resilient in the current conditions. Properties in the sub-$750,000 price bracket continue to perform well with demand levels remaining quite resilient,” CBRE director of residential valuations Jarrod Frazer.”

2012. Its going to be a bumpy ride…