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The Australian Economy’s Real Estate Noose; Economy privately in hock to its eyeballs on the most overpriced real estate in the world
Topic Started: 26 Sep 2013, 04:29 PM (578 Views)
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The Fed, the taper, the RBA, and the Australian economy’s real estate noose

Sep 25, 2013

By baulking at starting the taper of its $85Billion per month Quantitative Easing programme, the US Federal Reserve has made a political rod for its own back, and complicated things for the Australian economy too – starting with ratcheting up the risk of a real estate boom and bust.

What to taper

US Federal Reserve Chairman, Ben Bernanke, announced last Wednesday that the world’s most important central bank would not be starting to ‘taper’ its Quantitative Easing programme, after earlier floating the idea that it could start doing so in September. That programme, the most influential of a range of similar programmes by the ECB, Bank of Japan, Bank of England, is generally seen as having fended off global financial system meltdown in the aftermath of 2008 realisation that there were trillions of dollars worth of worthless paper on the world’s largest banks balance sheets, and the reason why global equities markets have had such a sustained upswing since 2009. The reasoning behind QE has been straightforward: flood the financial system with money to prevent a lack of credit causing a recession, then force investors as far out the yield curve as possible, by buying all the short dated debt themselves, in the hope they will do something economically productive. In order to be credible QE also needs an exit strategy for the Fed; a time at which it can say things are getting back to normal and the QE can be turned off.

That plan has had a few shortcomings. Flooding the system with cash has certainly worked to ward off another system shock. But crowding the financial system out of short term treasuries to do something productive has been less effective. Faced with a paucity of worthwhile investment opportunities, in a US economy where the rebound has been weak, and a global economy where meltdown has all too often seemed a real risk, global capital has simply bid up the price of whatever was available which seemed ‘safe’ – or less likely to lose value – or, where it has been forced to take on risk, has responded by taking the shortest, most easily escapable option possible, for the maximum possible return. It has all too often ceased to facilitate investment in capacity, to facilitate speculation or rent seeking on whatever growth is about – that has seen equities, commodities and real estate prices in the English speaking world in particular firmly supported.

When to taper

The second of those issues has troubled the Fed. Simply put, all that extra cash hasn’t delivered extra economic activity, and more importantly US jobs, anywhere near the rate required, or anywhere near previous recoveries from recession. On Wednesday Bernanke stated that QE would remain in place “at least as long as the unemployment rate remains above 6.5%”. US unemployment is currently 7.3% and it is currently anticipated it will slip below 7% in the first quarter of 2014. And it is this timeframe which is now looking more volatile for global financial markets, because every GDP or consumer sentiment or non-farm payrolls figure out of the US is now going to be seen through a prism of what it means for the Fed in shaping when they start to taper, as well as every meeting of the Fed. That starts to see the volatility which followed Wednesdays announcement played out over a lengthy timeframe, presumably until markets begin to see a firm announcement on when and by how much the Fed actually starts taking away the money which has given them a free ride.

Monetary policy in a galaxy far, far away

On the other side of the planet the RBA has been playing an entirely different game with Australian monetary policy. With more than 200 basis points of cuts between late 2010 and now, it has been trying to do three things – bring the Australian dollar lower, and coax a more robust consumer and retail outlook, while sparking an increase in housing construction to fill in the gap left by the downturn in mining investment which has long been in the pipeline.

AUD does Icarus

So far the rate cuts have failed to bring down the AUD to anywhere near a level where Australia’s globally exposed industries – particularly manufacturing, services, education and tourism – are anywhere near globally competitive. The AUD dropped from about 1.06/USD in April to below 0.90 in early September, but the general consensus is the globally exposed part of Australia needs it below 0.75, and probably well below that for time enough to give the idea to industries seared by an above USD parity dollar for 2-3 years.

Exile on main street

The rate cuts have also largely failed to boost main street, with Australia’s retail sector basically in recession, which is fairly obvious from the large number of vacant shops in suburbs and towns across Australia and the large scale retrenchment in the sector (losing 36 thousand jobs in the three months to August). The enduring strength of the AUD has seen shoppers increasingly buy online from overseas, leading to plaintive cries from major retail chains for GST to be imposed on internet purchases, with government (both sides of politics) taxation policy effectively encouraging Australians to spend money offshore.

The far bigger issue for retailers is simply that as individuals Australians are far too far in debt. According to the RBA Australian household debt to disposable income is currently running at 147% and it has been at that level for about 4-5 years – a level worse than the US in 2008, and a level which would be ringing alarm bells anywhere else in the world. That effectively means that Australian consumers simply cannot spend much more, because on average they are already too busy paying off what they already owe, with widespread recession like conditions and the increased threat of unemployment lending strength to the savings impulse.

Constructing something as mining investment drops

Where the RBA’s rate cuts are beginning to show some impact is in the increased housing construction figures, with housing starts and financing figures starting to pick up from very weak levels. More overtly, the mainstream media is again filling with headlines along the lines of ‘There’s never been a better time to buy Real Estate’ as clearance rates in major capitals and average sales prices start to rise. The RBA and government effectively need housing prices to rise (although there was no mention of this from either side of politics during the recent election campaign), as this sends a signal for increased housing construction, and they need the increased housing construction to fend off a recession as the investment in mining, which reached a peak of about 7% of GDP in the December quarter of 2012 begins its descent back to a historical average of about 2%, providing a major headwind for the economy for at least the next three years, and which will place significant downward pressure on wages, disposable incomes, and the urge to take on credit while setting the scene for higher unemployment.

Ransoming todays jobs and future generations of home buyers to housing speculators

The uptick in housing construction starts has been weaker than responses to previous rate cutting cycles, with First Home Buyers having largely vacated the field, and in key states more mortgages being retired than new ones taken on. What has been far more noticeable has been the response by property investors speculating on rising prices with APRA recently noting that 39% of all mortgages are now being serviced on an interest only basis (not paying down the principal – generally reflecting investors waiting for prices to rise before selling). The real estate investment industry – the one filling media pages with 25 year olds who ‘own’ 50 properties, on the path to wealth, and the reason production values for real estate inserts in newspapers are noticeably better than the quality of reporting on real estate issues in them – has heavily promoted the use of self-managed superannuation funds to invest in real estate, and dampened any questioning of Australia’s unwieldy real estate fundamentals – in particular why any government (again both sides of politics) would not question a negative gearing policy which seems designed to encourage loss making landlords to speculate in existing housing stock, rather than construct new dwellings, and subsidise this to the tune of $3.7 billion from the budget in the last financial year (roughly ten times all other forms of industry assistance for manufacturing, primary industry and research combined).

With interest rates in Australia currently at the lowest they have been in generations the motivation for anyone with access to credit is to borrow to ‘invest’. Those with assets to use as collateral (generally older) have been in a position to benefit, and they are doing so. However this too has major risks. Those buying for investment purposes, currently the bulk of the market, will be looking to sell at the point when prices have risen, or for those negatively gearing, when their other income against which they write off their losses has ceased (eg. upon retirement). With an estimated 2/3 of Australia’s property investors estimated to be within 10 years of retirement that capital gain payoff needs to be fairly overt, and soon.

Back to the US Fed

What is decided by the US Federal Reserve to deal with the US economy has directly affected what has unfolded in Australia in a number of key ways. First it has meant that there has been plenty of money in the global of financial system looking for whatever return it can get. That has meant that funding costs for Australian banks in particular (which get about 25% of the funds they lend domestically on international wholesale markets) have been down, making credit more available, and cheaper, in Australia, for those with access to it.

QE has also meant strong demand for Australian sovereign debt, reflecting an economy which certainly does not have a public debt issue as far as the rest of the world is concerned (currently about 22% of GDP compared to more 3 times this across the OECD, despite the focus of both major parties insofar as they discussed economic issues at all during the election campaign) and has an AAA rating. This, in turn, has played a large part in why the Australian dollar has not come down the way it needs to, and is the biggest single factor in why the globally exposed parts of the Australian economy (away from mining) are so horribly uncompetitive.

On the radar looking forward

Anyone catching a sight of the 2% jump in the AUD within hours of Bernanke’s comments was seeing the RBA’s conundrum in real time. The RBA (and government, although no side of politics would come out and acknowledge it) is trying to steer an economy which is privately in hock to its eyeballs, mainly on some of the most overpriced real estate in the world, and which is profoundly uncompetitive globally because of an overly strong currency, with interest rates. Those interest rates aren’t generating the same reactions that they once did because there is a far larger central bank affecting global financial flows though QE.

They are steering it in such a way as to make that real estate more expensive (notwithstanding that real estate also has a number of supply side issues affecting its price), so that employment can be kept up though construction activity, because stimulating any other sector of the economy, after they have been seared with a high AUD for 3 years, may not work. The reason they need to keep employment up is because if any significant number of people become unemployed then the household debt to disposable income figure starts to show up as a non performing loan problem on bank balance sheets. Nobody wants to go there with the downturn in mining capex as the backdrop, and with Australia’s government the backstop behind its banks – as the implicit guarantee reduces bank lending costs on global markets, and in turn makes the costs of those banks sensitive to the credibility of the government and its budget position.

The RBA looking at the Fed

The RBA knows that the moment the US Federal reserve does begin to taper then the US dollar will rise and that the AUD will weaken. They also know that cutting rates to try and weaken the dollar while the Fed has QE in play is taking part in artillery duel with a popgun, and isn’t likely to work. They also know that, away from the AUD, demand across much of Australia is so weak that it is effectively in recession like conditions and that rate reductions are the only thing staving off worsening conditions. But they know too that they have only about 50-75 basis points of rate cuts left with Australia needing to ensure that international investors continue to fund a generations worth (and more) of chronic current account deficits, which presumably requires at least around 2% as a risk reward for funding about the most heavily indebted people on earth, doing little more than swapping amongst the world’s most expensive real estate with each other, while hollowing out their globally exposed sectors as the investment phase of the mining boom heads downhill. At 2% or below then the RBA would be effectively close to an Australian variant of zero interest rate policy, and the closer it gets to that point then the closer it gets to a foreign buyer exit, and ensuing AUD slump, followed by interest rates heading back up – either to ward off a bout of currency slump related tradable inflation, or to ensure Australia doesn’t face a balance of payments issue. That point would be somewhere within 3 more 25 basis point rate cuts. So that means how they play any rate cuts from here is tricky. If the Fed starts to taper soon, then there is far less need for the RBA to think about cutting rates further, but if the Fed signals it is likely to hold off for longer, then the Australian dollar will remain stronger, adding to the global competitive and consumer malaise it is currently experiencing.

Real Estate heads off to the races again

The other issue making things tricky are the increasing signs of a real estate boom in Australia’s capital cities. Although the RBA wants a gentle uptick in real estate in order to stimulate construction, the last thing it wants is a fully fledged 2010 style boom, as the one thing it will be sure of getting is a load of ultra-heavily indebted ‘investors’ piling in without thinking to bid up Australia’s already high real estate prices to something stratospheric. More to the point, although it isn’t directly an RBA concern, political sensitivity about inter-generational housing affordability is increasing, and can be expected to increase still further within this parliament. Anything taking Australian debt to disposable income, or mortgage debt to GDP higher will have alarm bells ringing within the RBA, who would be only too aware of recent moves by the Reserve Bank of New Zealand to head off further real estate related financial system risks there, by bringing in Loan Valuation Requirements (LVR). With so much of Australia’s real estate buyers investment community buying to pay off interest only and leveraging themselves highly to do so, they are putting themselves at greater risk should there be any likely rise in interest rates, which is precisely what the RBA would be forced to do if a real estate boom further impinged on the stability of Australia’s financial sector. If the US Fed signals that it will push the taper back, it increases the likelihood that the RBA will need to cut rates further to help support demand locally, as well as take the sting out of the AUD, but this at the same time increases the risk the Australian economy will be disfigured further by a real estate price boom. This, in turn, would over the longer term suggest that the RBA would need to lift rates, catching a lot of property investors exposed, while at the same time carrying a negative implication all over for the AUD, for consumer demand – a protracted flat spot for the economy.

Has it never been a better time to buy real estate for you too?

So in the coming weeks and months expect to be subjected to an almost schizophrenic business media coverage when trying to fathom what is about to unfold. If bad data in the United States is good for markets because it means the FED keeps QE stimulus in play for that much longer, it could also be bad for the Australian economy by adding to the uncompetitiveness of virtually every part of it, which in turn forces the RBA to go a rate cut too far. That might be good for real estate prices in the short term as spruikers cultivated a final tilt at the debt summit which has kept Australian real estate at nose bleed levels for nearly a decade. But from there it wouldn’t be a question of which direction next, but the rate of the descent. And unless the RBA makes every step a winner in playing what the US Federal Reserve deals over the coming months Australia’s economic road ahead has a number of serious potholes.

Read more: http://theinfinitive.com.au/business/fed-taper-rba-australian-economys-real-estate-noose/367
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