It is my humble opinion (still!) that the world is going to enter another recession. The rationale for this can be seen on my recession call post….
The ExodusPoint Partners International Fund returned 0.36% for May, bringing its year-to-date return to 3.31% in a year that's been particularly challenging for most hedge funds, pushing many into the red. Macroeconomic factors continued to weigh on the market, resulting in significant intra-month volatility for May, although risk assets generally ended the month flat. Macro Read More
and some more recent commentary from the ECRI in this great interview
What’s most telling about this video is the gently mocking tone of the CNBC hosts as they completely fail to grasp that Lakshman Achuthan doesn’t make stock market calls and focuses purely on leading indicators not the co-incident or lagging ones that the market has recently been rejoicing over!
If this macro premise is correct then I believe we will enter another round of the Global Risk OFF game. One of the most appealing risk off trades from my perspective is short AUD/USD which is now quoted at a near 30 year high against the greenback. This idea was first brought to my attention by Chris Pavese at Broyhill and I have leaned heavily on their analysis, they have been onto this trend for a while now. Check out their blog at http://www.viewfromtheblueridge.com/
Australian Central Bank has Started Lowering Interest Rates
The Reserve Bank of Australia cut official interest rates by one quarter of a percentage point to 4.50% on the 1stof November. At the same time it also cut its own growth outlook by 50 basis points for the next 12 months to reflect “risks to global growth and heightened financial volatility”. They also highlighted “changes in household spending and borrowing behaviour” which is crucial to the future I envisage.
In January, the Westpac-Melbourne Institute Index of Consumer Sentiment was down 10.7% in annual terms. Ouch!
The index level is still below where it sat just three months ago and prior to two rate cuts of 25 basis points each from the Reserve Bank of Australia (RBA), in November and December. Rate cuts from the RBA typically are a significant boost to consumer sentiment in Australia, given that more than 90 per cent of the country’s mortgages are set at variable rates. But the rate cuts still aren’t working, perhaps the first signs of an Australian household focus on “debt minimisation”?
An economic slowdown in Australia, which would flow from a global slowdown and a weakening of China’s growth rate, will force the RBA to start cutting rates from their current levels which are far in excess of the developed world average.
Although lower rates will help to ease any slowdown in the Aussie economy it will remove one of the key advantages AUD has enjoyed over most other currencies in the last few years – positive carry. If you can borrow money in GBP, USD or JPY at near zero and then invest it in an appreciating AUD earning 4.5% interest then you can cream off that 4% a year without having committed much, if any, capital. It’s a no-brainer, any old mug can do it, and they have!
There is a very strong correlation between foreign ownership of Aussie bonds and the AUD – this makes intuitive sense because people would have to buy the currency to buy the bonds. It seems likely that much of the money has been flowing to AUD because of its safe haven status and its perceived economic invincibility. As sovereigns around the world get downgraded there is a smaller and smaller “AAA Club” and therefore the pools of capital which are forced to own only the highest quality paper are forced to search further and wider. Should this safe haven status ever be called into question, and no-one is sacrosanct anymore, then those currencies most reliant upon capital flows would be the most vulnerable.
Weakening Commodity Demand from China
They call Australia “The Lucky Country” for very good reason. It is surfing the crest of a decade long resource and real estate boom stemming from China’s credit driven demand. Virtually every material that Australia was blessed with has seen enormous price increases over the past decade. Increased demand for Iron Ore, Gold and Coal has been bolstered by massive price increases to boot.
Australia isn’t just lucky though, its symbiotic relationship with Emerging Market demand, particularly Chinese demand, has been the result of a long courtship. Since the mid 1970’s, when colonial ties with Britain were severed, the Australians have naturally sought to do more business with their nearest neighbours. Ironically, what was once a prison island far away for banished convicts is now arguably the most geographically advantageous land mass amongst all the first world nations. China now absorbs far and away the largest share of exports, followed by Japan and South Korea. As you would expect the share of exports to slow or no growth Europe, US and UK is considerably less.
China accounts for 25.3% of Australian exports in 2010. But Australia’s actual export dependency may be great suggest the Interest Rate Observer, Japan get’s 19% and South Korea 9%, both of whom likely take Australian resources, turn them into high tech capital goods and then sell them to China. That’s close to 60% of exports which are highly sensitive to Chinese growth.
This 20 year boom has fundamentally restructured the Australian economy. Over the last 15 years, mining has jumped from 4% to 10% of GDP. At the same time, manufacturing was pared back from 15% to 10%. That enabled the country to more easily absorb the blow when China took over the world’s low end manufacturing industry, which has caused so much damage to industry and employment in the US and here in the UK.
Because of this heavy reliance on commodity exports and mining as a percentage of GDP, Australian markets, including currency, equities, bonds and real estate have become a leveraged play on the growth of the global economy. My own pet theory is that being bullish on Australia is only a little more nuanced and “safe” than being wildly bullish on China, but it’s ultimately the same trade.
When markets are bullish and the Risk ON trade is in full swing, Aussie assets outperform. AUD nearly doubled against the USD since the March 2009 bottom as the world re-embraced risk, global growth and Antipodean decoupling. When markets turn around and go “Risk OFF” the opposite happens – AUD fell by 15% during the last correction.
What no-one is talking about is that most of the Australian economy is possibly already in recession. This is near unthinkable because the world’s 13th largest economy has not had a year of negative GDP growth since 1991! That is astonishing. To quote James Grant
“To applaud a 20 year recession drought is to subscribe to the unlikely proposition that Australia has gone 20 years without overdoing it.”
My opinion now is that only the filter through from the Sino-Demand related industries is keeping the economy humming along. It was a big shock to me when I saw “The number of companies entering some form of insolvency administration in calendar year 2011 continues to set new records” from Dissolve.
Not to worry, there is investment abound from the mining companies planned for years to come. Direct Mining Investment as a share of the economy has gone from 1% to 3% and is heading toward 6% if they hit planned expenditures. This is the highest rate in 100 years.
People discredit the Chinese growth boom as unsustainable due to the predominance of fixed asset investment – the building of roads/buildings/bridges/factories. Often it seems this investment is very wasteful and creates excess capacity just for the sake of GDP growth (Google “Ordos”). Well in 2009 Fixed Asset Investment was 48% of the Chinese economy, in contrast it was only 12% in the US. In 2010, Australia clocked a number of 27.4% according to James Grant – that is China-esque.
Bursting Housing Bubble
“Almost 311,286 properties are for sale across Australia, the highest in more than five years and almost 30 per cent more than the same time last year. In Melbourne, there are 50 per cent more properties for sale, 30 per cent in Sydney, 14 per cent in Brisbane and almost 40 per cent in Adelaide more than this time last year” Perth Now Newspaper article December 1st
Jeremy Grantham is one of the most prescient investors alive today and in 2010 he said
“Australia had an unmistakable housing bubble and that prices would need to come down by 42 per cent to return to the long-term trend. Bubbles have quite a few things in common but housing bubbles have a spectacular thing in common, and that is every one of them is considered unique and different.”
As an example, he cited the British housing market bubble of 1989. At the time, he said people dismissed the bubble because there was no more re-zoning allowed by the councils, creating a land shortage and as such, they believed prices would rise forever. Seven years later they had hit the lowest multiple of family income since the record began in 1945.
There is always some variation of this theme, for example in the US “there isn’t oversupply as the spare houses are in the wrong place”. With Australia it is, “there isn’t enough land in the major cities or on seafront property”and “immigration is creating consistent demand” or “Asian buyers entering the market”. To be fair, Sydney is probably cheaper than Shanghai!
In Australia’s case, Mr Grantham described the housing market as a “time bomb” just waiting for interest rates to rise to levels where prices and mortgages could no longer be supported. In this respect perhaps the rate cut this month will help soften any blow to house prices.
If the Australian housing market did not mean revert to the normal multiple of family income, he said “it will be the first time in history.” This contraction could mean moving from 6x family income down to the current post bubble US levels of nearer 4x – or a price decline of 33% presuming incomes stay flat. What does that do to consumer confidence?
Houses can be bought for relatively low deposits of 5-10% despite what bulls will tell you of conservative lending practices. This article provides some reputable anecdotal evidence of a Real Estate bubble in full swing.
According to Guy Debelle, Assistant Governor of the RBA, low-documentation loans account for almost 10% of new loans and almost half of all new home owners are opting to go for “interest only” mortgages. In other words, they are relying on prices going up.
I think this reaching a point of unsustainability. See the following quote from Prosper Australia.
“There are 1.3 million Australians with negatively geared rental properties. They are diverting all rents and some personal income to meeting interest payment in the hope of capital gains. When only capital losses are expected, investors will flood the market and overwhelm demand.”
This is in the face of interest rates being cut, when even lower rates lead to difficulties meeting mortgage payments the only other options are writedowns or sales.
Steve Keen, Australian economist, shows that Household Debt to GDP in Australia is higher today than it was in the US before the crash.
Chris Pavese said….
“We also find it curious that “investor’s” share of new home loans has risen almost uncontrollably, while first time buyers disappear from the market – a clear indication that affordability is declining, and a big red flag, as first time buyers represent an important link in the housing chain.”
A startling 460,000 households spend more than half of their income on housing costs. It’s no wonder Australian’s are shouting out for help. The cost of housing is the single biggest cost of living issue in Australia today. Steve Keen estimates mortgage interest payments account for an eye watering 65% of after-tax wages. We know from recent experience that the two lines below cannot diverge for long.
In a recent report, Moody’s warned that there are “meaningful uncertainties” for Australian housing and mortgage delinquency rates are likely to increase over the next decade. We doubt it will take that long. “Capital city house prices have more than quadrupled and household debt has tripled since 1990. Simple metrics indicate that the current price levels are not sustainable.”
If a second global recession occurs credit markets will tighten up. Australian banks already have up to 40% exposure to European debt and the big four Australian banks ratings were downgraded by Moody’s Investor service due to this wholesale funding exposure. A recent WSJ article highlighted that the spreads on Commonwealth Bank’s new issues are widening. Unfortunately, in 2011 Australian borrower home loan arrears hit a 15 years high with Australian banks and borrowers in a binge-buying hangover. Mortgages originated at peak prices between 2008 and 2009 combined make up 40 per cent of the mortgage loan books of the major Australian lenders. This equates to slim slivers of equity in many households.
Anthony Doyle of M&G says “The end of a bubble is always difficult to predict and identifying the trigger for such an unwind is similarly fraught with difficulty. Given that markets are extremely sensitive to the potential for asset price bubbles bursting and with the effects of such events still in mind, the Australian housing data are key to AUD maintaining its lofty levels. Something else that is worrisome is that the Australian banking sector dwarfs the size of Australia’s economy at 3.5 times nominal GDP (Ireland’s banking sector was 4.4 times GDP in 2008). The key challenge facing the Australian banking sector is its exposure to the housing market, with about two thirds of assets on the banks books consisting of housing loans.”
Unwinding of Carry Trade/Hot Money
Although Australia has been running large current account deficits for 50 years, the shortfall has been more than made up by large foreign capital inflows for investments or the carry trade. Most recently, China has attempted to take large minority stakes in several firms, especially in the resource area. This will accelerate in coming years to the extent that Australians permit it. A capital shortage in the country there is not, mostly because every man and their dog is rushing to get a piece of the action.
A continuation of home price/currency appreciation at these rates is a mathematical impossibility. Once prices stop going up, the hot money will exit, usually this happens all at once. And like real estate markets everywhere, there is a ton of liquidity on the upside and none on the downside.
Foreign investors bought a record $23.9bn of Australian government bonds in Q3 2011, which takes foreign ownership to 80.4%, which is also a new record high. To quote Anthony Doyle again “this is worrying as heavy foreign ownership of government bonds can be very dangerous, particularly when this is combined with a country running a current account deficit (i.e. the country is reliant on capital inflows from abroad). Ireland and Portugal, which saw similar levels of foreign ownership before the crisis hit, are great (or poor?) examples of how this combination can leave a country’s exchange rate and solvency very exposed if the country hits a crisis.”
AUD has been used as a Risk ON proxy for at least the last 5 years. Movements in AUD/USD are closely related to EM outperformance over the S&P 500. Currently the discrepancy in this correlation is as wide as it has been, the EM/US relative equities have turned down brutally since 2010 and yet AUD/USD remains resilient. I expect AUD/USD to play catch up as people realise this is not a safe haven with a free spread.
US Dollar – How Counterintuitive would it be if we have already had the Dollar Collapse?
The strength of the US economy relative to the rest of the developed world in the last few weeks is likely to help the USD side of this trade. The economic momentum has also likely put off the risk of QE3 discussions for at least a few months and therefore one of the major downside risks to the Dollar has been mitigated.
With rates anchored at zero in the US and therefore no risk of USD weakness due to rate cuts but a ton of “wiggle room” for the RBA to cut and weaken the AUD.
So I think it’s set up as a very skewed risk/reward currently. Could it rally up to $1.10 from today’s $1.04? Probably, but I don’t think that’s likely given the USD momentum. On the downside, we saw $0.60 in the financial crisis, but I think $0.80-$0.90 is a reasonable target if the cracks start to show.
No-One Expects It
Talk to Australians and they are optimistic and upbeat about the future. I have friends that are considering emigrating, and quite a few who already have! To put this into context, the Australian economy is roughly the same size ($1.4 trillion) as the state of Texas – and I don’t know anyone who has ever emigrated there. But no wonder they all go to Australia, the money on offer is absurd, especially when converted back to GBP or USD. Guys in their low to mid 20s can earn $200,000 a year working in oil services, mining or in specialist fields like dentistry or medicine where they have newfound affluent demand.
The money these guys make juices the rest of the economy – by working a “21/9” schedule, which means working for 21 consecutive days at a remote mine, and then getting 9 days off, they arrive back with a wallet full of cash and looking to spend it on partying, clothes, flash cars and nice apartments.
I have a friend who has emigrated to work as a dentist – below is a quote from him responding to an email where I voiced my concern regarding Australia’s overheating currency and property market.
“All a bit sensational I think mate. And do you really think I want to be seeing 40 patients a day instead of 15 and earning £15 per filling as opposed to $215.”
Just to be clear – he can charge 10x as much per filling in Australia as he can in the UK, two countries that are broadly equally affluent.
I am reminded of the phrase “If something cannot go on, it will not go on”.
And finally, the Wall Street Journal says in the opening line of this article “Don’t bet that a slowdown in the global economy will drag the Australian dollar down like it did in 2008.”
Short AUD/USD currently represents a 16% position within Kelpie Capital initiated at an average price of around $1.02.