Friday, 29 April 2016 12:08

Euro Refugee Crisis

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The flow of refugees into Europe has been staggering.  The human side of this tragedy is horrible, but here we are only considering the economic implications of the European Refugee Crisis.

 

We recently spoke with Clay Smolinski (Portfolio Manager Platinum Asset Management) to ascertain what he thinks are the key risks of this situation from an investment perspective.

 

Here is a video of our conversation - and a transcript below.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mark Draper: Here with Clay Smolinski from Platinum Asset Management and the Europeans have been through a lot really in the last decade and they’ve got plenty of coming up.

One of them has to do with the refugee crisis over there. So we just want to spend a couple of minutes looking at the investment aspects of the European refugee crisis. Can you just take us through your thinking on that?

Clay Smolinski: Yeah, absolutely. So the refugee crisis for me, the issue is – the risk of it is that it’s another challenge that the political will of the European Union needs to face.

For me the crisis alone probably wouldn’t be a huge deal for the union but the issue is that it comes on top of a lot of the problems, those individual – the union of countries has had to face over the last few years.

So we think about the union. Through the sovereign crisis, they got through the major battle, which was the economic battle needing to cut the budget deficits, needing to where – you know, that higher unemployment that that caused. From the economic perspective, we can fairly definitively point that that battle has been won. The economy is now recovering but that has left that political will far weaker.

Since then we’ve seen that in subsequent elections, more radical left or right wing parties have been voted in. Examples of this would be Podemos in Spain or Syriza in Greece. We now have major members like the UK going to referendum on deciding whether it’s an exit or not and now we have the refugee crisis and immigration is always a very politically-charged issue and it’s clear that the member countries have differed in their views on how to exit, on how to handle it. That just creates – it’s another issue. It’s another reason for people to get upset, the voting populous and maybe vote for an exit.

What is interesting for us as well and is a bit of mitigant to that is how Germany is – has behaved through this and certainly through the sovereign crisis, the response to that crisis was very much dictated by Germany and that has forced a lot of the other member countries to go through a lot of pain.

Now with the refugee crisis, they’ve really stepped to the fore and said, “We’re going to do more than our fair share to handle this. We’re going to take a lot of these people on to our soil. We’re going to provide additional funding to the others to work through this,” and I think it’s their way of standing up and saying, “Look, we know you’ve done your part and now it’s our time to really give back and to show solidarity in the union.”

Mark Draper: So a major risk here would seem political for that in terms of the uprising of hard left or hard right – well, probably hard right in this situation.

Clay Smolinski: It’s very hard to factor that back into a definitive investment decision but it’s certainly something that we need to keep in mind and often when you compare the European market to the US market, the European market does trade at a valuation discount. But I think at least some of that discount is warranted given the – I guess the more uncertain political outlook for that region.

Mark Draper: So be alert, but not alarmed at the moment. It’s a work in progress.

Clay Smolinski: That’s how we’re viewing it.

Mark Draper: Thanks for your time Clay.

Clay Smolinski: You’re welcome

Friday, 29 April 2016 08:51

China - Hard or Soft Landing?

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The Chinese economy is critically important to Australia as one of our key trading partners.  It used to be said that if America got the 'sniffles' Australia gets pneumonia, now it can be said if China has a headache, Australia develops a tumour.

So with China making headlines in recent months, we asked Clay Smolinski (Portfolio Manager - Platinum Asset Management) whether he believes the Chinese economy is heading for a Hard or Soft Landing?  (note definition of Hard Landing is "An economic state wherein the economy is slowing down sharply or is tipped into outright recession after a period of rapid growth, due to government attempts to rein in inflation")

We bring you the 3 minute video of our conversation below, or alternatively you can read the transcript.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mark Draper: Here with Clay Smolinski, Portfolio Manager at Platinum Asset Management. Thanks for joining us Clay.

Clay Smolinski: You’re welcome, Mark.

Mark Draper: Let’s talk about China. Hard or soft landing economically?

Clay Smolinski: Certainly. I think when answering the question when looking inside of China, evidence of the hard or soft landing is very much determined on what industry you’re looking at, at the time. So we take the heavy industries. So we’re talking about industries like steel or cement where there’s over-capacity. There is a clear hard landing going on.

So there has been a big fall-off in construction activity. The government is now planning forced closures of capacity in those industries. We’re talking about 1.5 million steel workers being laid off over the next 12 months. Times are very tough there. However, you look at other sectors of the economy and we’re talking about sectors such as air travel, ecommerce, healthcare. There’s no concept of a landing there. These sectors are in take-off mode, growing very strongly, creating a larger amount of new employment and that’s really where we’re focusing our attention and that’s really where our investments are today in China at Platinum. We’re focusing on those consumer and service-focused industries.

Then the question is when we put those two together, what are we seeing on a broad basis? And what we see is – we look at the leading indicators. What we see is that while growth has slowed, the economy certainly isn’t in store mode.

So first, one leading indicator, a good one is wage growth. So two years ago, wage growth across China was growing at 10 percent per annum. Today that number is five percent per annum. A big step down but five percent per annum is still fairly healthy in our book.

Another interesting indicator is housing prices. So you can forget about the stock market. The real investment class of this nation is residential and commercial property and house prices in China have actually been really strong over the last 18 months. We’re seeing very strong in tier one cities like Shanghai and Beijing but it’s also prices are rising in tier two and tier three cities.

Then finally we see the government and the government is increasingly becoming more – really need to take more measures to support growth. We see that through cuts through interest rates. But also there are a number of industries where a lot can still be done.

China is not a developed country yet by any standards. So we think about the investment that can go into things like healthcare, the investment that can go into environmental solutions. They have a large environmental problem. So these are areas where we can see stimulus that – and it will be stimulus that will be productive and good for society.

So when we put all that together, it feels to us that the economy has stabilised and we’re very much in the soft landing camp for now.

Mark Draper: That’s great. Thanks for your update Clay. I appreciate it.

Clay Smolinski: You’re welcome.

Since Motor Registration stickers were no longer issued, the chances of forgetting to pay your car's registration have risen considerably.

Most people would focus their mind on the $400 fine that applies in South Australia for driving an unregistered vehicle ($800 in Victoria), and if that was the only downside for not paying your car registration, this article would end here.

The harsh reality though is that part of the cost of motor registration is provision of third party person insurance, which covers personal injuries resulting from motor vehicle accidents.  One of the most notorious motor accident personal injury claims involved the late actor Jon Blake who was awarded nearly $8m following a car accident that left his severely disabled.  The risk of driving an unregistered car is that in the event of an accident, you may be liable to pay insurance costs that would otherwise be paid by the compulsory third party person insurance - which could result in bankruptcy for you.

To help motorists, the South Australian Government has introduced a smart phone app - called EzyReg.

 

EzyReg allows motorists to check when their registration is due and also add a calendar reminder to their smart phone.  Payments can also be made on this app.

Finally - monthly payments for motor registration is now available, which can further reduce the risk of missing an annual car registration bill.

A $400 fine is painful enough if you forget to register your car - but the real risk lies with the compulsory insurance cover.

Thursday, 21 April 2016 12:17

Sustained Sluggishness

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In this edition of IML (Investors Mutual) Market Musings, Hugh Giddy, IML’s Head of Research and Senior Portfolio Manager, reflects on the current state of global growth & indebtedness in the years since the GFC. Musing on the various measures taken by central banks, governments and public companies.  He explains some of the headwinds that the world faces that investors should be mindful of when setting their expectations in a low growth, high debt environment.

 

Here is the start of the report -

"In December the US Federal Reserve finally raised interest rates by a miniscule 25 basis points after six years of effectively zero rates. It has surprised almost everyone, not least of all the Federal Reserve, how sluggish the recovery from 2008’s Global Financial Crisis has been. Over that period economists have continuously forecast growth levels more reminiscent of previous recoveries and steadily had to cut those forecasts as actual events unfolded.


The authorities have tried many different approaches to stimulate growth, including punitively low interest rates for savers (in an attempt to make borrowing even more attractive), and in some European countries both short and long rates are now negative. Japan has just joined the club of central banks charging depositors to store their money in the banking system by lowering rates 1below zero. This can hardly be popular amongst Japan’s large population of retirees who would be hoping to get a positive return on their savings.

Quantitative easing (QE) has been tried repeatedly without leading to any useful real economic benefit – inflation remains low (higher inflation encourages people to spend rather than watch the real value of their savings erode), credit growth is anaemic despite low interest rates and growth has barely budged. Japan continues to experience swings in and out of recession despite aggressive monetary easing and money printing through QE. Indeed one could argue that the flailing efforts of monetary authorities to stimulate economies has actually been harmful in that the only noticeable effect has been a sharp rise in financial asset prices – with strong rises in selected share prices and indices, probable property bubbles, particularly in commodity exporting countries such as Canada and Australia, and very low spreads for high yield debt, i.e. very high risk debt, - until recently. The surge in these financial assets has distorted the pricing mechanism, and bubbles inevitably end in a bust."

 

Click on the icon below to download the full report.

Also - Hugh Giddy, the author of this report appeared recently on Sky Business with Paul Switzer in the "Switzer Report" - he discusses the themes that are outlined in the report.  You can watch this video here in addition to reading the report.

 

 

Friday, 15 April 2016 10:15

Apple in focus - Magellan buys a stake

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One of Australia's most successful investors, Magellan Financial Group, has recently built a stake in Apple.

Here is the investment case behind this purchase - makes for an interesting read:

Apple is amongst the largest companies in the world. The company enjoys strong brand recognition globally and extensive market penetration for its flagship products, most notably the iPhone. While speculation around the success of Apple Watch, Apple TV, iPad, or even the likelihood of an Apple Car often captures headlines, we estimate that iPhone and iPhone-related services represented around 70% of Apple’s revenue and 80% of Apple’s gross margin in FY15. Despite its relatively high price, there is strong demand for the iPhone in both developed and emerging markets, with China now contributing 24% of Apple’s total revenue.

Apple’s growth has been driven through its position as a consumer hardware vendor. There are few, if any, examples of consumer hardware vendors which have endured over the long term as the products have typically commoditised over time. However, having built a powerful, enduring ecosystem, we view Apple today as a leading mobile platform and services company with sales of its devices reflecting effectively a “subscription” payment to access its platform and services.
Apple displays several attractive investment characteristics which support our longer term outlook for the company.

To download the rest of the report - click on the icon below (note the report also contains financial market commentary for March 2016 quarter)

download button 1

 

 

Thursday, 31 March 2016 09:18

State tax competition - issues for South Australia

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Helen Hodgson, Curtin University

Australia’s federal government initiated two major reform processes after the last election: a tax reform process and reform of the Federation. Prime Minister Malcolm Turnbull’s plan to hand income taxing powers to the states sits at the intersection of the two.

Under the Constitution, the states already have the right to levy income taxes. They effectively conceded this power to the Commonwealth after the Uniform Tax Cases, in wartime 1942 and affirmed in 1957. Both held that the Commonwealth use of the grants power was valid.

The Turnbull proposal is based around the Federal Government cutting income tax rates, then allowing the states to raise income tax directly from residents of that state.

The first challenge is the administration of such a proposal. The Commonwealth took over the collection of state income taxes in 1923 when the states agreed to the national collection of income tax. This led to the introduction of the Income Tax Assessment Act 1936, which ensured income tax laws were applied uniformly across Australia.

Turnbull has said the Commonwealth would continue to collect the tax for the states to avoid compliance costs. The Coalition government has campaigned against red tape, implementing a range of initiatives to reduce overlapping reporting requirements. These include the single touch payroll system that allows employers to report income tax and superannuation obligations in real time. The tax receipts that were issued to accompany tax assessments in the 2015 year would presumably be modified to show the share that was levied by the state.

The biggest challenge that would emerge is if states chose to exercise the right to increase or decrease their income tax rates. Accountability is one of the reasons being put forward for the proposal, on the basis that if the tax is more transparently related to services delivered by the state, the state government will use those taxes more wisely.

However tax competition can also lead to a race to the bottom: if one state lowers its taxes, other states are likely to follow.

Uniformity dominates

If tax competition results in lower income taxes in one state than another, interstate migration could increase, putting more pressure on the states that have not reduced their income tax rates. We have seen the problems that national governments are encountering regarding the appropriate jurisdiction to levy taxes: it can be expected that similar issues would emerge between the states, requiring a range of residency tests to attribute the residency of itinerant or technology-based workers.

Increasing migration between states would put pressure on state governments to reduce their own tax rates. Recent history shows that when the Queensland government reduced state taxes and abolished death duties in the late 1970s all other states and the Federal Government followed. A general lowering of tax rates would defeat the stated intention of allowing states to raise additional funding for health and education.

It would not be surprising to see mobile workers relocating to low tax states, while people more reliant on good health and education services, who may be at a stage in their life when they do not pay tax, would remain in states with better services.

Recent tax policy initiatives in Australia have focused on tax harmonisation as an antidote to tax competition. For example, since 2007 the states have implemented a harmonisation agenda to ensure that the administration of payroll tax is consistent across the country: however it does not extend to rates and thresholds.

There is also a question over what is meant by accountability: is it code for cost shifting? The Prime Minister has already acknowledged that states such as South Australia and Tasmania, which have a weak economic base, would have to be protected. Does this mean that if other states experienced a downturn in economic conditions they could also apply for assistance?

In his announcement the Prime Minister referred to this as the most significant change since World War II. History shows that it has been tried before: in 1978 the Fraser government introduced legislation that allowed the states to levy income tax. It did differ in the detail, but allowed states to impose surcharges or allow rebates. This legislation remained in force for 21 years without being applied by any states, partly due to changes in the political and economic environment.

As it stands the reaction from the premiers on the current proposal has been lukewarm. It would seem that a GST style agreement would be advisable to ensure passage through all relevant parliaments.

While both the formal tax and federation reform processes appeared to have stalled, it seems the government is putting them firmly on the election agenda.

The Conversation

Helen Hodgson, Associate Professor, Curtin Law School. Curtin Business School, Curtin University

This article was originally published on The Conversation. Read the original article.

Thursday, 31 March 2016 09:00

Oil Price rising to $70 per barrel

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We recently met with Clay Smolinski, Portfolio Manager at Platinum Asset Management and discussed with him why they believe the oil price is likely to rise to $70 per barrel over the next couple of years.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Here is the transcript of the video too.

 

Mark Draper: Here with Clay Smolinski, Portfolio Manager of Platinum Asset Management. Thanks for joining us Clay. We’re talking about the oil price today, which has been smashed back from $100 a barrel recently over the last couple of years back to around $30, $40 a barrel as they’re today. How do you see it playing out from here?

Clay Smolinski: Certainly. So from here, we see a fairly realistic case of where the oil – where oil is on a path back to roughly $70 over an 18-month period. But let me quantify that. So first of all, why do we think the price is going up at all? And it’s simply because we see that supply and demand balance starting to tighten.

So we can go through some simple maths. So at the start of 2015 is when the oversupply in oil became very apparent and at that time, we had a global oversupply of about 2.5 million barrels a day. On top of that 2.5, we can add a million extra barrels of production coming from Iran. That it’s going to step up production after the US sanctions were lifted. So starting base, 3.5 million barrels of oversupply to work through.

We can now think, “Well, what has happened since then?” So from the demand side in 2015, demand did what you would expect. The price fell and people consumed more. So demand was actually strong and it grew by 1.5 million barrels in over 2015.

On the supply side, we saw the first effect of the big reduction in activity in the US shale-oil markets and US shale production fell by half a million barrels. So combining that, we can take 2 million barrels off that oversupply and that leaves us with 1.5 starting 2016 now.

So what do we expect? Well, the activity cuts in US shale have intensified and we think you will see at least another half a million barrels of production coming out of that market this year, probably more like 800,000 and then it comes down to what’s demand going to grow at this year.

We think demand should grow at least by say 700,000 barrels, somewhere between 700,000 and a million barrels a day and that’s being underpinned by additional oil consumption out of China. So China’s oil demand is still growing by say 400,000 barrels a year.

So you’re putting that together. You can quickly see how we move from heavy oversupply to a balanced market. Then the other question is, “Well, why $70? Why does that make sense?”

The way we look at all the framework is since 2009, so the last seven years, the world is now consuming six million barrels a day of oil more. So we’ve gone from 84 million barrels of consumption in 2009 to 92 million barrels today.

Where did that additional six million barrels of oil come from? Well, four of the six came from US shale alone. So the US was absolutely integral to meeting that additional demand. How did they do it? Well, they really ramped that industry up by using a lot of debt and issuing a lot of shares, raising a lot of equity. We think that game is up now.

The market is now looking at this industry and saying, well, you need to be able to fund yourself. Now, as we move into a situation where the US – where oil demand is growing again and the US is going to move us from a situation of falling production to needing to grow again, to meet that high demand, we can then work out, “Well, what price of oil do US shale producers need to have to be able to fund their existing operations and generate enough cash to be able to drill more wells?”

When we look at the cost base of that industry, it’s roughly $70 to $80 so that’s how – that’s our line in the sand for the oil price.

Mark Draper: Those are very valuable insights and it comes back to supply and demand like every other market and we really appreciate the in-depth view on that.

Clay Smolinski: Absolutely.

 

 

 

 

 

 

 

There has been much chatter in the media about the possibility that Treasurer Scott Morrison may reduce the maximum contribution limits that individuals can make into their superannuation fund (either on a tax deductible or after tax basis).

While clearly we have no inside knowledge of what is going on in Canberra in the lead up to the Budget which has been bought forward by a week to Tuesday 3rd May 2016, there has been sufficient noise about changes to the superannuation system for us to believe that we are being prepared for changes.

It is with this in mind that we are flagging to investors that if you are intending to make a superannuation contribution this financial year under the existing rules that allow a deductible contribution up to $35,000 for those over age 50 ($30,000 for those under 50), or an after tax contribution of $180,000, then you may wish to do so before the Federal Budget.

We remind investors that the main reason behind investing in the superannuation system is to obtain a tax advantage, therefore before making any contribution we recommend investors seek advice to determine that they will be gaining an advantage by contributing into superannuation.  For instance retirees over age 65 have an effective tax free threshold for income of around $30,000 each ($60,000 per couple) courtesy of the tax free threshold of $18,200 that applies to everyone, plus the seniors rebate.  Therefore some retirees may obtain no benefit what so ever from contributing into superannuation.  Low income earners are another group that may not benefit from contributing into superannuation.

Below is a table summarising the contribution rules that apply to determine whether individuals are eligible to contribute into superannuation in the first place.

 

 

The bottom line on the balance of probabilities is that it is reasonable to expect changes to superannuation in the May Budget and we are simply putting a message out there that if you were going to contribute to superannuation before the end of the financial year, it may pay to do this before May 3rd.

It sure will be an interesting Federal Budget and we will have full coverage on it after budget night.

 

Thursday, 31 March 2016 07:43

$AUD likely to resume downtrend

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Introduction

After hitting an almost seven year low of $US0.6827 in January the Australian dollar has rebounded by 12% or so hitting a high of $US0.7680. The rebound begs the question as to what is driving it and more fundamentally whether the 38% decline from its 2011 high against the US dollar has now run its course. This note looks at the main issues and what it means for investors.

Why the rebound?

A classic aspect of investing is to be wary of the crowd. When investor sentiment and positioning in an asset reaches extremes it often takes only a slight change in the news to drive a big reversal in the asset’s price. And so it is with the Australian dollar. After its large fall to below $US0.70 big speculative short (or underweight) positions had built up. This coincided with a lot of talk about a “big short” in Australian property, banks and the $A. This can be seen in the next chart.

Source: Bloomberg, AMP Capital

And then over the last month or so the news for the Australian dollar has turned more positive with commodity prices bouncing back (from their recent lows oil is up 50%, copper is up 15% and iron ore is up 45%), the Fed sounding more dovish and delaying rate hikes which has pushed the $US down generally and Australian economic growth holding up well. The combination of a more dovish Fed and better Australian data has seen a widening in expected interest rate differentials between Australia and the US, which makes it relatively more attractive to park money in Australia. So with more positive news on Australian export earnings and the relative interest rate in favour of Australia, speculators and traders have closed their short positions and the Australian dollar has rebounded.

More broadly the rebound in the $A has been part of a return to favour by growth assets since January/February that has seen shares, commodities, corporate debt and growth sensitive currencies rebound as worries about a global recession receded. This is often referred to as “risk on”.

Will the rebound in the $A be sustained?

In the very short term the $A could still go higher yet as long positions in it are still not extreme and the Fed’s new found dovishness could linger. A rise to $US0.80 is possible. However, it’s premature to say that the $A has seen its lows and the trend is now up. In fact my view remains that the trend is still down. First, just as the long term upswing in the value of the $A from $US0.48 in 2001 saw multiple setbacks, including a 39% plunge in 2008, on its way to the 2011 high of $US1.10 the secular down trend that started in 2011 is likely to have several reversals too. There will always be short term/cyclical swings.

Second, the recent rally looks a bit like the 9% short covering rally that occurred in early 2014. After falling through parity in 2013 the $A hit a low of $US0.8660 in January 2014 by which time large short positions had been built up. These were then closed as the RBA saw it prudent to opt for an extended “period of stability” in interest rates and commodity prices bounced higher which pushed the $A up and left it stuck around $US0.94 for five months. Once short positions had reversed, commodity prices resumed their downswing and it looked like the RBA would have to cut rates again the $A resumed its downswing.

Third, fundamental drivers still point south for the $A:

  • Commodity prices - while the worst is probably behind us, commodity prices likely remain in a long term, or secular downswing thanks to a surge in supply after record investment in resources for everything from coal and iron ore to gas and slower global demand growth. As can be seen in the next chart raw material prices trace out roughly 10 year long term upswings followed by 10 to 20 year long term bear markets. This long term cycle largely reflects the long lags in supply adjustments.

    Source: Global Financial Data, Bloomberg, AMP Capital

    Plunging prices for commodities have resulted in a collapse in Australian export prices and hence our terms of trade and this weighs on the value of the $A. This is highlighted by the iron ore price which at the start of last decade was below $US20/tonne rising to over $US180/tonne in 2011 and is now running around $US55/tonne.
  • Interest rates – the interest rate differential in favour of Australia is likely to continue to narrow, making it relatively less attractive to park money in Australia as part of the so-called “carry trade”. While Fed hikes have paused recently in response to global growth worries, they are likely to resume at some point this year in line with the so-called “dot plot” of Fed officials interest rate expectations pointing to two 0.25% hikes this year.

    Meanwhile, although it’s a close call we remain of the view that the RBA will cut interest rates again in the months ahead: as mining investment continues to unwind; the contribution to growth from the housing sector via building activity and wealth effects starts to slow over the year ahead making it critical that $A sensitive sectors like tourism and education are able to fill the gap; to offset possible further out of cycle bank interest rate hikes; and as inflation remains at the low end of the target range. The strengthening $A also adds to the case for another rate cut.

A final critical driver of the Australian dollar is the US dollar itself – but it has become more ambiguous. The ascent of the US dollar from 2011 was a strong additional drag on the $A both directly and via its impact on commodity prices. However, it also added to concerns about the emerging world (as a rising $US makes it harder to service US dollar denominated loans raising the risk of some sort of financial crisis) and as a rising $US constrains US economic growth, doing part of the Fed’s job for it. Consequently, the sharp upwards pressure on the value of the $US may have run its course. But with the Fed still gradually tightening a sharp fall in the $US is unlikely either. Rather it’s likely to track sideways.

Source: Bloomberg, AMP Capital

$A likely to resume its downswing

So while the big picture outlook for the $US has turned neutral, the combination of soft commodity prices and the relative interest rate differential between Australia and the US set to narrow point to a resumption of the downtrend in the $A in the months ahead. How far it may fall is impossible to tell. One guide is via what is called purchasing power parity (PPP), according to which exchange rates should equilibrate the price of a basket of goods and services across countries. The next chart shows the $A/$US rate against where it would be if the rate had moved to equilibrate relative consumer price levels between the US and Australia since 1900.

Source: RBA, ABS, AMP Capital

Right now the $A is around fair value on this measure of $US0.75. But it can be seen from the chart that the $A rarely stays at the purchasing power parity level for long and is pushed to extremes above and below. Right now the commodity down cycle is likely to push the $A to overshoot fair value on the downside. In a way this could be seen as making up for the damage done to the economy during the period above parity. This is likely to take the $A towards $US0.60 on a 12 month horizon.

Implications for investors

There are a several implications for investors. First, the likely resumption of the downtrend in the $A highlights the case for Australian based investors to maintain a decent exposure to offshore assets that are not hedged back to Australian dollars (ie remain exposed to foreign currencies). Put simply, a declining $A boosts the value of an investment in offshore assets denominated in foreign currency one for one. This has been seen over the past five years to February where the fall in the value of the $A turned a 7.1% pa return from global shares measured in local currencies into a 12.9% pa return for Australian investors when measured in Australian dollars.

Second, having an exposure to foreign currency provides a useful hedge for Australian based investors in case we are wrong and the global growth outlook deteriorates significantly. The $A invariably falls (and foreign currencies rise) in response to weaker global growth.

Finally, the fall in the value of the $A to levels that offset or more than offset Australia’s relatively high cost levels is very positive for sectors that compete internationally including manufacturing, tourism, higher education, agriculture & miners. This in turn should continue to help the economy weather the mining downturn and is in turn positive for the Australian share market. Roughly speaking each 10% fall in the value of the $A boosts company earnings by 3%.

 

Shane Oliver

AMP Chief Economist

To modify Benjamin Franklin, it seems that in Australia nothing can be said to be certain, except death, taxes and endless debate about property prices. Why is it so unaffordable? Are foreigners to blame? Is it a good investment? Is negative gearing the problem? Are property prices about to crash?

Worries about a property crash have been common since early last decade. In 2004, The Economist magazine described Australia as “America’s ugly sister” thanks in part to a “borrowing binge” and soaring property prices which had seen it become “another hotbed of irrational exuberance”. At the same time the OECD estimated Australian house prices were 51.8% overvalued. Since the GFC, predictions of an imminent property crash have become more common with talk that a property crash will also crash the banks and the economy.

Our view since around 2003 has been that overvaluation and high levels of household debt leave the housing market vulnerable. As such it could be seen as Australia’s Achilles heel. However, in the absence of a trigger it’s been hard to see a property crash as a base case. Not much has really changed. This note takes a look at the key issues and what it means for investors.

Overvalued, over loved and over indebted

The two basic problems with Australian housing are that it is expensive and household debt is high. Overvaluation is evident in numerous indicators:

  • According to the 2016 Demographia Housing Affordability Survey the median multiple of house prices in cities over 1 million people to household income is 6.4 times in Australia versus 3.7 in the US and 4.6 in the UK. In Sydney it’s 12.2 times and Melbourne is 9.7 times.
  • The ratios of house prices to incomes and rents are at the high end of OECD countries and have been since 2003.
  • Real house prices have been above trend since 2003.

Source: ABS, AMP Capital

The shift to overvaluation more than a decade ago went hand in hand with a surge in the ratio of household debt to income, which took Australia’s debt to income ratio from the low end of OECD countries to now being around the top.

Source: ABS, RBA, AMP Capital

Overvaluation and high household debt are central elements of claims that Australian house prices will crash. These concerns get magnified whenever there is a cyclical surge in prices as we have seen recently in Sydney and Melbourne.

But a crash seems elusive

However, given the regularity with which crash calls for Australian property have been made over the last decade and their failure to eventuate, it’s clear it’s not as simple as it looks.

First, the main reason for the persistent "overvaluation" of Australian home prices relative to other countries is constrained supply. Until recently Australia had a chronic under supply of over 100,000 dwellings, as can be seen in the next chart that tracks housing completions versus underlying demand. Completions are at record levels but they are just catching up with the undersupply of prior years.

Source: ABS, AMP Capital

Consistent with this, vacancy rates while rising are below past cycle highs. In fact, in Sydney they are still quite low.

Source: Real Estate Institute of Australia, AMP Capital

Secondly, Australia has not seen anything like the deterioration in lending standards other countries saw prior to the GFC. There has been no growth in so-called low doc and sub-prime loans which were central to the US housing crisis. In fact in recent years there has been a decline in low doc loans and a reduction in loans with high loan to valuation ratios. See the next chart. And much of the increase in debt has gone to older, wealthier Australians, who are better able to service their loans.

Source: APRA, AMP Capital

Third, and related to this, there are no significant signs of mortgage stress. Debt interest payments relative to income are low thanks to low interest rates. See the next chart.

Source: RBA, AMP Capital

By contrast in the US prior to the GFC interest rates were starting to rise. Yet in Australia bad debts and arrears are low. While new loan sizes have increased, Australians seem focussed on cutting their debt once they get it.

Finally, while some seem to think that because property prices in mining towns like Karatha are now crashing this is a sign that other cities will follow. This is non-sensensical. Property prices in mining towns surged thanks to a population influx that flowed from the mining boom. This is now reversing. Perth and Darwin are also being affected by this but to a less degree. By contrast the surge in property prices in cities like Sydney and Melbourne that occurred into early last decade predated the mining boom and their latest gains largely occurred because the end of the mining boom allowed lower interest rates.

The current state of play

Our assessment is that the boom in Sydney and Melbourne is slowing thanks in large part to APRA’s measures to slow lending to property investors. However, house price growth is likely to remain positive this year. Price growth is likely to remain negative in Perth and Darwin as the mining boom continues to unwind. Hobart & Adelaide are likely to see continued moderate property growth, but Brisbane may pick up a bit. Nationwide price falls are unlikely until the RBA starts to raise interest rates and this is unlikely before 2017. And then in the absence of a recession or rapid interest rate hikes price falls are more likely to be 5-10% as was seen in the 2009 and 2011 down cycles rather than anything worse.

Source: CoreLogic RP Data, AMP Capital

What to watch for a property crash?

To see a property crash – say a 20% average fall or more – we probably need to see one or more of the following:

  • A recession – much higher unemployment could clearly cause debt servicing problems. At this stage a recession looks unlikely though.
  • A surge in interest rates – but the RBA is not stupid; it knows households are now more sensitive to higher rates.
  • Property oversupply – this is a risk but would require the current construction boom to continue for several years.

Implications for investors

There are several implications for investors:

  • While housing has a long term role to play in investment portfolios it is looking somewhat less attractive as a medium term investment. It is expensive, offers very low income (rental) yields compared to all other assets except bank deposits and Government bonds and it’s vulnerable to possible changes to taxation arrangements around property.
  • There are pockets of value, eg in regional areas. You just have to look for them.
  • As Australians already have a high exposure to residential property (directly and via bank shares and property trusts), there is a case to maintain a decent exposure to say unhedged global shares because it could provide an offset if it turns out I am wrong and the Australian property market does have a crash.