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Australia’s record run fizzling out

A downturn in property prices, high household debt levels, changing global economic trends and a likely drop in the profitability of its banks could finish off Australia’s dream run. Sheldon Slabbert looks into the vulnerability of our near neighbour and second largest trading partner.

Australia currently holds the record for the longest economic expansion in modern economic history – with 28 years having elapsed since it last experienced a recession. This fact becomes even more impressive when you consider what the country has had to navigate over this period, at both a regional and global level -  including major bumps like the Asian Financial Crisis, the Dotcom crash and, more recently, the Great Financial Crisis.

But how has this been possible? Are conditions just different in Australia? If not, what could be the iceberg that sinks their economy into a recession?

Confidence

There is little doubt that almost three decades of expansion has fostered a high level of economic hubris in Australia - especially when it comes to residential property, where we have seen tremendous property appreciation. This confidence has inevitably led to high levels of speculation, fuelled by a recency bias related to ever-increasing property values and justifications as to why Australia is and will be different to the US, Europe and other property bubbles over history.

In many cases, the expectation of continued capital growth has prompted investors to borrow at higher costs than the rental return they can achieve from the property. This strategy works well in an up-market, but over the last 12 to 18 months we have seen values stagnate and in certain areas we have seen markets roll over. This has exposed the vulnerability in this widely adopted strategy and it is having an impact on behaviour.

Beyond this, cases such as the Opal Tower in Sydney and the Spencer Street fires in Melbourne have raised concerns over building quality and safety, and the hidden risks that could impact property investments.  

These factors could see investors revaluate the widely accepted view of being “Safe as Houses”, and their expectation of continuous capital growth year on year. It is possible that the “fear of missing out” mindset that helped stretch affordability to extremes could turn into the “fear of not getting out”, as many of the investors/speculators are sitting on paper gains that may evaporate.

Credit

The markets are currently digesting the Hayne’s Royal Commission Report into the behaviour of institutions in the Australian finance sector. This report may have come at an inopportune time – with the potential of further impacting borrower confidence as they learn more about the misconduct.

While, at a minimum, we could expect bank-lending conditions to tighten up as a result of the Commission’s findings, it is actually a lack of demand that has slowed new credit creation.

When we consider that we are nearing the end of a massive debt cycle that started in the early 1980s, it’s not hard to see that consumers may have reached a point of debt saturation.  

Changing Economic Conditions

At a domestic level, demographic pressures such as the retiring Baby Boomer generation have become a headwind in most developed economies - and Australia is no different.

Looking to international factors - it is a well-known fact that China’s economy is slowing, but what is also worth noting is their transition from a low-value, export-driven economy to a value add and service based economy, with a higher level of domestic consumption. They are pivoting to a developed market model as their economy matures.

This means that their labour force are also directed up the value chain, creating more global competition in the professional services space. Emerging markets such as China and India have been able to close much of the skills and technology gap that developed markets like Australia have enjoyed for over a century.

We see this expressed in depressed wages in the West as the price of labour is pushed lower in a more globalised market place, and as global growth slows one could expect competition to heat up.

Knock-on Effects

Australian banks carry large exposures to the highly leveraged property markets, and Commonwealth Bank and Westpac in particular carry greater exposure to the domestic retail market. We may start to see higher provisions for non-performing loans, which may impede new credit creation and future profitability of these banks. While Australian banks currently pay good dividends, if that should change, we could see bank stocks under pressure.

New Zealand markets have very similar dynamics to Australia. We carry similar exposures to China and slowing global growth, and have many of the same banks operating here – so it’s not a stretch of the imagination to think that some of those policies could have filtered through into our mortgage markets as well.

ANZ has significant exposure to agriculture in New Zealand, creating high-levels of risk given that farms throughout the country are struggling across the board. Heartland Bank ANZ , Westpac and BNZ might all be on the short sellers list should the downturn be confirmed here.

Both the New Zealand and the Australian Dollar have recently seen increased volatility. The Australian Dollar experienced a big move on January 3 and the New Zealand Dollar fell by nearly two per cent, following a weaker than expected employment number.  The individual currency and banks may be the preferred vehicles for traders looking to trade a possible downturn in Australia.

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