It’s always darkest before the dawn

The fallout from the sub-prime crisis has caused a huge disconnect between real markets and financial markets. And that has been compounded by escalating fears of US recession, the impact on the global economy and hence on Australia.

Equity markets around the world have fallen sharply and, indeed, may fall further before this is over. Markets have switched from greed to fear, overreacting on the downside. To me this repre­sents an opportunity to take a careful, well thought out position, always careful not to get caught in the fallout but end up with a significant position taken during the rout.

To me, that’s most evident in the property markets. Listed property trusts (LPTs), having traded significantly above their net asset backing for some time, have fallen by 20 to 25 per cent, with many now trading significantly below their net as­set backing, leaving the income-earning operations apart from their property holdings unvalued or negatively valued.

That’s not to say that the crisis won’t extend to an impact on property valuations. To some extent, it will. But leasing markets are strong, demand is strong, we’re not building enough, vacancy rates will tighten and rents will rise over the next few years. It may take six months or even a year for these finan­cial market ructions to work their way through the system – but then we’ll return to a market driven by real property market conditions.

This is just a temporary setback in an upswing that has yet to mature. As such, to my mind, the fallout over the next six months will present an extraordinary opportunity to take a position in markets on terms that we haven’t seen for years. Not everyone will be in a position to take advantage of these opportunities – credit is scarce and expen­sive. Cash is king.

But it does require taking a position. And I don’t care whether it’s in real property or LPTs. Let me work through my view of how things will pan out.

Will there be a recession in the United States? It’s still too early to tell, though the US does seem to be trying to talk itself into one. The economy is certainly weakening, but most of the weakness in the December quarter was associated with a rundown in stocks. The key will be whether talk of recession will frighten consumers and impact on investment.

Even so, it’s drawing a long bow to talk about US recession causing a recession in Australia. There is already some flow-on in Europe and the UK, where the high values of their currencies, some would say overvalued exchange rates, are affecting competitiveness. But the undervalued currencies in Asia will soften any impact on exports. In particu­lar, we’re likely to see continued strong investment and growth in China.

Meanwhile, it’s the minerals boom that’s driving the strength of the Australian economy, with strong investment underwriting strong growth in employ­ment, household incomes and expenditure. The problem here is inflation, not growth, with capacity, labour and infrastructure constraints leading to demand inflationary pressure, tightening monetary policy and rising interest rates. Problems in the US are unlikely to have a significant impact unless they cause a minerals bust, but even then committed projects currently in train would hold up invest­ment and growth for a few years yet.

The minerals boom has led to a disconnect between the US and Australian economies, at least in the short term. Most of our exports go to Asia. Demand and growth will stay strong in Australia.

The other issue is the impact of events in the financial markets on the real side of the economy. In particular, the failure of overseas debt facilities has meant a rising cost of funds and tighter credit, in particular for second tier borrowers. The debt markets, too, have gone from greed to fear, reassess­ing risk and raising risk margins on debt. This will have some real side impacts. Banks will be tighter on loan to asset ratios. There will be some rationing of funding. It will be harder to fund development.

For property market participants, there will be reductions in gearing by a number of players. Gone are the days of securitisation when yields greater than interest rates meant cash positive investment with any capital growth the kicker to total returns.

There are two ways to reduce gearing. The first is to sell equity. And we have seen notable recent examples of capital raising by major players, sometimes to overseas investors, at substantially lower equity prices. We will see more. The second is to sell assets, and we will see a lot more of that over the next six months. The result will be a soften­ing of prices – in other words, a rise (softening) in yields – we think by half to 1 per cent. Most players will want to sell their secondary, non-core assets, but those will take a greater hit to yields, forcing sales of premium assets not usually available.

The anomaly is that leasing markets will stay strong, driving rising rents, in particular for the already tight and tightening office markets. Retail sales will stay strong with the economy. Industrial markets will stay strong with investment. The upswing has several years to run. And once the cur­rent financial market setback works its way through the system, the strength of leasing markets and rents will take over as the driving force for capital growth. There’s more in this upswing yet.

While all this has been going on, we’ve seen the rising popularity of unlisted funds with many funds managers attracted by the lower volatility of valuation-based pricing compared with listed funds subject to sharemarket fluctuations. That has prob­ably helped in the current circumstances, but now there’s a logic to switch back to the undervalued listed vehicles. Longer term, my concern is that the investment period for the unlisted funds will take investors into the next downturn. The boom hasn’t finished, but it won’t last forever.

We don’t need the US to cause a recession in Australia. We can do it all by ourselves, thank you very much. The danger is that, once the minerals boom is over, we may. But not for some years yet.

Meanwhile, equity markets have overreacted (as usual). There are great bargains amongst LPTs. And it looks as though there will be some great properties available.

Incidentally, my comments are not limited to property and, because of the opportunities presented by the sharemarket downturn, extend to equity markets. Again, it’s essential to understand the prospects for the profitability of the underlying operations.

You can see that my approach is tactical rather than strategic. This is a cyclical market and invest­ment strategy is dictated by the cycle. Given that in many industries, in particular property, the cor­rection has been caused by financial markets rather than the underlying operations, this is the time for a value investor.

The switch between fear and greed as drivers of equity markets has always caused market fluctua­tions to overreact. This is no exception. Be fearful when markets are greedy – invest when markets are fearful. And keep your eyes on the underlying value.

This is a financial market phenomenon, not matched on the real side of the economy, not yet at least.

It’s always darkest before the dawn.