Slowdown we had to have

The financial crisis. US and UK “recession”. Interest rates starting to bite and impacting on retail sales and the housing market. Fear of a credit squeeze. The collapse of confidence. Fear of a downturn in Australia – the press are having a field day. And we’re buying their story.

We’re all in “fear” mode, creating a classic bear market. There is no sense of perspective – we only hear the bad news. We are overreacting. The reality is not nearly as bad as the picture being painted.

I don’t want to underplay the damage being done. But nor do I want to overstate it.

The sub-prime loan problem is still working its way through the banking system with exposure being written off in bank and fund accounts as we speak. In Australia, that exposure is limited.

The credit squeeze caused by the sub-prime affair was severe in the US, UK and Europe. In Australia, the drying up of funding for more risky lending has severely impacted on non-bank lenders but has left the banks with increased market share and facing less competition. In aggregate, though, the credit squeeze has been remarkably moderate in Australia.

Australia has a current account deficit and has always funded that deficit through significant offshore borrowings. In recent years, the major banks have operated as consolidators of that debt, providing funding for domestic lending by borrowing partly from Australian sources and borrowing the rest from overseas sources, in particular the interbank loan market. That latter source of funds dried up as a result of the sub-prime problem.

At the beginning of this year, the banks were apprehensive about the extent of the credit squeeze that would be caused by the blockage in overseas funding. They tightened their risk criteria and aggressively sought additional funding from domestic sources, raising their borrowing rates and hence market interest rates in the process. As it turned out, many corporate borrowers sought and obtained funding directly offshore. With a strong economy, high interest rates relative to overseas markets and a strong dollar, Australia was an attractive destination. And that has significantly reduced the overseas borrowing requirement for banks and hence the extent of the credit squeeze. Certainly, there has been some curtailment of project funding as risk criteria were tightened. But the margin between market and RBA-determined rates has blown out to a very limited extent. Unlike previous episodes, the credit squeeze has turned out to be remarkably mild in Australia.

The impact on Australian sharemarkets has been much greater. Sharemarkets around the world, including Australia, are well entrenched in a bear phase. The finance sector and listed property trusts/real estate investment trusts (LPTs or REITs) have been particularly affected. In Australia, bad news is still emerging in both of these sectors. Write-offs of bad loans have affected the banks. And LPTs have been hit by the inability to raise new funds, the need to reduce dividends to levels which can be funded by cash rather than valuation based capital returns, and the reduction in profits from some of their associated activities.

The financial engineers are the worst affected and many won’t survive. Only a few years ago, the analysts demanded that all LPTs gear cash flows to improve return on equity. Now they’re leading the lynching party. But the pressure to reduce gearing is across the board. Certainly, pressure to reduce gearing has led to a buyers’ market and the prospect of softening of yields; but tight supply is continuing to keep pressure on leasing markets. While some analysts have been making assumptions of significant reductions in book values, I expect that valuation declines will be limited, offset by rising rents. The REIT markets have overreacted and are a cheap place to buy property. Indeed, substantial portions of the equity markets are looking pretty good value.

On the economic front, the fear is that the dismal conditions in the US, the UK and Europe will cause a downturn in Australia. I doubt that. The strength of Chinese demand for minerals and the impact on minerals investment plus the long-awaited surge in exports and the prospective rebound in agricultural output will cushion the Australian economy. Australia’s problem is inflation, not growth. Any weakening of the economy will be domestically- rather than externally-caused.

The recent collapse in consumer and business confidence, together with the stalling of retail sales, has been greeted with dismay. Commentators have turned pessimistic, predicting a downturn or even recession, and calling for significant reductions in interest rates.

But this is precisely the slowdown we had to have! Certainly, interest rates have started to bite. And the RBA will welcome the stalling of retail sales. That’s what the interest rate rises were designed to achieve. The impact on housing was collateral damage. The RBA needed to reduce growth below the capacity- and labour-constrained “speed limit” to reduce demand-inflationary pressure. At the end of last year GDP growth was running above 4 per cent and employment growth just under 3 per cent. The RBA had in mind a speed limit of GDP growth around 3 per cent and employment growth around 2 per cent. Given the strength of investment, the impact had to be on households and consumer demand. Had we not seen the weakening in demand, the RBA would have continued to raise interest rates until it happened!

Now that we have seen a setback to demand, we know that we are coming to the end of the phase of interest rate rises. Will interest rates fall? It’s still too early to tell. Remember that market rates are still above RBA-determined rates, making the bank’s control difficult. And the setback to demand has been largely precautionary. I suspect that growth this year will be around 3 per cent rather than the more severe declines that some commentators expect.

Everywhere I look I see excessive pessimism. Opinion has swayed to the fear side of the scale, looking for the bad news. I expect that the economy will turn out stronger than many expect. While demand is softening a little as nervous businesses delay leasing decisions, property markets will not collapse – they are not oversupplied. The credit crisis impact is overstated – the current desperation will gradually dissipate. I expect that by this time next year it will be back to business as usual.

All this has taken a toll on investment markets and investor confidence. Through all this uncertainty, investors have retreated into their shells, waiting until it sorts itself out. Hence the severity of the current bear market. The flight to security through fixed interest is shutting the door after the horse has bolted. To me, there are bargains throughout equity markets for value investors willing to take a tactical rather than strategic position. Certainly, the market may have further to fall. But no-one will ring a bell at the bottom.

For me, this is the time to take a position and shift allocation back towards equity and property markets. A year from now I want to have invested. And this is the time to start.