What an extraordinary year was 2008 – the year of the financial crisis. This year we find out the damage to the real economy.
Meanwhile, markets remain volatile, focused on the short term. The collapse in the equity market last year was an overreaction, opening up invest ment opportunities for those brave enough to take them. The current downturn won’t last forever. We can only judge value by looking beyond the current shock.
Last year, banks switched mode from greed to fear, with emphasis on avoidance of risk leading to a tightening of credit criteria. Certainly, Australia’s Current Account Deficit and overseas debt means an annual overseas borrowing requirement that locks us into world financial market conditions. But relatively high interest rates and lower risk should make Australian debt relatively attractive. Even now, with interest rates having fallen around the world and with central banks pumping cash into the system, corporate credit remains expensive and tight.
That’s particularly so for asset-based lending, with banks fearing falling asset prices compounding the impact on net assets and loan-to-value ratios (LVRs) and triggering a repeat of the 1989 episode. While that is a problem for many oversupplied markets overseas, apart from excessively geared securities it is not a problem in Australia. Asset prices may fall, but not by enough to force banks to take them over.
This is the year when we find out the damage to the real economy as the fallout from the financial crisis, which came to a head last October, works its way through the system.
How bad will it get? How long will it last? That remains uncertain. My own feeling is that Australia will have a soft landing.
The US, the UK, Japan and parts of Europe will go through a sharp recession followed by a protracted period of weak investment constraining growth. Those markets will experience a 1989-style episode with oversupplied asset markets and falling property values causing bank debt write-offs and destroying the asset base of the financial system.
Australia does not have the same nature of problem. It is not undergoing a 1989 episode. There is nothing like the degree of oversupply of asset markets. While there will be further falls in asset prices, they will not be enough to trigger significant bank debt write-offs. Australia’s banks will come through this episode relatively unscathed. And there won’t be chronic weak investment con straining growth prospects.
The outcome for the Australian economy will depend on the interplay of a number of primary drivers, operating either to reduce or boost growth.
– The 3 per cent decline in interest rates in the last quarter of 2008, with more to come as long as the economy stays weak, is pumping household dis posable income into the mortgage belt. The stalling of retail sales and consumption expenditure was caused by last year’s collapse of confidence, with fear of unemployment the catalyst for a phase of precautionary saving. The objective of stimulatory monetary policy is to turn this around, to under write a boost in spending and set the scene for the next upswing in housing markets and residential investment.
– Weak world demand will affect Australian exports, particularly minerals demand and prices.
– The boost to competitiveness from the significantly lower Australian dollar will mitigate the impact of weak world and Australian demand, particularly for services such as tourism. More importantly, it will boost the competitiveness, prof itability and market share of domestic import-com peting industries. It will also boost the Australian dollar prices of world price denominated goods and services. The other side of the coin is that it will reduce the penetration and profitability of imports. For retailers with a high import component, it means the end of what has been a golden age of profitability.
– The setback to world minerals demand and prices will bring to an end the current phase of minerals investment, impacting on sectors and states servicing that investment. Given that invest ment is a primary driver of growth, the miner als boom towns, cities and states are at risk of a substantial downturn. But not yet. Work in hand from currently committed projects will sustain investment work done for another year or more. It is the next round of projects that is at risk. And there could well be differences between prospects for different minerals.
– The credit squeeze and tight credit/risk criteria, together with the impact of the economic downturn on financial feasibilities, have impacted on private investment projects across the board, including both residential and non-residential building projects. On the non-residential side, this has curtailed the upswing before there was a chance to create significant oversupply, underwrit ing the next recovery two to three years hence. For residential property, this will make the already large deficiency of residential stock worse, underwriting an even stronger upswing.
Short term, we expect a recovery in residential property and construction plus increased house hold expenditure in the second half of this year to lead the Australian economy out of the current downturn. Hence our expectation of a soft landing for the economy this year. Fiscal stimulus and lower interest rates pumping money into the mortgage belt will cushion the downturn. In any case, we expect weak employment to make unemployment rise to 6 per cent by the middle of next year, making it difficult for new entrants to the workforce to get jobs.
While we don’t expect a technical recession in Australia, we could shoot ourselves in the foot through excessive caution in spending, both by households and businesses.
The saving grace is that Australia has just come out of a long period of under-investment through the whole of the 1990s and into this decade, both in the private sector and in the public sector. While we could see a setback to investment as a result of the current difficulties, in most sectors investment will be stronger five years from now. The resump tion of investment will underwrite a solid growth over the next five years.
The risk is that the short-term outlook could be worse. But that wouldn’t change the magnitude of investment prospects, just the timing.
While most investment markets will recover quickly after the current setback, the main concern is the duration and magnitude of the minerals investment downturn. The net effect will be a primary issue for growth prospects in the medium term.
The other major driver of growth will be the impact of the lower dollar on competitiveness, the consequent boost to the share of exports and domestic import-competing industries and the negative impact on penetration and profitability of imports and hence on retailing.
These influences on investment and growth, by sector and by state, will be the primary deter minants of outcomes for the different property markets. The extent of the current shock means that neither developers nor banks will be willing to underwrite speculative development. And that means that financial feasibilities will have to work to underwrite the next round of development.
Given that there will be a shortage of stock in some sectors and states, we know that in those sec tors rents and property values will go to levels that make those financial feasibilities work.
That’s how we can understand market prices post the current shock.
That’s the benchmark by which I will judge value and the opportunities provided by the current market overreaction.