The current risk aversion in both debt and equity markets means we’re setting up for a big one. Here we go again, says Frank Gelber.
Will we repeat the mistakes of the financial engineering (FE) boom? Not exactly. There are a whole lot of new mistakes we’ll make next time around. But the essence of the FE boom overseas, and the 1980s boom/bust both here and overseas, is similar in that they were driven by aggressive debt financing of property projects leading to oversupply. Is this the end of cycles? Definitely not!
To the contrary, the mildness of the impact of the GFC on Australia is leading to a new complacency about Australian prospects and institutions, which will end up translating into the next property cycle. But it’s not warranted. Australia missed the extremes of the FE boom. Certainly, we saw a gearing up of corporates and property, which Australia associated with the financial engineering logic. But we didn’t get to the stage where property development led to a major oversupply of markets. Not that we can take any comfort from that. The truth is that we were lucky. We were slow into the financial engineering game and hence avoided going over the top in terms of overinvestment. We were headed that way. But the GFC came soon enough to prevent oversupply.
In effect, the banks did us a favour by pulling the rug out from under supply before the cycle had a chance to run its course and significantly oversupply property markets. Interesting times. It’s easy in retrospect to see that we made mistakes; that we succumbed to analyst and investor pressure to gear up, to get rid of “lazy balance sheets”. We bought the story about “yield compression” being warranted. We ignored the influence of weight of money on prices, preferring to attribute the strength of capital growth to the benefits of securitisation, not realising that property values had overshot. We swallowed the logic of “yield accretive” investment by listed property trusts (LPTs), not realising that this was reducing yields on secondary and more risky assets. We forgot the old-style property investment logic. We forgot risk and were carried away by the logic of financial engineering.
Tighter regulation might have been the reason for Australia’s more benign experience. It may have helped. But both the equity markets and the banks were willing participants as the players geared up. It’s just that the GFC burst the bubble before we had a chance to go over the top. When greed switched to fear in debt and equity markets, it precipitated a collapse in property investment markets that was more of a correction, after the excesses of the FE boom, than a shock to the market. And now debt and equity finance have gone risk-averse, inhibiting the next round of development and setting us up for the next boom. Have we learned our lessons? Can regulation save us? I doubt it. We’ll do it all again.
The economy is in a lot better shape this year than last. The worst of the GFC impact has now passed. And the damage is nowhere near as bad as many feared. Low interest rates, strong fiscal stimulus and improved confidence have underwritten the initial recovery. Housing investment has rebounded strongly. But the high Australian dollar is having an adverse effect on the domestic “tradeables” industries, particularly manufacturing, tourism and other tradeable services. And business investment remains weak. The next five years will be strong, with the only question being how quickly the upswing will come through. Confidence has picked up with a run of good news. And accordingly, interest rates have been tightened from extremely low levels. Unfortunately, I think that we’re getting ahead of ourselves. Weak household disposable income and weak construction will constrain growth, keeping conditions tight for another year before recovering investment drives strong growth, starting in 2011.
Initially, we thought that there would be a substantial decline in construction, constraining the recovery in economic growth. However, as history unfolded, that decline has become later, shallower and shorter, with the prospect of a strong subsequent upswing driving growth prospects. The next phase of growth will be driven by rolling investment cycles: – Already we’re seeing the stimulus associated with public investment in schools and then hospitals cushioning the downturn. – Meanwhile, lower interest rates have triggered the start of a residential recovery, which will build momentum into what will become a boom over the next four years. – Mining investment will be the next cab off the rank, followed by commercial building – first retail then industrial and office development. The strength of the upswing in construction will drive strength in the economy, feeding back into the demand for property. There may be winners and losers, but the next property upswing, sector by sector, will be underwritten by the current under-building. And the strength, both of construction and the economic upswing, as well as the subsequent downturn, will depend on the degree of synchronisation of construction cycles.
With property prices now below replacement cost, that means strong rises in rents and property prices before we can underwrite the next round of construction. Will we go over the top? Of course we will. This time is different, they say. But to me, it’s not very different. Strong returns will attract both equity and debt finance. After a long upswing, we always forget. And given that we are starting from a low base, we’re in for a long upswing in rents and property prices. Strong returns will attract capital inflows and, in turn, debt financing, further increasing prices and underwriting the next round of investment, eventually leading to oversupply and a subsequent downturn. Indeed, it’s the initial risk-averse caution, the consequent delay in development and the shortage of stock that will drive the strength of the next upswing into what will become a boom in the second half of the decade. We’re just setting up for the next cycle. Here we go again.