Forget the GFC, says Frank Gelber. Financial markets are undervalued and it’s time to look forward.
The global financial crisis (GFC) is over – past history, for Australia at least. It’s not relevant to our future investment decisions. It’s time to look to the future.
But there remain residual anomalies – particularly in our investment markets, which are still shell-shocked by the course of events. They remain in limbo, still unwilling or unable to initiate the projects required to prepare for solid growth and demand in the medium-term future.
While we remain dominated by the memory of the GFC, excessive caution in both debt and equity markets will do two things: firstly, it will prevent us from taking advantage of the extraordinary investment opportunities currently present; and secondly, by constraining investment at the front end of the cycle, it will ensure the shortages of capacity that will drive a stronger upswing in the future – particularly in those sectors characterised by long lead times between the investment decision and additions to capacity.
Australian office markets are a classic case in point. The current caution is impeding new development and, given gradually strengthening demand, constraints on the supply side are setting us up for a long period of tight leasing markets, initiating strong income and capital growth, building momentum into a property boom. And I’m using that “boom” word carefully.
‘The GFC is over – past history – for Australia at least. It’s time to look to the future’
Remember, the GFC wasn’t an isolated shock. It triggered a correction in prices/yields following the excesses of the preceding financial engineering boom. Weight of money had driven prices too high and yields too low. Before the GFC, Australian equity markets were over-geared, overvalued and in danger of oversupply. The fall in prices triggered by the GFC blew out loan-to-value ratios (LVRs), creating difficulties for banks. But it took away most of the risk.
In our post-GFC world:
• Prices are no longer overvalued – if anything, they are undervalued.
• Much of the excessive gearing has been reduced.
• And the collapse of development funding removed the danger of oversupply.
Looking backwards gives the impression that risk is high. It’s not. The correction removed much of the risk. Risk of falling prices or cash flows is now low, not high. Sure, it’s still tough overseas. But our problems are nowhere near as severe in Australia.
Certainly, we’re still working through residual problems created by the GFC. In particular, the fall in asset prices reduced shareholder equity and increased LVRs. And that was compounded by debt. Some highly geared borrowers refinanced, reducing gearing by taking in new equity. Others were unable to raise new equity. For the banks, these remain problem loans and they are slowly working their way through them.
But we didn’t have a financial crisis in Australia. Most of the capital losses were taken by more risk-exposed overseas banks while the big four Australian banks have gone from strength to strength. It must have been dreadfully embarrassing for them to have to write back all of those provisions for bad debts on their way to a 30 per cent increase in profits, while many of their smaller customers were still doing it tough. For the four pillars, their problem loans don’t constitute much of a problem. They are already looking to increase their exposure to more conservative borrowers. And this is just the beginning.
On the economic front, growth has weakened following the post-GFC rebound. To me, that demonstrates the strength of government stimulus during the GFC period. As those projects are completed, and there is a new focus by governments on reducing budget deficits, that expenditure is winding down. The issue is whether private spending will come through in time to offset the fall in government investment.
Meanwhile, despite the strength of employment growth – which is boosting household income – private consumer spending remains weak. To me, that’s an indication of the strength, not weakness. Households are saving, not spending. But that cautious saving behaviour represents a latent spending power. It won’t be permanent. As they build confidence, households will gradually loosen the purse strings.
Private investment remains weak, largely as a result of the withdrawal of both debt and equity funding for new projects, and partially as a result of caution following the shock of the GFC.
Following an initial rebound, the residential recovery has paused. Interest rate rises and tentative investors have played a role. There is certainly no “bubble”. We are not building enough and there is a deficiency of residential stock. Our forecast is that the recovery will resume, only to be curtailed by strong interest rate rises two to three years hence.
Commercial and industrial building was slaughtered by the withdrawal of credit and the need to reduce gearing during the GFC. Commencements halved across-the-board. We expect rolling recoveries in these markets, but slowly. The GFC price correction means rents need to rise to replacement cost levels. Current excessive caution is setting up a boom, particularly in office markets, in five years’ time.
The exception is engineering construction, where the resources boom has fast-tracked another round of major projects, which will sustain activity for the next five years.
Private construction and investment will recover in a series of rolling cycles. And that will underpin the strength of the economy. Indeed, given already emerging labour and capacity constraints, the Australian economy will undergo a structural change to make room for the minerals boom. That will become a priority for the RBA, which will continue to raise interest rates on signs of strength. We face a lot more interest rate rises over the next three years. And the structural shift will come as the high dollar and interest costs impact on the competitiveness of domestically produced tradeables.
