Australian bank growth expected to slow

Last week I observed:

…the RBA will resist cutting rates unless the situation gets really desperate. Ultra-low interest rates encourage risk-taking and speculative behavior, offering short-term gain but courting long-term disaster. Walter Bagehot, editor of The Economist, observed more than 100 years ago: “John Bull can stand many things, but he cannot stand 2%.” Sound economic management requires that central bankers make the hard choices, resisting pressure from commercial banks and politicians.

Total assets of the four major banks grew at a much faster rate than nominal GDP from 2004 to 2014. This was only achieved through rapid expansion of debt in the economy.

Major Banks Total Assets and Nominal GDP

The sharp rise in debt pushed households into a precarious position, with record levels of debt to disposable income and a serious bubble in house prices.

Australian Household Debt to Disposable Income

The RBA and APRA have used macro-prudential measures over the last few years to rein in debt growth, with some success. The ratio of major bank total assets, mainly debt, to nominal GDP declined considerably since 2015.

Major Banks Total Assets over Nominal GDP

This is a major policy success by the RBA and APRA and they are unlikely to want to reverse course. But they may decide to slow, or even for a time halt, the decline in order to prevent a downward spiral in the housing market. Expect total asset growth of the big four to match nominal GDP growth, at around 5.0%, over the next decade. Comprising 3.0% real GDP growth and 2.0% inflation. A far cry from the heady days of 10% annual growth between 2004 and 2014.

Australia: Headwinds persist

From Elliot Clarke & Simon Murray at Westpac:

…the take home from Budget 2019 is that, while supportive of activity over the long-term, the near-term impact on incomes and activity is limited. Labor’s alternative proposals, as per the budget reply, are also spread out over time. So no matter which party wins in May, the headwinds of persistent weak income growth and declining house prices are set to hold growth well below trend through 2019. This is clear justification for interest rate cuts from the RBA, which Westpac believes will come in August and November.

While the RBA is yet to adopt an easing bias, the April meeting decision statement did emphasise the fluidity of the situation…

The last sentence is important: the RBA has not yet adopted an easing bias. Perhaps because of the housing debt bubble.

Australia: Household Debt and Disposable Income

Business investment has already failed to respond to interest rate cuts.

Australia: Business Investment

10-Year AGB yields are already below US Treasuries but have failed to significantly weaken the Australian Dollar.

Australia: Difference to US 10-Year Bond Yield

House prices are falling.

Australia: Housing Prices

Plunging high-density housing approvals promise a sharp slow-down in housing construction.

Australia: Building Approvals

Dwelling Investment is likely to join Mining Investment in the red, detracting from GDP growth. Windfall iron ore prices (Exports) are keeping the economy afloat, while they last.

Australia: GDP Components

Bank’s impaired and total non-performing assets are low, but likely to rise if the housing fall (and construction down-turn) continues.

Australia: Bank Non-Performing Assets

Bank capital ratios are modest at just over 10% of common equity (CET1) against risk-weighted assets. But that falls to about 5.5% without risk-weighting (leverage ratio). Not a lot of room for comfort.

Australia: Bank Capital

ASX 200 spikes but will it last?

The reason for the upward spike in the ASX 200 is clear. While shortage in iron ore supply may be temporary, while Brazil reviews mine safety, it is sufficient to cause spot prices to jump 20% in the last week.

Iron Ore

Windfall profits are likely to benefit not only the Materials sector but the entire economy over the next few months. The ASX 200 Materials Index ran into resistance at 12500 while a bearish divergence on Money Flow continues to warn of selling pressure.

ASX 200 Materials

The ASX 200 broke resistance at 6000 but remains in a bear market. Reversal below 5650 would signal a primary decline, with a target of the 2016 low at 4700.

ASX 200

ASX 200 Financials Index rallied on release of the Royal Commission on Banking final report. The outcome could have been a lot worse, or so the market seems to think.

ASX 200 Financials

I suspect the bank rally will be short-lived. Credit growth is falling and broad money warns of further contraction.

Australia Credit and Broad Money Growth

House prices are falling and concerns over a slowing economy have caused many to call for further rate cuts. I believe this is short-sighted.

Australia House Prices and Household Debt

One of the biggest threats facing the economy is ballooning household debt. Tighter credit and falling house prices are likely to curb debt growth….provided the RBA doesn’t pour more gasoline on the fire.

I have been cautious on Australian stocks, especially banks, for a while, and hold more than 40% in cash and fixed interest investments in the Australian Growth portfolio.

ASX awaits bear market confirmation

The ASX 200 is testing the former band of primary support between 5650 and 5750. Respect is likely and would confirm a bear market for Australian stocks. Target for a primary decline is 5000.

ASX 200

ASX 300 Metals & Mining Index is testing primary support at 3400. Declining Trend Index peaks warn of selling pressure. Breach of 3400 would confirm a primary down-trend, strengthening the bear signal.

ASX 300 Metals & Mining

House prices are falling but this has not yet had an impact on the record high ratio of household debt to disposable income. Wages growth is slow and it will take a long time for debt ratios to return to saner levels. Expect the housing bear market to last for a similar length of time unless the RBA is desperate enough to make further rate cuts.

RBA: Credit & Broad Money

Bank performance is closely aligned with the housing market. The ASX 300 Banks Index is testing long-term support at 7000. Declining Trend Index peaks warn of selling pressure. Breach of support at 7000 is likely to lead to another decline, with a long-term target of 5000.

ASX 300 Banks Index

I have been cautious on Australian stocks, especially banks, for a while, and hold 40% cash in the Australian Growth portfolio.

Australian banks under selling pressure

The ASX 300 Banks index are a major drag on the broad market index. Having respected resistance at 8500, a test of primary support at 8000 is likely. Twiggs Trend Index peaks below zero warn of strong selling pressure.

ASX 300 Banks

Return on equity is falling.

Australian Banks Return on Equity

A combination of narrow interest margins.

Bank Net Interest Margins

Soaring household debt.

Bank Net Interest Margins

And rising capital requirements as APRA desperately tries to protect their glass jaw.

Bank Capital Ratios

Don’t let the ratios fool you. They are based on risk-weighted assets. Common Equity Tier 1 (CET1) leverage ratio for at least one of the majors is as low as 4.0 percent.

More evidence of a bull market, except in Australia

One of my favorite indicators of financial market stress is Corporate bond spreads. The premium charged on the lowest level of investment-grade corporate bonds, over the equivalent 10-year Treasury yield, is a great measure of the level of financial market stress.

Moodys 10-year BAA minus Treasury yields

Levels below 2 percent — not seen since 2004 – 2007 and 1994 – 1998 before that — are indicative of a raging bull market. The current level of 2.24 percent is slightly higher, reflecting some caution, but way below elevated levels around 3 percent.

The Financial Stress Index from St Louis Fed measures the degree of stress in financial markets. Constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. The average value of the index is designed to be zero (representing normal market conditions); values below zero suggest low financial stress, while values above zero suggest high market stress.

St Louis Financial Stress Index

Current levels, below -1, also indicate unusually low levels of financial market stress.

Leading Index

The Leading Index from the Philadelphia Fed has declined slightly in recent years but remains healthy, at above 1 percent.

Philadelphia Fed Leading Index

Currency in Circulation

Most recessions are preceded by growth in currency in circulation falling below 5 percent, warning that the economy is contracting.

Currency in Circulation

Current levels, above 5 percent, reflect healthy financial markets.

Australia

On the other side of the Pacific, currency growth is shrinking, below 5 percent for the first time in 7 years. A sustained fall would warn that the economy is contracting.

Australia: Money Supply

Further rate cuts, to stimulate the economy, are unlikely. The ratio of Household Debt to Disposable Income is climbing and the RBA would be reluctant to add more fuel to the bonfire.

Australia: Household Debt

There is no immediate pressure on the RBA to raise interest rates, but when the time comes the impact on the housing market could be devastating.

BIS: High household debt kills growth | Macrobusiness

From Leith van Onselen, reproduced with kind permission from Macrobusiness:

Last month I showed how Australia’s ratio of household debt to GDP had hit 123% of GDP – the third highest in the world – according to data released by the Bank for International Settlements (BIS):

ScreenHunter_16670 Dec. 13 07.13

Martin North also compiled separate data from the BIS, which showed that Australia’s household debt servicing ratio (DSR) is also the third highest in the world:

Despite record low mortgage rates, Australia’s mortgage slaves are still sacrificing a far higher share of their income to pay mortgage interest (let alone principal) than when mortgage rates peaked in 1989-90:

ScreenHunter_16672 Dec. 13 11.05

Now the BIS has released a working paper, entitled “The real effects of household debt in the short and long run”, which shows that high household debt (as measured by debt to GDP) has a significant negative long-term impact on consumption and growth. Below are the key findings:

A 1 percentage point increase in the household debt-to-GDP ratio tends to lower growth in the long run by 0.1 percentage point. Our results suggest that the negative long-run effects on consumption tend to intensify as the household debt-to-GDP ratio exceeds 60%. For GDP growth, that intensification seems to occur when the ratio exceeds 80%.

Moreover, the negative correlation between household debt and consumption actually strengthens over time, following a surge in household borrowing. What is striking is that the negative correlation coefficient nearly doubles between the first and the fifth year following the increase in household debt.

As shown in the table above, Australia’s household debt-to-GDP ratio was 123% as at June 2016 (higher now) – way above the BIS’ 80% threshold by which GDP growth is adversely impacted.

According to Martin North:

This is explained by massive amounts of borrowing for housing (both owner occupied and investment) whilst unsecured personal debt is not growing. Such high household debt, even with low interest rates sucks spending from the economy, and is a brake on growth. The swelling value of home prices, and paper wealth (as well as growing bank balance sheets) do not really provide the right foundation for long term real sustainable growth.

Another obvious extrapolation is that there could be carnage when mortgage rates eventually rise from current historical lows.

Why Australian Consumers Are Happy With Their Finances But Aren’t Spending | Business Insider

From Greg McKenna:

There is a lot of focus on the wealth of Australians through property and super but many Australian households and Australian households in aggregate are still carrying a large amount of debt. A stock of debt which must be repaid with a flow of earnings no matter how wealthy they might be on paper.

So consumers are more confident about their finances and their financial future but they aren’t spending — yet.

Something that puzzles me is why household debt as a percentage of disposable income is constant. If consumers have accelerated their credit card and mortgage debt repayments, surely this figure should be falling.

Read more at Here's The Best Explanation Of Why Australian Consumers Are Happy With Their Finances But Aren't Spending | Business Insider.

Platinum founder warns on property “act of faith”

ScreenHunter_3505 Jul. 29 08.50

By Leith van Onselen

The founder of Platinum Asset Management, billionaire investor Kerr Neilson, has released an interesting report warning about Australia’s frothy house price valuations and the risks of a correction once “conditions change, [and] a lot of the assumptions are found wanting”.

The report highlights four “facts” about Australian housing:

1. Returns from housing investment are often exaggerated and flattered by inflation.
2. Holding costs of rates, local taxes and repairs are estimated to absorb about half of current rental yields.
3. Long-term values are determined by affordability (wages + interest rates).
4. To be optimistic about residential property prices rising in general much faster than inflation is a supreme act of faith.

It then goes on to examine each of these facts.

On returns, the report notes that “the rise in the price of an average home in Australia…[has] been about 7% a year since 1986. In dollar terms, the average existing house has risen in value by 6.3 times over the last 27 years. No wonder most people love the housing market!”

But rental returns have gotten progressively poor:

…we earn a starting yield of say 4% on a rented-out home or if you live in it, the equivalent to what you do not have to pay in rent. But again, looking at the Bureau of Statistics numbers, they calculate that your annual outgoings on a property are around 2%. This takes the shape of repairs and maintenance, rates and taxes, and other fees. This therefore reduces your rental return to 2%, and what if it is vacant from time to time?

And the prospect for future solid capital growth is low due to poor affordability:

…the last 20 or so years has been exceptional. Australian wages have grown pretty consistently at just under 3% a year since 1994 – that is an increase of about 1% a year in real terms.

Affordability is what sets house prices and this has two components: what you earn and the cost of the monthly mortgage payment (interest rates).

…even though interest rates have progressively dropped, interest payments today absorb 9% of the average income, having earlier been only 6% of disposable income.

ScreenHunter_3506 Jul. 29 09.21

Today, houses cost over four times the average household’s yearly disposable income. At the beginning of the 1990s, this ratio was only about three times household incomes. As the chart over shows, this looks like the peak.

ScreenHunter_3507 Jul. 29 09.22

Finally, the report argues that for Australian home prices to significantly outpace inflation over the next ten years, as they have in the past, “would require a remarkable set of circumstances”, namely a combination of:

1. Continuing low or lower interest rates.
2. Willingness to live with more debt.
3. Household income being bolstered by greater participation in the income earning workforce.
4. Average wages growing faster than the CPI.

The last point is improbable seeing that wages and the CPI have a very stable relationship, while the other points are not very likely.

Reproduced with kind permission from Macrobusiness.

Deflating Australia’s land bubble

ScreenHunter_18 Jul. 05 10.22

Great post by Leith van Onselen
Reproduced with kind permission from Macrobusiness.com.au
.

Prosper Australia has provided a submission to the Senate Inquiry into Housing Affordability, which is well worth a look. The submission first provides nine metrics illustrating Australia’s residential property bubble, which include the following:

ScreenHunter_1461 Mar. 03 14.43

It took forty years from 1950 to 1990 for housing prices to double, but only fifteen years between 1996 and 2010 to double again. The surge in housing prices is driven by the tremendous growth in household debt, as owner-occupiers and investors take out ever larger mortgages to speculate on housing. The household debt to GDP ratio reached a record high of 98 per cent in 2010, the same year real housing prices peaked. In 2013, the mortgage and personal debt ratios were 86 and 9 per cent, respectively, for a combined household debt ratio of 95 per cent.

ScreenHunter_1462 Mar. 03 14.45

As mortgage debt escalated, investors’ net rental losses increased rapidly from 2001 onwards. In that year, net rental income losses were just over $1 billion, rising to $9.7 billion in 2008 as the cash rate peaked at 7.2 per cent. By 2010, when mortgage debt reached its historical peak relative to GDP, investor losses eased to $5.1 billion as the cash rate fell to a then historic low of 3 per cent in 2009 following the global financial crisis (GFC). The latest data shows income losses rose to $8.2 billion in 2011, the second largest absolute loss on record…

The housing market meets economist Hyman Minsky’s definition of a Ponzi scheme, as gross rental incomes minus expenses are clearly insufficient to meet principal and interest repayments. As 67 per cent of property investors are negatively-geared as of 2011, investment decisions are predicated upon expected rises in land values, not rents. This strategy will inevitably fail, as the escalation in real housing prices can only be sustained by a continual acceleration or exponential rise in mortgage debt.

The price to income (P/I) ratio, otherwise known as the median multiple, is another measure of residential property valuation…

ScreenHunter_1463 Mar. 03 14.49

From the mid-1990s onwards, housing prices outpaced household incomes, and the P/I ratio increased from 4 to 7 nationwide. It is impossible for household incomes to match the rise in housing prices during the boom phase of a property bubble, as wages grow more slowly, usually just above the rate of inflation…

Land is the largest tangible market in Australia… Our housing bubble is actually a residential land bubble, as the total land values to GDP ratio doubled between 1996 and 2010, when it reached a record high of 298 per cent ($4.1 trillion). In real terms, residential land values rose from $895 billion in 1996 to a peak of $3.2 trillion in 2010, a relative increase of 262 per cent. This ratio is closely matched by a similar rise in the value of the residential housing stock. The rise in residential land values, rather than structures, is responsible for almost all of the increase in the value of the housing stock…

ScreenHunter_1464 Mar. 03 14.51

Prosper then places the blame for Australia’s expensive housing on convergence of factors, with Australia’s inefficient tax system front-and-centre:

A convergence of factors are responsible: a large cohort of irrational investors gambling on housing prices, a FIRE sector willing and able to facilitate a credit boom, and low property and land taxes attracting speculators to this asset class…

A positive feedback loop has emerged between housing prices and mortgage debt, with rising prices prompting the take-up of more debt in an upwards spiral…

An inefficient taxation system, comprised of low property and land taxes, allows landowners to expropriate ‘geo-rent’ (economic rent derived from land) by capturing the uplift in land values generated by taxpayer-funded infrastructure and rising economic productivity… Government willingness to tax wages and business ahead of land has elevated its privileged status, resulting in larger capital sums being paid by owner-occupiers and investors.

It also advocates land tax reform, which it claims would significantly improve incomes, affordability, and productivity:

Counter-intuitively, reducing wage and business taxation and increasing land tax would not necessarily lower fundamental land prices, given the offsetting boost to disposable wages, profits and hence rents, but it would certainly lower bubble-inflated land prices. Land tax reform – urged on government by every independent tax review in living memory – would firmly correct the price to rent and income ratios. If Australia wishes to escape or ameliorate the profound financial destruction of a bursting land bubble, the solution lies in this equation…

Prosper also slams housing-related tax expenditures, which undermine the integrity of the tax system:

The generous scope of tax expenditures relating to the housing market has served to further increase prices. Tax expenditures are defined as a deviation from the commonly accepted tax structure, whether it is a tax exemption, concession, deduction, preferential rate, allowance, rebate, offset, credit or deferral. Australia has the highest rate of tax expenditures among our OECD peers, at more than 8 per cent of GDP. Tax expenditures are vulnerable to lobbying, and often compromise the fairness and efficiency of the tax system. Lavish tax expenditures for both owner-occupied and investment property has significantly worsened housing affordability because they allow landowners to capture greater amounts of geo-rent and prioritise unearned wealth and income over what is earned. Existing home owners capture the most benefit, ahead of first home buyers, investors and tenants.

ScreenHunter_1465 Mar. 03 15.09

These tax expenditures provide a strong incentive to speculate on housing prices, and are reinforced by already low property taxes. Investors perceive rental income as secondary to expected rises in capital prices, while first home buyers over-leverage themselves to enter a bubble-inflated market…

Tax expenditures, combined with the ongoing deregulation of the banking and financial system, has transformed the housing market into a casino. Residential property is commonly viewed as a speculative asset to flip, rather than shelter to raise a family in…

Finally, Prosper provides two recommendations to the Senate Inquiry:

Recommendation 1: Reform Land Value Tax. The ideal tool to moderate land bubbles and properly fund infrastructure already exists in the hands of state and territory governments: state land tax (SLT). Unfortunately, this tax has been so riddled with exemptions and concessional treatments it must be considered dormant…

We suggest the current government introduce a nationwide one per cent federal land tax (FLT) – fully rebatable on SLT paid – to oblige the states and territories to use their taxing powers properly. State governments could adjust their tax rules and keep every dollar the FLT raises, to the benefit of all Australians. The Commonwealth Parliament would be entitled to argue this intervention is for sound economic reasons and dissipate the political fallout. Placing state and territory finances on sound bases would vastly improve the federal system mandated by Australia’s Constitution. Transitional arrangements would need to be considered. Rebating all stamp duty paid against a hypothetical past SLT obligation would address concerns of fairness and equity…

Recommendation 2: Macroprudential Regulation. A range of macro-prudential tools are needed to moderate housing price inflation and subdue credit growth in a pro-cyclical financial system, such as those affecting the loan to value, (LVR), debt servicing (DSR) and debt servicing to income (DSTI) ratios.26 Quantitative restrictions should be placed on the share of new mortgages with moderately high LVRs…

To reduce systemic risk, a large rise in capital and liquidity ratios (buffers) is required to ensure banks can withstand a future economic downturn, bank run or large fall in the value of collateral. Research suggests the probability of a banking crisis can be reduced to a 1 in 100 year event by raising core equity (Tier 1) capital ratios to 11 per cent in isolation or raising core equity to 10 per cent with an addition rise in liquid assets of 12.5 per cent (the rise in liquid assets over total assets). For the Big Four banks, this would represent a rise of around 3 per cent in core equity…

The full submission is available here.