Unintended consequences of Government COVID-19 Policies
By visual /May 13,2020/
For every action there is a reaction. And while we’re not criticising the government’s policy response to COVID-19, we recognise that such intervention often has unintended consequences.
Take lower interest rates for instance. Central banks intended to make the cost of investment cheaper and be stimulatory. Instead, Australian households borrowed more money to buy bigger and better houses and US corporates levered up to buy back shares. Both actions have contributed to the economy’s current precarious situation.
One needs to think laterally when considering unintended consequences, something we apply our collective minds to. Why? Unintended consequences can impact the long-term prospects of companies and industries, both positively and negatively.
A costly decision
Providing a payment holiday seems like the right thing for banks to do given the unique circumstances. However, is it simply delaying the inevitable?
While a payment holiday means you don’t have to pay principal or interest over a six-month period, interest still accrues. In other words, after the payment holiday you have more debt. Imagine if the asset against that debt, maybe your family home or investment property, is worth less in six-12 months’ time. That leaves you with a higher liability and lower asset value.
If the servicer of the loan cannot find a job and is forced to sell in a depressed market, this becomes permanent financial damage. The unintended consequence of a payment holiday for SMEs and households could be a bigger problem down the track.
Banks are experiencing significant demand for credit from existing customers. SMEs and households are getting payment holidays and larger corporates are drawing down any credit line they can. This is extremely capital consumptive for banks.
While the RBA is providing adequate liquidity and the government is providing motivation to extend credit to SMEs, there’s little motivation for banks to take on new customers, either consumers or SMEs. We believe credit rationing for new customers is likely, with non-bank lenders pulling back at the same time. This will provide a headwind for the economy, with a reduced number of business start-ups in the short to medium term.
SMEs are most likely to use retail and office properties. To keep SMEs afloat, the government is addressing the two biggest costs, one of which is rent. The government has set up rules for a Mandatory Code of Conduct which helps tenants with turnover up to $50m. Essentially, the commercial landlord must take the same revenue hit as the tenant. At least half of this rent is waived completely, and the rest is deferred.
This is a smart move politically because there’s a perception that commercial landlords are rich, so there’s little sympathy from the public. However, unintended consequences are likely.
Commercial property is an attractive investment for two reasons; the stability of cashflows and the ability to borrow large sums of money against the asset. Landlords generally don’t get to participate in the upside when a tenant’s sales are going through the roof, but on the flip side, when the going’s not so good, they still get paid or can replace the tenant.
Banks traditionally liked lending to commercial property owners because of stable cashflows, the security of a hard asset and there wasn’t that operating leverage as is the case in most businesses. A precedent has now been now been set.
Commercial landlords now must cop the downside being felt by their tenants. There is even a six-month moratorium on evictions; so this asset, which was generating cash and servicing a debt, is generating no cash and there is nothing the landlord can do about it.
When the dust settles, banks are going to want more collateral and will likely lower loan to value ratios at a time when values could be under pressure. Given the importance of debt finance for most commercial property investors, this is likely to negatively impact valuations in the medium term.
The unintended consequences could include landlords hiking rents to take this new risk into consideration. If unable to increase rents, the result could be an accelerated downcycle in commercial property valuations, which would provide a further headwind for credit providers, which in turn could lead to further credit rationing.
Policies being implemented today have numerous unintended consequences that may impact the long-term prospects of many industries. This includes changes to supply chains from global just-in-time inventory systems to relying more on domestic supply chains. Immigration may slow to a trickle which, in turn, will impact economic growth.
By visual /May 13,2020/
Market and Economic overview
The coronavirus ‘curve’ of known cases has flattened out, suggesting social distancing measures have been successful in slowing the spread of the disease.
The focus is now on a gradual easing of restrictions – people will gradually start returning to work as non-essential areas of the economy start to function again.
It will take time for conditions to normalise completely – borders remain closed to overseas visitors, for example, so tourism-related areas of the economy will continue to struggle.
It remains too early to say how significant the slowdown will be, but some observers have suggested the Australian economy could contract by approximately 5% in 2020. At the same time, consensus expectations suggest unemployment could double, from around 5% in February to perhaps 10% during the course of this year.
Job security is low and house prices appear likely to fall, which could further dampen sentiment. For now, credit card spending is running nearly -20% below the corresponding period a year ago, highlighting the current weakness in consumer confidence.
By the end of April, more than 1 million people in the USA had been diagnosed with coronavirus.
Like other countries, the US had implemented various closures and restrictions. The ‘30 Days to Slow the Spread’ expired on 1 May 2020 and President Trump has suggested social distancing restrictions will not be extended.
Trump appears determined to reopen the economy as soon as possible, against the recommendations of some medical professionals. Ultimately, he wants the economy firing again in the run-up to the Presidential election in November.
The latest data showed the world’s largest economy shrank at an annual rate of -4.8% in the March quarter, even worse than consensus forecasts.
The downturn was due to economic disruptions in March. Data for the June quarter is expected to be worse still given more extensive closures during April, at least.
Much of Europe remains in lockdown, although numbers of cases vary quite markedly across the region. Germany – the largest economy in Europe – has much fewer cases than some other countries such as France, Italy, Spain and the UK. The economic impact might therefore differ between countries but will undoubtedly be significant overall.
Euro Area GDP growth declined at an annual rate of -3.3% in the March quarter and is expected to fall further in the June quarter.
Annual growth rates were lower still in some of the region’s major economies: France -5.4%; Italy -4.8%; and Spain -4.1%.
Restrictions have been eased in New Zealand; ‘Level 3’ measures are now in place – similar to those in Australia – after the more stringent ‘Level 4’ lockdown was no longer deemed necessary.
The Reserve Bank of New Zealand remains very active with its recently introduced asset purchase program. The Bank is buying large amounts of government and local authority bonds to ensure the smooth operation of the local fixed income market.
China’s economy shrank at an annual rate of -6.8% in the March quarter; a sharp slowdown from the 6.0% year-on-year growth seen in the December quarter of 2019.
The industrial sector was hardest hit by the near two-month shutdown of non-essential parts of the economy.
Whilst alarming, the short-term contraction will not impede China’s long-term growth trajectory, according to officials. That said, conditions could remain subdued in the foreseeable future.
The Australian dollar clawed back all of its lost ground from March. The currency gained 7.0% against the US dollar, closing April at 65.5 US cents. Similar strength was seen against other currencies too.
Most commodity prices finished the month of April stronger as demand uncertainty eased. Following sharp falls in March, copper (8.0%), nickel (8.0%) and zinc (3.4%) posted solid gains, although not enough to recover previous losses.
Iron ore (1.4%) reversed its downward trend on signs of a turnaround in Chinese manufacturing activity and reflecting China’s economic stimulus plans.
Oil prices (WTI Crude -26.6%) continued to fall, although stemmed losses towards month end on evidence of falling production.
The gold price (7.6%) again proved resilient against a backdrop of ongoing market uncertainty, while platinum (9.8%) and silver (10.1%) bounced back after March’s sharp falls.
The equity market recovery in the last week of March continued throughout April. The S&P/ASX 100 Accumulation Index rose 8.4%, registering its strongest monthly return since 1988.
Confidence was initially supported by the huge monetary and fiscal responses to the pandemic and later by encouragement that social distancing restrictions were proving effective.
The full impact of the virus remains unknown, however, and the shock to company earnings and balance sheets has placed additional pressure on dividend policies. At the same time, most companies have withdrawn earnings guidance.
Australia’s banks continued to underperform, as delays to mortgage payments and decreased property activity threaten earnings. The growing prospect of dividend cuts and the view that the banks will play a key role in supporting the economy has further dragged on investor sentiment.
After plunging dramatically in March, global listed property markets rebounded in April. The COVID-19 situation continues to be the dominant driver of property securities. Due to virus containment measures globally, including widespread lockdowns, there are rising expectations for sweeping rent abatements across the sector, particularly in the most heavily hit sub-sectors such as discretionary retail. Many listed property securities globally have now withdrawn their earnings and dividend guidance due to the uncertainty.
Unprecedented levels of monetary and fiscal support helped global markets stage a remarkable recovery. The MSCI World Index bounced 10.6% in local currency returns in April – its strongest month since 1975. The appreciation of the Australian currency tempered global equity returns for domestic investors, with the MSCI World Index rising ‘only’ 3.7% in Australian dollar terms.
UK equities were the weakest performers in April, with oil giant Shell announcing a cut in its dividend. Financial stocks also weakened after Lloyds revealed a large drop in profits. Disappointing returns from energy and financials stocks have contributed to the underperformance of the MSCI World Value Index in recent months.
Global and Australian Fixed Income
Bond markets were substantially calmer in April compared to March as central bank support programs appeared to be having their desired effect.
The Reserve Bank of Australia, for example, has bought around $50 billion of government and state government bonds in the past few weeks. This has materially improved liquidity and helped steady the local bond market.
Benchmark 10-year US Treasury yields closed April just 0.03 percentage points lower, at 0.64%. Yields also declined in the UK, Germany and Japan, by 13 bps, 12 bps and 5 bps, respectively.
Australian yields moved in the opposite direction, though not significantly. The yield on 10-year Commonwealth Government bonds closed the month 13 bps higher, at 0.89%. This resulted in a modest negative return from the domestic bond market.
Like shares, corporate bonds were buoyed by an improvement in risk appetite globally. Credit spreads – the difference in yield between corporate bonds and comparable high-quality government bonds – narrowed substantially.
Companies looked to take advantage of improving risk appetite and strong inflows into the asset class by offering a substantial amount of new bonds. In some cases, this was to bolster their balance sheets to help cushion the impact of a more prolonged period of lower profitability.
Source: Colonial First State
Funding retirement income in a low interest rate environment
By Robert Wright /November 23,2017/
While a traditional bank deposit is generally regarded as one of the safest forms of investment, it also currently offers among the lowest returns. For those relying on bank deposits to fund their retirement income, the current record low interest rate environment offers little reward.
For those approaching retirement, low interest rates could mean having to rethink their retirement goals, retirement time frame and potential sources of retirement income. For existing retirees, it could mean having to re-assess their goals. Simply put: low interest rates means more capital is required to fund future income needs.
This raises the question – if interest rates stay low for the foreseeable future, how can you fund the retirement lifestyle you’d hoped for?
Regardless of whether you are preparing for retirement, or are already retired, the answer lies in focusing on factors you can control, rather than those you cannot. Whilst there are many aspects of investing that can’t be reliably predicted, there are many factors you can control, including:
- how much you spend;
- how much you save;
- how much investment risk you are prepared to accept;
- how you structure your investments; and
- how much you pay in fees.
For those still working, it could mean adjusting discretionary spending, so that more funds can be used to boost retirement savings, or additional mortgage payments can be made to reduce the amount owing, or a combination of both. Less spending now means more money for later.
For self-funded retirees, it could mean adjusting discretionary spending by taking fewer ‘big’ holidays or by considering the Age Pension in their future planning.
Inevitably, investors may feel compelled to move further along the risk curve to seek out the retirement income they desire. In other words, they may seek to diversify away from cash and invest a higher percentage of their capital in alternative forms of income producing assets – such as shares, property and infrastructure. This is often referred to as the ‘search for yield’.
Cash vs Alternative Income Assets
The cash rate in Australia is currently 1.50%, with some institutions offering around 3.00% depending on the deposit amount and timeframe. Compare this to shares, where it is possible to receive a 6.00% return (or more), often with the benefits of franking credits.
There are, of course, risks associated with growth assets that can’t simply be ignored, and investors need to feel comfortable that the value of their portfolio will fluctuate over time, as the assets respond to prevailing market conditions. Whilst a regular dividend can help to offset the impact of any future share price falls, there is no guarantee that dividends will continue to be paid at the same rate.
Managing investment risks can be achieved by:
- buying and holding quality assets;
- being prepared to stay invested for the long term; and
- being prepared to ‘capitalise’ on over-heated markets.
Structuring your Assets
The overall structure you employ is the foundation to your portfolio and impacts the net return you receive. Quality assets, poorly structured, can lead to lower real returns.
For self-funded retirees, the decision to hold assets via a super fund or account based pension, or in their individual names can lead to very different results, in the form of:
- Returns – some structures don’t pay tax on earnings, so holding assets in the right structure can lead to higher returns.
- Benefits – some structures offer Centrelink exemptions, so holding assets in the right structure can lead to increased entitlements.
Understanding the difference between structures, and how these relate to you, can be complicated as they relate to an individual’s personal circumstances. This is one area that is definitely not “one size fits all.”
The fees you pay, whether direct or indirect, will also impact the net return you receive and can make a significant difference over the long term. Fees can generally be categorised into three areas:
It is important to have a good understanding of the total fees you are paying, to be satisfied that you are getting “value for money.”
As outlined above, it is clear that there are many factors to consider when it comes to deciding which approach is best for you. Now, more than ever, due to the current low interest rate environment, it’s worth reviewing your overall position to determine whether your current strategy remains relevant to your needs and lifestyle. Please contact us to discuss your particular situation.
The Australian housing market – surging unit supply, the economy and what it all means for investors
By Robert Wright /November 23,2016/
Housing matters a lot in Australia. Having a house on a quarter acre block is part of the “Aussie dream”. Housing is a popular investment destination. And the housing cycle is a key component of the economic cycle and closely connected to interest rate movements. But in the last 15 years or so it has taken on a darker side as a surge in house prices that started in the late 1990s has led to poor affordability and gone hand in hand with surging household debt.
Reflecting this, predictions of an imminent property crash bringing down the Australian economy have been repeated ad nauseam since 2003. This note looks at the risks of a property crash, particularly given the rising supply of units, implications from the property cycle for economic growth and how investors should view it.
High house prices and high debt
The big picture view on Australian residential property is well known. First, Australian housing is expensive. According to the 2016 Demographia Housing Affordability Survey the median multiple of house prices in cities over 1 million people to household income is 6.4 times in Australia versus 3.7 in the US and 4.6 in the UK. In Sydney it’s 12.2 times and in Melbourne it’s 9.7 times. The ratios of house price to incomes & rents are at the high end of OECD countries and have been since 2003.
Second, the surge in home prices has gone hand in hand with a surge in household debt, which has taken Australia’s household debt to income ratio from the low end of OECD countries 25 years ago to now around the top.
How did it come to this?
While it’s common to look for scapegoats to blame for high home prices and debt, the basic driver looks to be a combination of the shift from high to low interest rates over the last 20-30 years which has boosted borrowing and buying power and the inadequacy of a supply response (thanks to tight development controls, restrictive land release and lagging infrastructure) to suppress the resultant rise in the ratio of prices to incomes.
A home price crash remains unlikely
The surge in prices and debt has led many to conclude a crash is imminent. But we have heard that lots of times over the last 10-15 years. Several considerations suggest a crash is unlikely.
- First, we have not seen a generalised oversupply and at the current rate we won’t go into oversupply until around 2017-18.
- Second, despite talk of mortgage stress the reality is that debt interest payments relative to income are around 2004 levels.
- Third, Australia has still not seen anything like the deterioration in lending standards seen in other countries prior to the GFC. In fact in recent years there has been a decline in low-doc loans and a reduction in loans with high loan to valuation ratios.
- Finally, it is dangerous to generalise. While property prices have surged 60% and 40% over the last four years in Sydney and Melbourne, they have fallen in Perth to 2007 levels and have seen only moderate growth in the other capital cities.
The risks on the unit supply front are a concern
To see a property crash – say a 20% plus average price fall – we probably need to see one or more of the following:
- A recession – much higher unemployment could clearly cause debt servicing problems. This looks unlikely though.
- A surge in interest rates – but rate hikes are unlikely until 2018 and the RBA knows households are more sensitive to higher rates so it’s very unlikely rates will reach past highs.
- Property oversupply – as noted above this would require the current construction boom to continue for several years.
However, the risks on the supply front are clearly rising in relation to apartments where approvals to build more apartments are running at more than double normal levels.
Due to the rising supply of units, vacancy rates are trending up & rents are stalling, making property investment less attractive.
Nationwide price falls are unlikely until the RBA starts to raise interest rates again and this is unlikely before 2018 at which point we are likely to see a 5% or so pullback in property prices as was seen in the 2009 & 2011 down cycles. Anything worse would likely require much higher interest rates, or recession, both of which are unlikely. However, it’s dangerous to generalise:
- Sydney and Melbourne having seen the biggest gains are more at risk and so could fall 5-10% around 2018.
- Price growth is likely to remain negative in Perth and Darwin as the mining boom continues to unwind but this should start to abate next year.
- The other capitals are likely to see continued moderate growth and a less severe down cycle in or around 2018.
- Units are at much greater risk given surging supply and this could see unit prices in parts of Sydney and Melbourne fall by 15-20% as investor interest fades as rents fall.
The property cycle and the economy
Slowing momentum in building approvals points to a slowdown in the dwelling construction cycle ahead. While this might be delayed into 2017, as the huge pipeline of work yet to be done is worked through, slowing dwelling investment combined with a slowing wealth affect from rising home prices mean that contribution to growth from the housing sector is likely to slow. However, as this is likely to coincide with a fading in the detraction from growth due to falling mining investment and commodity prices it’s unlikely to drive a slowing in the economy.
However, a likely decline in rents (as the supply of units hits) will constrain inflation helping keep interest rates low for longer.
Implications for investors
There are several implications for investors:
- Firstly, over the very long term residential property adjusted for costs has provided a similar return to Australian shares. Its low correlation with shares, lower volatility but lower liquidity makes it a good portfolio diversifier with shares. So there is clearly a role for property in investors’ portfolios.
- Secondly, there remains a case to be cautious regarding housing as an investment destination for now. It is expensive on all metrics and offers very low income (rental) yields compared to other growth assets. This means a housing investor is more dependent on capital growth.
- Thirdly, these comments relate to housing in aggregate and right now it’s dangerous to generalise. Apartments in parts of Sydney & Melbourne are probably least attractive but for those who want to look around there are pockets of value.
- Finally, investors need to allow for the fact that they likely already have a high exposure to Australian housing. As a share of household wealth it’s nearly 60%. Once allowance is made for exposure via Australian shares it’s even higher.