Macro Overview - June 2017

Australia’s economy and financial markets may be facing some headwinds as a global rebalancing is underway between the current account surplus nations and those with significant current account deficits. So what should Australian investors do, particularly when the property boom is beginning to subside? Where do the better opportunities lie?

The focus in our last quarterly macro overview was on the massive imbalances in global trade that have arisen over the last 20 years.  While China has been a well-known and recognised source of these imbalances, we noted that since the Global Financial Crisis, the Eurozone has moved from a small current account deficit to a surplus of over US$400 billion, and that South Korea has seen a fivefold increase in their surplus to US$100 billion.

For comparison, China generated a surplus of a mere US$271 billion in 2016, having peaked at US$421 billion in 2008.  What is important to remember is that when a country or region generates a current account surplus, these “excess earnings” (savings) are exported abroad and invested in other countries.  Over the last two decades, the major recipients of these flows have been the US, the UK, Australia and Canada, who have benefited from this capital being invested in their real economies and financial markets – bonds, shares, and property alike.  We think this pattern of trade and capital flows, which has been part and parcel of the global economy and financial markets, is set to change.  In China, the ongoing strong growth in consumption spending, and in Europe a cyclical recovery, will result in lower current account surpluses and less capital exported abroad.

If this rebalancing is indeed underway, then we think there are potentially significant implications for Australian investors.  Foreign capital inflows have long been a characteristic of the Australian economy.  All of our investment cycles, whether it is the mining investment boom that is now coming to an end or the current cycle in residential apartment construction in the capital cities, have been in part funded by foreign money.  At times foreign participation is clearly visible (as it has been in the case of property and mining), but it also plays an indirect and less conspicuous role via our debt markets and by funding our banking system.  There is nothing intrinsically wrong with this.  However, if the current account surpluses of the likes of Europe and China decline in the years ahead, we would be faced with a choice between:

• saving more (and reducing our dependence on foreign money),
• competing for our portion of a dwindling pool of funds by raising rates of return for investors (i.e. higher interest rates), and
• experiencing a fall in our living standards via a fall in the Australian dollar.

If this occurs, it will come at a time when the Australian economy and markets are particularly vulnerable.  We are hardly the first to make the observations that appear in the following paragraphs, and, indeed, the financial press has for some time been littered with predictions of a coming demise of our property market and, with it, our economy.  We don’t intend for this article to be another “bell ringing” prediction of an Australian property market collapse, though we do not discount this as a possibility.

The indebtedness of Australian households has been rising steadily over the last two decades and now stands at 189% of household income, high by global standards and ranking us fourth in the world.  Of course, this has been brought about by ever falling interest rates.  Nevertheless, it leaves Australian households vulnerable to either higher interest rates or falling asset prices, if and when either of these events occurs.  Falling interest rates and expanding household debt have clearly been a driver of residential property prices across much of the country.  A global study of property prices conducted in late 2016 shows that Sydney property prices were 12.2 times the medium household income (up from 7.6 times in 2004), making it the second least affordable property market in the world after Hong Kong.^[1]  Melbourne, at 9.5 times, is ranked the sixth most expensive market globally.  That Australians are highly indebted and our property prices are high is hardly news to readers, and indeed these observations could have been made for much of the last decade.

The other variable worth noting is the use of “interest only” (IO) mortgages.  According to the Reserve Bank of Australia (RBA), 23% of “owner occupied” mortgages are interest only, up from mid-teen levels a decade ago.^[2]  For investment properties, 64% of mortgages are interest only, though this has been relatively steady for some time.  There are numerous reasons for using interest only loans.  For investment properties, it can allow negative gearing benefits to be maximised, and for home owners it provides flexibility in the rate of repayment and allows for a simple redraw of funds.  However, compared with a principal and interest loan, IO loans also allow a borrower to access more funds than one might otherwise be able to.  To get a sense of the role IO loans played in the US housing crisis, one can watch the movie The Big Short, or for a more in-depth understanding, read the book of the same title by Michael Lewis.  Recently there has been much focus on the regulatory changes limiting banks’ ability to issue IO loans.  The result has been an increase in the interest rates on IO loans relative to traditional principal and interest loans.  Some commentators see this reduction in the availability of IO mortgages as well as the rise in the cost of these loans as the catalyst that will bring down the housing market.  That may be so, but it is problematic to have any degree of certainty without much more detail on household finances.  Nevertheless, the enthusiasm for IO mortgages certainly points towards a higher degree of speculative behaviour by property buyers than one might otherwise assume.

We think it highly likely that at some point the Australian property market will have some sort of setback, and that potentially along with it we will see significant distress in household finances and a significant jump in the credit costs of the banking system.  However, as we have seen elsewhere, the catalyst for and timing of such crises are notoriously difficult to predict, and when they do occur, it can happen in an instant.  And such events are not usually accompanied by numerous experts predicting their occurrence, as seems to be the case here (though we would caution readers not to take too much comfort in this).  Trying to prepare oneself for an onslaught that may not happen for some time, or that may not happen at all, is difficult.

So what should Australian investors be doing?  Our observation from meeting with many individual investors and their advisors is that there remains significant potential for Australians to increase their exposure to international markets.  Not only will it have the benefit of significantly diversifying the “Australia risk” in one’s portfolio, it also provides the added protection that a fall in the Australian dollar, which will likely accompany any calamity in the local property market, will add to the returns from offshore assets.   Now you may be thinking, Platinum, as a manager of global share funds, of course would be saying this!  Nevertheless, we do truly believe that there are investment opportunities beyond our shores, particularly in Europe and Asia, that are substantially more attractive than those afforded by the Australian market.  I would encourage you to read the article by Nik Dvornak, Europe’s Road from Austerity to Prosperity, in which he explores the experiences of the German economy and investor in contrast to those of the Australian economy and investor over the last 30 years.  The paper provides valuable insights as to why we think now, more than ever, is the time for investors to head offshore.

Outlook

Over the last 12 months stock markets in Asia and Europe have handily outperformed the US as economic recoveries have taken hold in China and Europe.  In local currency terms, Europe gained 20%, Japan 30.5%, and the rest of Asia 25.6%, while the US returned 17%.^[3]  The result has been strong in terms of absolute returns across Platinum’s full suite of funds which also achieved good relative returns in most cases.

After a strong year of performance across markets, and remembering that global markets have now delivered to Australian investors over 17% p.a. for five years, one should be more cautious about the year ahead.

In the US, the Federal Reserve raised interest rates in June, and has now raised rates in each of the last three quarters.  Additionally, the Fed will start to reduce its holdings in US Treasuries and mortgage backed securities, acquired during quantitative easing.  The issue is that monetary policy cycles tend to proceed until economic growth slows and stock markets decline.  The combination of rising interest rates and the high valuations of US stocks is the main reason to maintain a relatively cautious approach to markets.  With the federal funds rate at only 1%, it is tempting to assume it is still early in the tightening cycle, but given that we have already experienced additional tightening by the removal of quantitative easing, it is difficult to judge.  Certainly markets appear to have shrugged off that latest increase, but at some point we will likely see a setback resulting from higher interest rates.

Asia and Europe, on the other hand, seem to be offering better opportunities.  Despite their strong returns over the last year, our Asian and European investments are still showing a combination of attractive absolute valuations and underlying earnings growth, which we think will see these investments continue to produce good returns over the next three to five years.

During the quarter, one of the key developments has been the reform of the Chinese financial system where authorities have been enacting clearer regulations around securitisation and financial products (i.e. the so-called shadow banking system).  These reform measures, if successfully implemented, are without question a very positive development for China, as the reckless use of credit has clearly been a key risk for the country’s economy.  However, we have seen credit growth slow very significantly, and the short-term concern is whether this tightening in credit will cut short China’s recovery.  While robust pricing of industrial materials such as steel, cement and glass suggests that all is intact for the moment, there will be swings and roundabouts in China’s progress.  Importantly, most of our holdings in China have at the core of the investment case a strong secular growth story and tend to be less dependent on the short-term growth factors.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.