Views on Australian Economy (early 2019)

Earlier Comment: from “Early Signs of Negative Wealth Effect” at Rogermontgomery.com on 17 January 2019

It is basic common sense – when through regulation or general policy drift one sector of the economy is favoured over others, partly through co-option of the political and bureaucratic system, a smaller share of the pie must by definition be shared by the “others”. In this case the “others” were content to live with this while the pie was growing, but it was never sustainable to grow the banking/housing sector so out of proportion within the economy so that eventually the pie would shrink back and those proportionally smaller pieces of pie within a shrinking economy had to have serious consequences.

My disappointment is greatest with the RBA. They have treated everyone like we are Nongs (my wife’s favourite derogatory term 🙂 ) and have become confidence sellers – peddlers of hot air and baloney.

For example, until recently they argued that there would be no negative wealth effect on the basis that there was no discernible positive wealth effect as price rose strongly in recent years. Another far more plausible, and I have to say rather obvious, discussion around the topic would highlight that earlier stages of the long process of almost continually rising house prices, and concomitant household leverage, since the late 90s/early 00s was accompanied by strong wealth effects, and that the latest period of strongly rising prices in Sydney and Melbourne was not is suggestive that the positive wealth effects from these very strong rises in prices were counterbalanced by the negative wealth effects from the stock of household debt. In other words the laws of diminishing returns were very much in play and the end of the debt cycle was nigh, and the risks that Mr Stevens discussed in his 2012 paper “The Glass is Half Full” have in fact come to the fore .

From an investment perspective, I firmly believe that we have a deleveraging process that will go on for much longer than anyone would predict. A search for the truly long-term data on real house price movements in Herengracht provides sobering reflection…

I wrote the following to two mates in early May last year [2018]:

“FYI – obviously this ppt [presenting data of shop/restaurant closures in my near vicinity in Brisbane] is just for your eyes… don’t think it’s anything earth shattering, but I am convinced on this now and an effective* recession within 1.5-2 years is now my base case… It would be better if I was wrong, but I thought what I saw last November was a precursor and it continues to play out along those lines… I am sure that there will be policy thrown at the problem – and increasing the committed liquidity facility (to 250 billion) will stop the banks from going under and mean that we should not suffer a current account crisis (our own form of QE) – but there is a lot of vulnerability built into the system now (which the RC is addressing all too late) and the Government just has much less ammunition than it did 10 years ago (the AAA will be stripped, banks then downgraded, more sceptical voters so not sure first home buyer bribes, etc will work)… it’s going to be a long tough period for many over-leveraged Australians in my opinion…

Yes I have been bearish for a while… but the only reason to be bullish has been a belief in “too big to fail” and Government intervention which just leads to more and more moral hazard in markets… that’s hardly a reason to be confident over the medium to long term – well for anyone who is trying to build wealth through investing over their life time as apposed to those concentrating on earning a fat bonus from clipping the ticket of fund flows… there will be a time when Governments can not kick the can down the road for future Governments and taxpayers to deal with… And I rather suspect this is it for us…

I honestly look forward to one day being bullish 🙂

* “effective” because high immigration and increasing volumes of gas exports might prevent the technical definition from occurring – eg most business people here consider 2000/01 was similarly an unrecognised recession – but I think it’s going to get pretty bad so I think the definition will be met”

I continued on the same thread with this:

[For] businesses depending on discretionary spend I suspect a donut structure will be most rewarding – those targeting the zero or lesser leveraged cohorts in the young and the retirees, and the hole being the very highly leveraged in the middle. It will have to be a truly extraordinary business to do well in the middle because, in my thought process, house prices in Sydney and Melbourne relative to wages will fall for a decade or more if nominal price falls are capped at 20%. (Of course greater nominal house price falls will speed up the adjustment but that does not improve the investment case.) Eventually wages growth will do some of the heavy lifting on that but nobody believes that will be any time soon unless we get truly reformist or even radical (eg universal basic income). Based on the performance of our political/bureaucratic/business leaders over the last 2 decades, I can’t see how we can sustainably/enduringly avoid anything other than a long hard grind ahead in the middle… (I know it’s depressing, but I was amused to read [by James Montier, on GMO] that depression has been shown to be an advantage in investing… the author said they aimed to be miserable at work and jubilant at home… unfortunately it can’t be turned off and on 🙂 – but at least it’s not too challenging/confronting to accept depressing conclusions )…

Over the next 10 years or so there may well emerge one or two extraordinary businesses that do target this “middle” demographic… (in fact there is a case to make that tough conditions will produce exceptional businesses – like rugged ground and challenging conditions will produce exception wines – part of the reason why I am not deterred from investing in Chinese companies at present with growing headwinds of slowing growth within a changing economy within a changing global context) [See updated view on The Perils of Investing in Chinese Companies… I would suggest, though, that when analysing candidates, given these headwinds, it would be prudent to “lengthen the yardstick” and thus widen the margin of safety…

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© Copyright Brett Edgerton 2019