Economic Backdrop and Other Factors for Consideration
(Reproduced in full from Edgerton 2014, Financial Planning assignment, Semester 1 2014, Annexure 1 – since writing this I have read Garnaut 2013, “Dog Days: Australia after the boom”, and recommend it highly for anyone wishing to gain a more thorough understanding of the challenges facing Australia over the medium term which is highly beneficial to building and protecting wealth in this country)
In the period since the commencement of the global financial crisis (GFC) we have witnessed the collapse of venerable investment banks in the United States (US), an unprecedented US national house price collapse, bank solvency issues elsewhere leading to extraordinary actions such as nationalisation (e.g. in the United Kingdom) and sovereign guarantees of bank balance sheets (including in Australia), the essential insolvency of a nation (in Iceland) and near insolvency of European countries especially the Mediterranean states, and other critical dislocations in global markets. These dislocations have heralded a highly unusual period in global economics marked by monetary policy in many developed countries which until recently was considered “experimental”. In many developed countries the desire for ultra easy monetary conditions has resulted in interest rates being reduced to virtually zero and then massive expansion of money supply by what is colloquially referred to as money printing. Most countries complemented these policies with expansionary fiscal policies which included large stimulus packages, including in Australia and, just as importantly to Australia’s economic fortunes, China.
While memories of those events are fading, indeed we remain firmly in unusual circumstances today. There is no better illustration of that than the recent ructions to some key emerging markets and their currencies with growing anticipation of US monetary policy normalisation. Moreover, counter-intuitively global share markets, led by the US, remain buoyed by poor economic news and pessimistic with good economic news releases. Thus markets are suggesting that the affect of ultra easy monetary policy is more important to share prices than that of the economy via actual business performance. Global markets are far from normalised.
In Australia it is widely accepted that Government contributions towards standards of living in retirement are set to decline substantially. Pressure is being placed on Australia’s fiscal situation by a number of factors. Perhaps most importantly Australia’s demographics are challenging. The large Babyboomer cohort is beginning to retire and that demographic “bulge” is exacerbated by the increased life expectancy for all Australians. Consequently demographers predict that by 2050 in Australia, instead of the current 5 workers for each person over 65 years, there will only be 2.7 working Australians.
This challenge is now being articulated by the Australian Government, and particularly by the Treasurer, Mr. Hockey, in the lead up to the 2014 Federal Budget. Mr Hockey has reminded Australians that the aged pension, which set the current retirement age at 65, was implemented in the early 20th century when the average life expectancy was less than 60. He contrasted that with the current situation where around one-third of Australians born today are expected to live beyond 100 years. Mr. Hockey is promoting an open dialogue with Australians to increase understanding that the current fiscal balance is unsustainable, and that Australians will need to accept adjustments which, because of the challenging demographics’ impact on revenues from taxation receipts, will necessarily involve Australians reducing their expectations of the level of services that the Federal Government will be able to support into the future.
Moreover, it is becoming increasingly understood in Government circles that to merely maintain current living standards there will need to be a very significant rise in productivity which will be challenging to achieve. Simply, Australians have become accustomed to rapidly rising standards of living on the back of the emergence of China, and to a lesser extent India, as global economic behemoths. However, for their economies to become sustainable and more stable, China and India must rebalance away from fixed asset investment to more internally driven consumption models of development. Such rebalancing will reduce the growth in the need for mined resources which Australia has been very profitably providing. While this rebalancing still presents opportunities for Australia, such as in soft commodities and the provision of services, the natural advantages that Australia enjoyed in providing iron ore and coal, for example, do not exist. Thus to compete with other economies also seeking to capitalise on the emergence of the Chinese and Indian middle class, Australia needs to undergo an enormous productivity drive the likes of which we have rarely, perhaps never, seen in our nation’s history. Importantly, Australia is coming from a position of having high embedded costs which, ironically, have largely resulted from the first phase of Chinese development, a mild form of “Dutch Disease”. Australia’s cost problems are chiefly due to low productivity relative to labour costs. Thus it is difficult to be optimistic enough to suggest that Australia will manage to increase productivity sufficiently to prevent a real decline in standards of living.
With such a backdrop, it is clear that for Australians to achieve their life goals, many of which will be dependent on financial security and savings, they will need to focus intently on maximising their natural and learned talents. Critically, those who want to achieve the standard of living that their predecessors achieved, without the benefit of inheriting some of those proceeds from previous generations, will need to work much harder and more intelligently to succeed. The Babyboomer generation had the laws of supply and demand on their side in that their numbers were so great that their demand drove prices of assets higher and higher as can be seen in stock market and property returns from the 1980s onwards. However, as they move out of the asset accumulation phase, as they retire, it is an open question as to what will occur to asset prices. If most seek to live off the income from those assets and aim to bequeath them to their heirs, then they will have a neutral affect on asset prices. However, if most exchange their assets for cash for consumption, then they will have a deleterious effect on asset prices. Either way, it is generally accepted in the investment community that returns from assets in developed countries over the first half of the 21st century will likely be significantly less than was experienced in the second half of the preceding century. Thus, active portfolio management will be increasingly critical in wealth accumulation.
The historically high returns of the late 20th century cannot be attributed entirely to the Babyboomer generation. Concomitant with the Babyboomer generation entering the asset accumulation phase was the deregulation of the financial industry throughout the developed world, which dismantled much of the regulation enacted after the turmoil in the first half of the 1900s, as well as the development of central banking and monetary policy manipulation. Apparent economic stability and low inflation led to the period being known as “The Great Moderation”. The idea dovetailed with Francis Fukuyama’s essay “The end of history?” which argued that the developed world had reached the “end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of human government” (Fukuyama 1989).
This period of apparent stability resulted in the entrenchment of a number of maxims in the psyche of investors around the developed world. Investors had (have) come to believe that corrections in markets always present buying opportunities because markets always recover and go on to achieve new highs.
This new age thinking was brought to an abrupt end by the Global Financial Crisis (GFC). Belief in The Great Moderation has been challenged in part by renewed interest in the ideas of Hyman Minsky (Yellen 2009) who argued that periods of stability lead to periods of instability due to cycles of increased risk-taking (Minsky 1992). Perhaps these cycles have been exacerbated by the actions of central banks seeking to kick start economies by decreasing interest rates to progressively lower levels such that throughout much of the developed world interest rates are now at or approaching zero. Moreover, the crisis was so severe in many developed countries that zero interest rate policies were not sufficient to produce a recovery and central banks went further into unknown territory by enacting experimental policies, such as money printing, to ease monetary policy even further with the aim being to encourage risk-taking behaviour and thus reflating asset prices.
Whether monetary policy can be brought back to “normal”, or restored to the way it was used in recent history, remains unclear. However the dislocation is still clear and is particularly evident in global stock markets where investors are counter-intuitively optimistic with bad economic releases because they are seen as supportive of further money printing. Perhaps the most important aspect is that while these unconventional monetary policies saved the global financial system from collapse at the height of the crisis, it is not yet clear whether developed country politicians have the appetite to re-regulate the system to the extent required to prevent another even worse crisis from happening in the near to medium term. Some well respected investors and advisors argue that the ultra-easy monetary policies have only widened the imbalances in global economies and thus put the globe at (almost certain) risk of an even greater crisis; essentially the “kick the can” thesis. These commentators refer to capital flight from emerging markets since the US Federal Reserve began to reduce their money printing operations as partial evidence. Other equally well-regarded experts are more sanguine and suggest that global central banks are up to the task.
It is both salient and necessary to consider that whilst it has been true that asset prices have always reclaimed new highs, it is equally true that historically, even in the developed world, there have been occasions where asset markets have taken a very long time to reach pre-correction highs even in nominal terms let alone real (inflation-adjusted) terms. With the compounding affect of inflation, it is obvious that nominal asset prices will always go up if the time period is long enough. As an example, after the 1929 collapse of the American stock market, the Dow Jones index, consisting of the top American stocks, took 25 years to reach its peak pre-correction level (Harper 1998). Moreover, over that period the US dollar had lost 40% of its purchasing power! Thus the real (inflation-adjusted) value of assets is a critical consideration in investing, and Shiller (2000) provided what turned out to be an extremely prescient reminder of that, especially in his Figure 1.1 showing the historical real return of the US stock market, just before the “tech wreck”.
Shiller (2000) interestingly found a strong negative correlation between high prices for shares (as measured in relation to company earnings) and future returns (over the following 10 year period).
Historical data for property are not nearly as extensive as for share markets. However, it is clear that equally significant to returns from property will be the real inflation-adjusted return. The best long term data set on property prices is widely regarded to be from the Herengrecht in Holland. Eichholtz (1997) was able to construct a hedonic price index for properties along this Amsterdam canal over the period 1628-1973, and the same researcher has more recently updated the index to 2008 for an article in The Economist by Dr Lougani (then an IMF economist). These data show that the real price of property on this canal has frequently experienced extended periods of negative growth which have at times lasted for over a generation of ownership. As a dramatic example, in real terms the prices paid by buyers in the early 1700s were not achieved again until the latest boom in house prices in the early years of the 2000s! Within this period there were cycles of stronger and weaker prices, sometimes prices mostly rose for periods lasting decades, and then prices mostly fell for decades.
To the extent that buying a property is an investment as opposed to personal discretionary consumption, the true cost of buying at a time preceding a prolonged fall in the real value of property will be significantly greater due to lost opportunity.
It may be instructive at this point to come closer to home and consider the current situation in Australian property markets. Demographia (2014) considered that buying a home was affordable in none of Australia’s state capital. The report showed that as at September 2013 the median house prices in our capitals were between 580% and 900% of the median household incomes in those cities. It suggested that an established guide was that the price of a home should be no more than three times disposable income for it to be affordable, and on this basis found that Australia had the most expensive housing in the developed world. Australian Government bodies accept that Australian house prices are high relative to historical pricing and other countries, by some measures, but have produced other research (such as the proportion of disposable income required to meet repayments) which suggest that prices are not significantly out of line with past pricing and with other comparable countries. Moreover, Governor of the Reserve Bank of Australia Glenn Stevens has highlighted on a number of occasions that while he conceded there has generally been a boom in house prices over the recent decade, booms need not end in busts but that often they dissipate through prolonged periods of stable pricing which allows for incomes to “catch up” to prices. One could interpret that this is the Governor suggesting that this is what he would prefer to happen, and given the recent expanded mandate of the RBA to include financial stability, would appear to be a reasonable assumption.
Taking this all into consideration, when the current momentum of rapidly rising house prices comes to end, there is a reasonable probability that nominal prices of Australian houses will remain relatively flat for a prolonged period. Property prices may well still move higher at some stage over the next decade or so. However, whether Australian house prices in real terms appreciate further in the same period is less certain. And most importantly, if analysts who suggest that Australia is in or on the verge of a property bubble are correct, then house prices relative to household disposable income almost certainly will not reach these levels again for a very long time. If in the fullness of time these analysts are shown to be correct, then on a purely financial basis investments in housing may come at a substantial opportunity cost, and other non-correlated assets are likely to significantly outperform broad property markets (that is not to say that some pockets of residential property with specific attributes will not buck that trend.)
All of these issues must be weighed carefully and at length by the financial planner and investor prior to constructing investment portfolios. While these issues are complex, intertwined and fluid, and thus may appear daunting, this is the reality of investing today. In no way is it advantageous to the client investor to simplify the backdrop to the point where relatively benign investing conditions are perceived and a calculated return over a defined period is considered assured. Rather it is in the best interest of the client to be fully informed of the known risks and the potential rewards on offer so that this can feed directly into financial goal setting and ultimately portfolio construction.
References
Demographia 2014. 10th Annual Demographia International Housing Affordability Affordability Survey: 2014, Performance Urban Planning, http://www.demographia.com
Fukuyama, F 1989. ‘The end of history?’ The National Interest.
Harper, WS 1998. How to Handle a Bear Market: An Australian investor’s guide, Wrightbooks Pty Ltd, Elsternwick.
Minsky, HP 1992. ‘The Financial Instability Hypothesis’, Levy Economics Institute Working Paper No. 74.
Shiller, RJ 2000. Irrational Exuberance, Scribe Publications, Melbourne.
Yellen, JL 2009. ‘A Minsky Meltdown: Lessons for Central Bankers’, Presentation to the 18th Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies—“Meeting the Challenges of the Financial Crisis”, 16 April 2009.
© Copyright Brett Edgerton 2019
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