The Risk of Economic "Disaster" in Australia
Kieran Goodwin, co-founder of Panning Capital Management, joins Tony Greer…
The Rise and Fall of Credit Vol
Featuring Gerard Minack
Published on: April 23rd, 2019 • Duration: 55 minutes
Gerard Minack, founder of Minack Advisors, sits down with Matt Milsom of Qantex to discuss the macro drivers of Australia and of the global economy. Minack and Milsom dive into the macroeconomic considerations surrounding the beaten-up Australian economy, the bull case for Japan, and an explanation of how Modern Monetary Theory might operate in the real world. Filmed on April 15, 2019 in Sydney.
GERARD MINACK: Now, I'm not making a recession my investment base case yet, but if we were to get another two or three months of data like the sort we've had over last two or three months, then I think investors should make recession their investment base case in Australia. What deck of the Titanic are you on? If the ship hits the iceberg, let's not fuss about it. They're all going down.
MATT MILSOM: All right, Gerard, welcome back to Real Vision.
GERARD MINACK: Thank you.
MATT MILSOM: Great to have you.
GERARD MINACK: Thanks for having me.
MATT MILSOM: Should we kick off with an update on Oz?
GERARD MINACK: Sure. it's getting interesting.
MATT MILSOM: It is.
GERARD MINACK: I mean, the bears have known the outline of the bear case for some time, which is quite simply the world's most expensive housing stock-- I guess outside some small city-states-- a hugely indebted consumer that has no saving, and a reserve bank that's got very little room to respond if anything goes wrong. Now as they outlined, there have been some positives that have kept us away from the precipice for some time. And what I've focus on over the last four or five years is, first and foremost, population growth-- just keeps the wheels turning over. It means that it's not clear we have a huge excess supply in housing.
I'll give you one stat-- the rental vacancy rate is below average and falling. It's generating demand for infrastructure, and here we are in Sydney and all the roads are being dug up as part of the spending that it's doing. So, that's an offset. Another important offset is the mining Capex boom. And it did boom, then bust-- but the bust has almost run its course. So, mining Capex as a share of GDP went to 9% at its peak. It's now back at a little below 3%, so it subtracted 6% from GDP over the last four or five years. But that's probably now the floor for it.
There's a few other positives you can throw into the mix, such as we continue to debauch our tertiary sector-- that means more foreign students. And, statistically, by saying a lot of LNG will add to GDP growth-- although it's fairly calorie-like growth, it's not going to add much to anything. So, what we've been going through for the last, I guess, 18 months is the housing market starting to soften with the consequences that growth is starting to weaken. But we've been kept afloat by these positives.
What's happened over the last quarter or two is we're seeing signs that the downdraft in housing, borrowing, and wealth effects are starting to build steam, and that's making it increasingly likely there'll be a recession. Now, I'm not making recession my investment base case yet, but if we were to get another two or three months of data like the sort we've had over the last two or three months, then I think investors should make recession their investment base case in Australia. And if we were to see a recession, trust me, it would be world's best practice.
This would be disaster, given how indebted we are, how expensive your asset prices are, and the inability of policymakers to respond. That's if we get a recession. So, what's the odds? Well, I mean, the things to watch-- supply of finance to housing. I mean, when you have house prices as high as they are in Australia, the demand for housing is just a function of the supply credit.
House prices themselves, building approvals, now despite the population growth, the fall in approvals over the last four months has been large enough to suggest that residential construction will probably subtract about a percent from GDP over the next 12 months. But then the big one-- but this is also the big unknown-- is the wealth effect. So, it's quite clear that because house prices have been on this rampant bull market for some time, Australians have been willing to reduce their saving.
According to the Bureau of stats, we're now saving about two percentage points of our disposable income. But it's worth recalling that on the income side, the statistician includes the compulsory pension contributions that employers make. Now, once you take that into account and, sort of in a sense pull them out of the numbers, the saving rate's effectively negative. If you're saying, well, how much do you save out of what you actually trouser every week, I'm actually overspending.
So, if the wealth effect is strong enough-- in other words, if people adjust upwards their saving rate fast enough as house prices fall-- then we're toast. In particular, if we follow the pattern that we saw of economies that experienced material house price bubbles then busts in the GFC, what they saw on average was around about a 2 and 1/2 percentage point increase in household saving year two and three after the house price peak. Interestingly, the saving rate continued to fall for about a year after the house prices peaked in the GFC, much as the saving rate continued to fall in Australia last year, even though house prices were falling.
If we see that 2 and 1/2 percentage point adjustment, that, by definition, means spending has to grow lower than income. The trouble is in Australia at the moment, real aggregate disposable income growth is roughly zero. So, if you're going to increase your saving with no income growth, you've got to cut your spending. So, that is the recession scenario. And, interestingly, if you're looking for early hints that it's starting to unfold-- if you look at spending at the state level-- and I like to look at spending per person, so that I don't get confused by some of the interstate migration numbers-- spending over the course of last year in Western Australia-- capital city is Perth-- fell.
Now, what's interesting about that is house prices in Western Australia-- both in Perth and the regions-- have been falling for two or three years. In other words, if anybody in Australia is at the stage where household saving rates start to drift up, it's the West Australians. Now, this is circumstantial evidence. I have to use that, because the statistician doesn't publish the state-level saving rate data, so I can't just reference that.
But it's interesting that it's clear that consumers are weaker in Western Australia on a per capita basis than anywhere else. And they are further into this house price decline than anywhere else. And if the rest of the country follows that pattern, things will get worse in the second half of the year. And, as I said, investors need to make recession their investment base case.
MATT MILSOM: Do you think the Royal Commission let the banks off?
GERARD MINACK: I don't think the Royal Commission did, but I suspect the politicians have. I mean, speaking from the man on the street, which is staggering to find out just how big a gap it is between punishments when you rob a bank versus when the bank robs you. I tell you what-- if I was ripping hundreds of millions of bucks off people, I wouldn't be getting a rap across the knuckles-- and please don't do that again from the regulator.
So, even if we don't crack down hard on the banks for what they have done, surely they're aware now that every politician would love to hang one of them high in a tree for something they do going forward. And you would think that that's one reason we've seen this credit contraction. But, guess what? They're actually starting to check things. And one of the other surprises from the Royal Commission was that, yes, we do have a lot of liar loans in Australia. But, unlike in America where the lying was done by the borrowers, here, more often than not, it was done by the lenders.
MATT MILSOM: Or intermediaries.
GERARD MINACK: Or intermediaries-- their agents, that's right. So, that's part of the reason we've got this decline in credit provision, which is feeding directly through into weaker house prices.
MATT MILSOM: Seemed to be happening before the Royal Commission, though.
GERARD MINACK: It's done. I think that's because if you look at the detailed numbers, the initial decline in credit approvals was for investors. And, initially, that was a desire of the reserve bank, and APRA in particular, to slow the lending for investment properties. And they did actually put a cap on it. Now, that started to come into impact two and a half, three years ago. The new news just over the last six months has been the rolling over in lending for owner-occupiers. So, this is upgraders, and that's where the Royal Commission fingerprints are all over that.
The uncertainty is this-- is that recent decline, which started September-- we only have dire up until January-- is that a permanent tightening of credit standards, and will we continue to see credit aggregates continue to slow? Or, is it simply they put in place new processes that are extending the loan approval system, and what we're simply observing at the moment is an air pocket? But, once people get through this more extended process, the flow will resume at a more normal rate in a couple of months.
MATT MILSOM: For a soft landing.
GERARD MINACK: That's your soft landing scenario. That's where your credit approvals start to inflect, move a little higher in the next couple of months. If-- there's going to be a few, ifs, in this-- but if after that, you then get people going, house prices are 10%, 15% lower now than they were their peak. So, I'm now willing to borrow again and put a floor under it. This is against a backdrop of a still decent unemployment rate-- i.e. low.
That's your soft landing scenario. That's where we start to see the nosedive in house prices inflect. We then get a sense that house prices peak to trough nationally will not be falling 20%. They'll be falling, perhaps, at 15%. But, once you get that sense of a soft landing with a few other goodies from the government, we have a slowdown. I mean, we don't know how to support a slowdown here, but we don't get a tipping over the edge to job losses. Once you get job losses, that's the dynamite stick into the pond. There's going to be a few things float up.
And it's worth recalling in Australia that what we are now seeing with house prices declining is the first decline in nationwide house prices not associated with either RBA rate increases or a rise in unemployment. Now, if we were to get either of those things--
MATT MILSOM: We won't be getting RBA rate increases, that's for sure.
GERARD MINACK: You start the rinse and repeat cycle all over again. You get a second leg down in house prices. My view is without any rise in unemployment, we're probably talking about a 15% to 20% peak to trough decline in capital city house prices.
MATT MILSOM: Which is the average in previous downturns, right? Ish.
GERARD MINACK: It's at the high end. It's at the high end. But, I mean, it's not unprecedented. It's at the high end. If we were to get job losses--
MATT MILSOM: Which is green shooting at the moment. The rate of change is not particularly--
GERARD MINACK: In employment?
MATT MILSOM: Yeah.
GERARD MINACK: No, it's OK, but I can point you to a couple of things. Some of the leading indicators are starting to weaken. If you look at hiring intentions in corporate surveys, if you look at job advertisements-- say, the ANZ or the government's just cancelled the number of vacancies-- are clearly turning over. They're not yet at the stage of signaling outright job declines.
We can see evidence that we like to see at outright job declines is actually now in the construction sector. Guess what? Building approvals gives a pretty good lead on how many traders are going to be in employment about nine to 12 months ahead of time. And where we are now, it looks like you will see construction sector employment decline later this year. Now, they punch above their weight, because these are better paid jobs. So, there probably will be some weakness.
But I do agree with you-- I'm not yet at the stage of being a point to leading indicators that tell you you will see aggregate economy wide job losses. They're not there yet. And that's why the intermediate stage you need to go through is the wealth effect to weaken the consumer, then you are likely to see those leading indicators roll over. And that's why recession starts to become the base case. We're not there yet.
MATT MILSOM: When we are there, your favorite short will be the currency or the banks? Or banks before a dividend cut?
GERARD MINACK: If I got the option of all the above-- look, I mean, I think if we had a recession, the cash rate to zero, 10-year treasury below 1%, Aussie dollar to 60, and the banks get smoked. Now, the sequencing-- I mean, the RBA cuts, probably, I guess, come first. We're at 150 basis points with the cash rate target. But, of course, the market's already pricing in a couple of rate cuts.
So, it's almost as if now-- just simply to have more of the same, more of this tepid, anemic growth-- which probably does get one or two RBA rate cuts this year-- is what's in the price. To be bullish on Aussie short rates, you need, increasingly, to make recession your base case so they push the cash rate below 1-- which they for sure would in a recession scenario.
The currency give way-- now, what's already interesting about the Aussie dollar is if you look at how it's traded over last six months versus its usual commodity price barometers, it's actually underperformed.
MATT MILSOM: Massively versus iron ore.
GERARD MINACK: Specifically iron ore, but if you took a broader basket, it still underperformed. If you look at how it's performed vis a vis the interest rate differentials-- and I always like to use not the smart, cash rate targets, I use the futures so that captures the anticipation of policy changes. The currency has been stronger than you would have expected.
So, obviously, what we're seeing at the moment is this tug of war in the Aussie dollar behind, on the one hand, the currency differential-- which is pointing to a lower currency-- and commodity prices pointing to a higher one. But, in a recession, it's not just an interest rate differential story that starts to drive the currency, it's concerns about credit and people actively taking short positions as opposed to just scaling back some pre-existing long positions.
MATT MILSOM: Well, it's kind of likely to be a global recession and it's going to be a race to the bottom, right, for the currencies.
GERARD MINACK: Well, what's interesting here under my world view at the moment is this could be the first unilateral-- or solo Australian recession--
MATT MILSOM: Ever.
GERARD MINACK: Well, the 1961 credit crunch is arguably it-- Bob Menzies' credit crunch. But, no, it'd be very interesting. It's interesting from an equity perspective, because the Aussie dollar in a recession-- a global recession is, obviously, high beta. So, commodity prices get sold off, the currency's down. If you're a local fund manager with an ASX 200 benchmark, your natural preference is to go to stocks that have foreign currency exposure, but not the miners, because it's a global recession and commodity prices are getting hit.
What's interesting is this could be almost the perfect barbell scenario for being long the miners, because their commodity prices may hold up, and you get the benefit of the Aussie dollar down versus the banks. Because, in this scenario, it's where they cut their dividend. And one thing I think is appreciated by some offshore investors with our so-called franking or dividend imputation system is just how attractive equity offering a 7% dividend yield is to a local like myself.
MATT MILSOM: Franking.
GERARD MINACK: Franking. If I buy a company on a 7% dividend yield and-- assuming they're paying the full freight on the corporate tax rate and I'm on the top tax bracket-- that's like a pre-tax yield to me of low double-digit. Now, with a lot of self-managed superannuation pension accounts, buying stocks with those characteristics, that offers a lot of support. And if you look at the banking sector over the last two or three years-- and it has been underperforming versus the local benchmark for third period-- it keeps on bouncing off a dividend yield of 7%. And that's your support under the soft landing scenario.
But, the converse is if a lot of people are holding an equity because it pays a dividend and then it cuts its dividend--
MATT MILSOM: Telstra.
GERARD MINACK: It's all over. It's not broke, but it's a great short. Now, that's probably, in the sequencing of how you would play a recession, towards the back part of it. But, of course, if you shorted the bank's unhedged and you got the currency kick, that gives you some comfort, even if you've got, initially, some expensive carry to hold those banks as a short.
MATT MILSOM: I should think the offshore people should be disappointed in their shorts in the banking sector down here. It hasn't done much.
GERARD MINACK: No.
MATT MILSOM: Right?
GERARD MINACK: No, once you take a account of the resilience of the currency and carry, so far it's been probably a wash. They would've been better finding something else to short, I guess, is the way to put it. So, that's why timing is important. And that's why what's interesting-- we've seen the rate market move from saying, everything's OK in Australia, which is where they were a year ago-- the start of last year, the rate market was expecting a couple of RBA rate increases. To now saying it's not so good-- in fact, now the RBA is going to cut.
So, you've already made money by taking a glass half empty on the rates space. And, indeed, even on the currency space-- I mean, at the start of last year, we forget the currency was over $0.80. So, there's been an adjustment there as well. It's the banks where it's more of a binary trade in the sense that there's not been a lot of money made from people going, yeah, this economy's softening. The real money is going to be made when they go. And I proved correct in saying it's a hard landing. So, the banks are more binary than some of those other options to trade Aussie macro disappointment.
MATT MILSOM: Who's the first to cut their dividend?
GERARD MINACK: My view is it's what deck of the Titanic are you on? If the ship hits the iceberg, let's not fuss about it-- they're all going down. I wouldn't hazard to guess, and, for me, it's not that pertinent. I think they're all, as a basket, just short the lot of them. The one thing is, I don't think they go bust. I mean, this