Australia: Danger Lies Ahead – Part II
To read the first part of this two part series click here.
How the bubble continued to grow post-crisis:
During the days of the “The Great Recession”, Australians, who were already holding large amounts of debt, went from marginal deleveraging back to re-leveraging with the help of government intervention and support from the Chinese commodity import machine, which too was helped by an unprecedented amount of stimulus when GDP dropped into mid-single digits. The ratio of mortgage debt to GDP has risen from 17% in 1990 to its current level of around 90%. Household debt as a percent of household disposable income is a whopping 170%, with only the U.K. to top it. The outcome of sustained trends in debt levels has been for another leg up in a real estate market which was already on an unsustainable path before the global downturn in 2008.
The end looks to be near, if not already here:
The turn could be in as recent reports show upward momentum in home prices to be severely waning as increased supply hits the market. A recent survey from the National Australia Bank shows an anticipated drop of 5.1% in national RE prices over the next 12 months. Provided the magnitude of the property overvaluation and household debt levels this appears to be overly optimistic. In the event the Chinese growth machine slows, there will be considerable pressure placed on the Australian economy, further exasperating a trend which already looks headed to buckle under its own weight. The outcome for this bubble will not differ from any other asset bubbles witnessed throughout history; a sharp down-turn looks imminent. Indeed, this is one of my favorite macro themes to watch going forward as opportunity is abound anytime there is a major dislocation in asset prices.
AUDUSD: The Carry (Risk) trade de jour:
Recently, the ‘risk-trade’ came under severe pressure on the heels of the earthquake and nuclear threat in Japan. Broad selling in ‘all-things-risk’ pushed the AUDUSD below multi-month support, but only temporarily, as it alongside other risk assets has since rebounded sharply. Impressively, the Aussie sits perched at a 29-year high at over 1.05, providing little reason at this time to place bearish wagers. It will be prudent to wait for the bullish tides to turn before taking a stance on lower prices.
Australia and the Emerging market connection:
Since the onset of the global financial crisis and through its continued recovery the correlation between most major asset classes has been historically high, but it is difficult to find two markets which have traded in lockstep to the degree in which the Australian Dollar and Emerging Markets (EMs) have. Looking at the graph below, the correlation is striking. It has been a story of both investors reaching for yield (‘risk-on’ trade) and strong fundamental underpinnings. Again, going back to Part I, these countries have an abundance of raw materials; China is in great demand for these raw materials.
Further exasperating the trend in a reflexive manner is the easy monetary accommodations around the world. Over the past two years an unprecedented amount of government stimulus spanning the globe has provided investors with reason to snatch up higher yielding assets. Ben Bernanke, back in late August, during his speech in Jackson Hole, Wyoming once again lit the fuse for this trend when he brought QEII to the table, which was later implemented in November. However, this coming June, when the LSAP program is set to unwind, how much more incentive will be left for investors to continue taking on risk, and will the Fed issue another round of QE should the U.S. economy materially weaken? The answers to these questions could have a dramatic impact on the trajectory of asset prices.
AUDUSD vs. Dow Jones Wilshire Emerging Markets Index
A large interest rate differential makes for “safe” investing:
Australia currently sports a short-term rate of 4.75%, providing it with one of the largest interest rate differentials in the world. With this kind of cushion it is easy to see why investors feel at ease holding Australian Dollars. However, 12-month interest rate expectations are trending lower and nearing the lowest levels seen since the second half of 2010, and are among the lowest in the G-10. Currently, markets are pricing in a ~30 basis point increase in lending rates, which is even lower than the U.S.’s expected increase of 35 basis points. This is important because it’s not just the current rate which makes for strong underpinnings, but also expectations about future levels of rates. Should the economic tides turn unfavorably the expectation for modest gains in interest rates won’t have far to fall before turning negative, leaving little to support a currency sitting at such lofty levels.
A significant disconnect between the fundamental outlook and the price of the Australian Dollar looks to be well underway. The AUDUSD is displaying signs that it is in the latter stages of its trend, where the rubber no longer meets the road; meaning, investors in their reach for yield are ignoring deteriorating fundamentals and rising risk associated with holding Australian assets – potential for a sharp slowdown in China, a property bubble on the verge of bursting, and a weak future interest rate outlook. However, before trades can be made in favor of lower prices we will need to see price action, the final arbiter, and fundamental factors coincide with one another before the prospect of significantly lower prices can become a reality. For now, the trend is up, and such, it should be respected until further notice – a notice which I expect to be served sometime in the next 6-9 months.
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