The latest bear market rally is likely to last until another stint of bad news sours confidence. Market volatility is here to stay and investors leading into 2012 should ensure that they are well placed to profit from the ups and to stay well clear of the ditches.
The word of the moment is de-leverage, meaning to reduce debt, and that’s the process that businesses, Governments and consumers are undertaking at the moment – and will continue to do so for quite some time. During 2000s, the world embraced debt like never before, which underpinned growth rates in developed and developing countries, boosting almost every asset class conceivable from stocks and property to art and vintage cars. As consumers and businesses took on more debt to buy more things, prices moved higher. But those days are over; the time has come to pay the debt back.
In the 1980s, the household net saving ratio in Australia was 15%. By the early 2000s, it was zero. Today, it is marginally higher but trending upwards as investors attempt to build wealth without the fallback of rising property prices. As Australians save more, they consume less – and this behavioural change will have a noticeable affect on growth rates and investment returns. It short, we’re unlikely to witness double-digit returns on property and the sharemarket in the near future as the process of de-leverage plays out.
On top of this, demographic changes, notably our aging population, is affecting consumption patterns and investing behaviour; notably, aggregate consumption is falling and investing activity is moving from the measures to accumulate wealth (such as borrowing to invest in shares and property) to drawing down on assets. Although little research has been undertaken, it’s probable that an aging population could suppress overall sharemarket and property returns over the long haul as baby boomers start liquidating assets to fund their retirement.
Of course there are always opportunities for those well versed in the macroeconomic environment; for those who shun the vulnerable sectors and asset classes, who protect their cash, and who understand how investment flows work.
For instance, you don’t have to be an investment guru to figure out that discretionary retail spending will decline as consumers tighten the purse strings. It’s hardly surprising that retail stocks like Billabong, Myer and David Jones have suffered share price falls as analysts’ adjust target prices based on a more subdued growth outlook. Consumer staples will suffer a more modest drop in comparison as consumers attempt to reduce aggregate spending at the shopping mall, liquor outlet or petrol browser.
A booming property market has been instrumental in ferocious consumer spending over the past decade. As house prices spiked, Aussies drew down on home equity to renovate and redesign, shelling out large sums on home furnishings, cars and clothes, driving business activity and employment growth. And as property values soared, the banks continued to loan money – fueling further property price growth, further consumption growth and the cycle continued.
The worrying trend is the reverse scenario - falling consumption leading to layoffs and rising unemployment, cutting off consumption even further. Investors need to be on the right side of the trade if it eventuates, and to stay clear of vulnerable sectors. So which sectors are vulnerable?
You’d be wary of not just discretionary retailers, but any company exposed to discretionary spending across the board. Goods that people can easily live without are at greater risk than essential items.
Australian real estate investment trusts (AREITS) with exposure to retail specifically are targets for lower growth as vacancy rates rise and rents come back accordingly. You’d want to be wary of AREITS exposed to shopping malls, with small to mid-sized shopping centres riskier than premium centres housing the big name brands.
Also, the rising use of the internet to shop should not be overlooked as we encroach 2012. The internet has allowed consumers to buy direct, which is a dramatic shift from the wholesale and retail distribution network business of the last 150 years. No longer do consumers need to wander through David Jones for a glimpse at the latest batch of products; today, they can just log onto the Internet. According to Forrester Research, Australian online retail sales will double from $16.9 billion in 2009 to $33.3 billion in 2015.
A report titled The Connected Continent by Deloitte Access Economics noted that in 2010 the internet made a direct contribution to the Australian economy of $50 billion, or 3.6 per cent of gross domestic product. It was of similar value to the retail sector or Australia’s iron ore exports, and the growth is twice as fast as the rest of the economy. “The internet is having a profound effect on how the economy and society works in many ways that we don’t fully yet understand,” Deloitte Access Economics director Ric Simes.
The growing popularity of internet shopping will hurt retailers, AREITS and myriad other businesses; you’d want to analyse the effect of internet competition on stocks that you hold or are placed on your watchlist. At risk are companies like Harvey Norman that sells electronics goods and appliances in direct competition with cheaper online websites with minimal inventory or staffing costs, many of whom are located overseas. In contrast, other sectors such as logistics – delivery and warehousing of goods bought and sold on the internet – is a booming sector of the market to watch.
The European banking crisis is a cause for concern, but its affect on Aussie banks is minimal. As at 31 March 2011, Australian banks had US$25.9 billion worth of loan exposure to Europe, including France, Netherlands, Luxembourg and Italy – but zero exposure to Portugal, Greece, Ireland and Spain. In other words, Aussie banks' exposure to the European debt crisis is minimal, at roughly 1% of total loans outstanding in the entire banking sector.
Our distance from the banking crisis in Europe is certainly good news; however, Australian banks have other worries to consider closer to home.
The debt-fuelled property and buying frenzy over the last few years has been a bonanza for banks; an unacceptably high proportion of the average Australian’s disposable income now heads into banking coffers to meet interest on property loans. Admittedly, it’s not a great outcome for the average Australian, but banks are cleaning up.
But times are changing; demand for home loans is falling as first-home buyers resist the temptation to throw their current and future income into buying a roof over their heads; some 40,000 first-home buyers shunned property over the past year compared to a year earlier – amounting to a loss of $11 billion to the industry. Banks suffer if home loan activity falls.
Economist Steve Keen notes that impaired banking assets represent about 1.25% of total assets, which is comparable to the level of impaired assets in US banks before house prices collapsed and the subprime crisis occurred. “Since real estate loans are worth roughly 7 times bank Tier 1 capital—up from only 2 times in 1990—it wouldn’t take much of an increase in non-performing housing loans to push Australian banks to the level of impairment experienced by American banks in 2007 and 2008,” notes Keen.
Keen continues: “Debt is more broadly distributed in Australia than in the USA…the negative effects of debt service on consumption levels are likely to be greater here than in America. This is especially so since mortgage rates today are 50% higher here than in the USA. Interest payments on mortgage debt in Australia now represent 6.7% of GDP, twice as much as in the USA. It’s little wonder that Australia’s retailers are crying poor.”
“So if America’s consumers are debt-constrained in their spending, Australian consumers are even more so—with negative implications for employment in the retail sector. Compared to the USA therefore, there is no reason to expect that Australian banks will fare better from a sustained fall in house prices.”
So what should you do with your bank shares?
Generally bank shares go up with house prices and fall when property tumbles. According to Keen, falls in bank share prices is normally very steep and occurs shortly after house prices have passed their peaks.
“Holding bank shares when house prices is falling is a good way to lose money – and conversely, if you get the timing right, betting against them can be profitable,” notes Keen. “That’s why Jeremy Grantham – and many other hedge funds managers from around the world – are paying close attention to Australian house prices,” he admits.
A chill will pass through anyone looking at the shares of US and European banks over the course of this banking crisis. Below is a quick example of how much investors have lost on retirement accounts and investing portfolios on the so-called ‘defensive’ banking stocks.
Bank Of America
Bank of Ireland
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