Pete Wargent blogspot

Co-founder & CEO of AllenWargent property buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place), and CEO of WargentAdvisory (providing subscription analysis, reports & services to institutional clients).

5 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the finest property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"The level of detail in Pete's work is superlative across all of Australia's housing markets" - Grant Williams, co-founder RealVision - where world class experts share their thoughts on economics & finance - & author of Things That Make You Go of the world's most popular & widely-read financial publications.

"Wargent is a bald-faced realty foghorn" - David Llewellyn-Smith, MacroBusiness.

Wednesday, 19 March 2014

Debt deflation

Debt deflation

The theory of debt deflation has been around for decades. John Maynard Keynes was familiar with the concept that shrinking levels of debt could become self-fulfilling and the cause of recessions, and if the liquidity trap is not remedied through direct intervention and heavy government spending, ultimately depressions.

Irving Fisher became a convert to the debt deflation theory after he was one of the most heavily impacted victims of the Wall Street Crash of 1929, since he had been investing in US shares using a hugely leveraged position in a market which fell by 90% from its peak. His losses in today's dollars would be the equivalent of $100 million. 

Debt deflation took its hold in the 1930s, unemployment soared to the horror level of 25% and the US fell into the infamous Great Depression.

Although the theory did not always receive the widespread acclaim it perhaps deserved, the ideas were rediscovered some decades later by Hyman Minsky who developed his Financial Instability Hypothesis (effectively a strong rebuttal of the flawed Efficient Markets Theory) which explained how bubbles can and do form, particularly emphasising the role of debt.

The ideas of Minsky were neatly applied to Australia's residential property markets by Philip Soos among others.

In his 2001 book Debunking Economics, Steve Keen mused whether the internet stock bubble could see the US suffer from debt deflation and fall into another decade as brutal as the Great Depression or perhaps a long drawn out recession such as experienced by Japan.

As it turned out, the bursting of the tech bubble did not have those effects directly, but only a few years later the housing bubble in the US and the related subprime crisis did cause a painful recession from December 2007 through to the middle of 2009. Despite unprecedented remedial action in the US, the recovery has been long, slow and painful...and is ongoing.

Of course, just like the efficient markets hypothesis, the Minsky theory is just that...a theory. In reality, markets are complex beasts and are not free markets in the conventional sense. Markets are distorted by all manner of factors and interventions as we saw during the last property downturn in Australia.

Sydney housing market

I attracted a fair amount of flak at the time for suggesting that capital city property markets such as Sydney would likely not crash over a prolonged period despite the impacts of the financial crisis, primarily for one very simple reason - a diabolical lack of supply.

I'm certainly no expert in every housing market in Australia but it was quite clear in Sydney at least, where prices had been essentially flat since the boom which ended in early 2004, that housing supply was continuing to fail miserably over a period of some years. 

After the boom ended, dwelling approvals fell dramatically from their 2004 peak (see chart below). My firm view was that while a market shock was naturally always a possibility, a long drawn out downturn in prices would likely cripple supply yet further until upward pressure on prices eventually returned.

Source: RP Data


We got the downturn, sure enough - although it was temporarily arrested by regulatory interventions, including "emergency low" interest rates, first home buyer grants and a relaxation of ownership rules for temporary residents - and as the global  financial crisis unfolded, the number of unit approvals fell to desperately low levels in Sydney, as denoted by Point A on the chart.

The level of dwellings approved fell to a level simply light years away from the supply required to meet a city population growth soaring towards 65,000 per annum.

With rock bottom borrowing rates having taken hold and investors returning to the market, prices have increased by well over 20% since their most recent trough in Sydney, and forecasters such as SQM Research expect to see prices booming further in 2014, perhaps by another 15% or more

Basic housing economics dictates that such a strong and sustained upturn in prices should see supply responding and coming to the market over the coming years.

Supply is at last now responding

Interestingly, dwelling approvals in Sydney are now really taking off (point B on the above chart). 

If Greater Sydney needs, say, 27,500-30,000 more dwellings per annum as an adequate supply response, then we do indeed seem to be heading in that direction, while duly acknowledging that various hurdles can hamper approvals from becoming converted to actual dwelling commencements.

A few observations

Clearly, the future is uncertain and predicting it accurately is impossible, but what can be said is that the risk of a sharp property downturn in Sydney is likely to be greater next time around than it was during the long financial crisis, since the supply side of the equation is now set to respond meaningfully after a decade's hiatus.

Of course, any market which is highly leveraged can always suffer from a shock and a rapid downward repricing of assets if credit markets are short-circuited - that always remains the case. 

Indeed, we saw exactly that in Britain. Prime Minister Gordon Brown lamented that the Q2 2008 figures reported by the Council of Mortgage Lenders on July 18 of that year, which showed an annual decline in lending of 32%, "made his blood run cold". 

Brown knew exactly what a dramatically shrinking debt market could mean for the British economy, specifically recession, and perhaps even a depression if the deflation in borrowing could not be stemmed.

The response in Europe was swift, concerted and included a vast bank bailout, yet even with interest rates stuck at close to zero (ZIRP) prices fell dramatically in northern England, by more than a third in some cases.

More than half a decade later some markets continue to struggle, although nationally prices have eventually returned to all-time highs in Q1, 2014.

Similarly, the US saw many of its property markets plunge very significantly from their peaks.

On the other hand London prices have continued to break new highs. Construction dried up during the financial crisis and the London market became phenomenally tight and remains so to this day.

Whilst we can't see what's ahead with any great clarity, we look set for property price gains in Sydney in 2014, but, increasingly we are seeing stronger levels of supply set to come on to the market. Some new apartment developments are coming with extraordinary price tags attached, and therefore appear to bring an elevated level of risk. 

Property investors need to be wary and learn lessons from elsewhere. Areas and suburbs which become flooded with supply are likely to be more prone to a sharp correction in due course.

Time horizon

Of course, risk is also related to time horizon. Keen highlighted in Debunking Economics how stock market crashes are effectively inevitable given the irrational nature of markets and the level of speculation undertaken by many market participants.

Does that mean you shouldn't invest in shares? Not necessarily. Clearly, the Buffetts of the world have demonstrated that by viewing investment as the buying a share of a business - focusing on the quality of the underlying asset and the income streams derived therefrom, rather than the prevailing share price - the long-term outcome can be very favourable.

Similarly, for property markets in the housing markets risk is related to time horizon.

In his British book The Default Line, Faisal Islam describes how "there is a moment in the inevitable descent into bust when boom-time exuberance suddenly flips and becomes an inescapable iceberg".

A powerful mental image, and if that is the way in which you visualise housing markets then you would surely only ever rent and never buy. Others have long recognised market cycles and resolved to accept that while tides inevitably flow both in and out, over the long term inflation and wages growth push nominal prices higher.

Although it is doubtless scant consolation for those who bought at the peak of the UK boom and subsequently lost their employment, a prolonged and desperately sustained effort by the British Government and the Bank of England which has included half a decade of ZIRP, some £375 billion of quantitative easing and repeated housing market interventions (schemes including Funding for Lending and Help to Buy) has seen the economy return to a decent level of growth in 2014.

And UK house prices are back to record highs in 2014 too. Indeed, prices are increasing at such a frantic pace and so far ahead of income growth that many are questioning whether any lessons have been learned from the financial crisis at all. In supply-constrained London prices have simply kept on going up.