What happens if Australia's house price bubble bursts?
Investment Director – The Fleet Street Letter
David Stevenson Apr 15, 2011
Which stock market has made investors the most real money over the last 111 years?
The answer may be a surprise – it's Australia. Between 1900 and the end of last year, shares 'down under' have returned their owners 7.4% a year, says the London Business School. Even better, that's a 'real' return, ie after inflation has been taken into account.
In contrast, the US scored a 'real' annual 6.3% return over that time, the UK came in at 5.3% while the rest of the world has lagged at just 5% a year.
1%-2% a year may not sound much, but over time it really stacks up. So should you plough a large slice of cash into the Aussie market?
Maybe not. Australia has a huge house price bubble. And this could be about to burst. Here's what that could mean.
Think of Australia's stock market, and commodities spring to mind
The country has shed loads – the world's largest known supplies of bauxite, iron ore, lead, zinc, silver, uranium, industrial diamonds and mineral sands. Provided these can be 'got at', Australia's scope for cashing in over the very long run is huge.
But in the shorter-term, it could be quite different. Some signs are appearing that suggest the global commodity boom may be about to peak, as John Stepek explained yesterday: Does Glencore's float mark the top of the commodities boom?
However, a pause in the commodities boom may not be Australia's only worry. There's a bigger threat to it's economy. What's more, it could dent that great stock market track record.
Australia has managed to inflate a huge housing bubble. In nominal, ie actual price, terms, domestic property prices have risen about six times in the last 25 years. Compare that with the UK, where values rose just over four-fold between 1986 and 2007, and the States where the increase between 1986 and 2006 was about 3.5 times.
There's another big difference too. Prices in the US have fallen, on average, almost a third from that 2006 market top. In this country, values are some 12% lower than they were 3½ years ago. But in Australia, there's been hardly any drop at all.
Of course, whenever prices hold up in one market but fall everywhere else, there's always talk that "this time it's different".
Australia is no exception. Several experts have recently said they don't expect a fall in property values. The current house price to income ratio is about 4.5. And though these commentators accept this is higher than it was, they're not spooked.
They reckon lower inflation and interest rates mean buyers can afford to pay higher prices than they used to. Anyway, the country 'stress tested' its banks last year to see how they'd cope with a 30% house prices fall over three years. The conclusion was they'd still be OK because they'd still have enough capital to absorb the potential losses.
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So does this mean there's nothing to worry about?
Of course not. Australia's house price bubble is no different to any other. It's been based on how much credit has been available. And the country's banks have been pumping it out. Home loan debt has increased seven times compared with GDP in the last 20 years.
Home loans now account for 57% of all the advances on Aussie banks' balance sheets. That's an all-time high. And those banks' share prices have risen on the back of this lending boom, too.
But the big problem, says economist Steve Keen, is that the country's housing market has become a giant Ponzi scheme. The last buyers in pay for the profits of those who sell out to them.
"It's great fun while it lasts", say Keen. "But all Ponzi schemes end [because] they aren't making money, but simply shuffling it and growing debt. When new entrants can't be enticed to join the game, the shuffling stops and the scheme collapses under the weight of accumulated debt. There are very good odds that as this Ponzi scheme collapses and house prices fall, bank shares will go down with them."
Aussie lenders could then find they don't have enough capital after all. Raising extra would hit their shares further. For anyone who's invested in European and American banks, that sounds very familiar.
Why does this matter for investors in Australia? Because the financial sector accounts for around a third of the stock market. If the banks get hit hard, that will hurt the overall index too. So it's time to be careful about putting money in, say, an Australian fund.
And what about investors closer to home?
We're always advising readers to protect their portfolios with defensive stocks. And broadly speaking we like high yielders too. Over time they tend to provide better overall returns than low-yielding growth stocks. What's more, they act as handy hedges when inflation is rising, as it is now.
And if you look at the Australian banking sector, you'll see what seems at first glance to be a list of very appealing high yielders. The average yield is over 6%. But that's for a very good reason. Which is that investors are already demanding a very chunky yield as extra compensation for the risks of holding these shares.
Very high yields tend not to stay that way for too long. Either the price of the underlying asset rises – which reduces the yield for new buyers – or the payout is cut. In the case of Australia's banks, the latter looks the more likely. In other words, those Aussie yields don't look worth the risk for income seekers either.
In fact, if you're looking for some decent yield, you don't need to go as far as the other side of the world. In this week's magazine my colleague Tim Bennett has looked at a checklist of "three ways to spot dividend gems". And he tipped three UK "dividend bargains". Subscribers can read Tim's piece here: Three ways to spot dividend gems. If you're not already a subscriber, get your first three copies free here.
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