It was almost exactly 6 years ago that the first signs of the GFC began to show. Six years later, its malign effects have still not been dissipated. In the US, output has only just exceeded the level reached in 2007, and total employment has still not reached previous highs. In Europe, even though the pan-European economy has turned up at last, things are far worse. Output is still far below the previous peaks (except for Germany and one or two others), and unemployment remains very high. The natural question is whether another financial crisis of this magnitude and ferocity will occur again. And the answer is surely yes, but not for many, many years. Why?
The GFC occurred because overconfidence in the “natural” trend of house prices to rise inexorably led to overlending and insufficient capital in banks. After all, what did it matter if you lent people 100% or even (as one memorably incompetent British building society did, 125%) of the purchase price of their house? House prices would always rise. The loans would soon be well secured as house prices rose. And why would banks need lots of capital to provide a cushion against loans? The loans would, of course, never go bad.
But they did. And the collapse in house prices took down the banks and governments and the real economy with them. For many countries (Greece, for example) the economic collapse was worse than the great depression of 1929 to 1933 in the US. And after 6 years, Europe as a whole has only just started to recover.
Everybody has learnt from this disaster. Banks have become much more cautious and regulators have imposed much higher capital ratios. Whereas some US banks went into the GFC with effective capital just 2% of assets, now they have 10% plus. Whereas banks were willing to lend 100% of purchase price, now the LVR (loan to valuation ratio) is usually 80% or better. And where banks have been tempted to lend imprudently, for example in China and New Zealand, central banks have raised capital, liquid asset and LVR requirements, choking off any boom. House prices in Australia are rising, but a moderate annual rise is perfectly consistent with our demographics and the rise in personal incomes. Mind you, should either immigration or wage growth slump, our house prices will stagnate or fall.
The usual warning signal of an impending fall in share markets is excess. Booms lead inevitably to busts. But, except for China, governments and central banks have been so far from engineering a boom that monetary policy is likely to remain accommodative for at least another year, and probably longer.
In Australia, growth is slowing as the mining boom ends, and government spending cuts are likely to exacerbate the downturn. This weakness will be to some extent offset by a falling currency, and most probably, further cuts in the cash rate. If a falling mortgage rate leads to a house price boom, you can be sure that the Reserve Bank will tighten required LVR and capital ratios to restrain it. (Central Banks have also learned much from the GFC.) Consumers are cautious. Consumer confidence is weak and the savings ratio is high. A runaway boom in Australia—or in the world—is not going to happen. Not yet, anyway.
Ironically, this is a good environment for the share market. Falling or flat interest rates combined with even slow profits growth tends to produce rising markets. And remember, even if the sharemarket is flat over the next year, the dividend yield at 5.5% (adding back franking credits) is still much higher than the cash rate of 2.5%. Our firm view is that over the next year, far from staying flat, the market will rise by 5 to 10%, and dividends will add another 4 or 5% to that. World share markets, in Australian dollar terms, are likely to beat this, because not only will they also rise moderately in their own currencies, but the A$ will at the same time fall, increasing Australian returns. One risk is that bond yields will jump because of the end of “quantitative easing” in the US and other countries. But two typical reasons for rising bond yields (rising inflation and spiralling government deficits) will be absent, and yields have already risen sharply off their lows on speculation that QE is easing. There may not be much further to go, in the short term. Our view is that this deterioration in the bond market will not stop share prices advancing, but it will hold them back from large increases.
All of us here at SIRA group wish you all a healthy and prosperous 2014.
