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Australia’s House of Cards

15 February 2019

Gold had a relatively uneventful week this week, pulling back slightly to USD$1,312 as did silver to $15.62 per ounce.
 
After a terrible performance last week, the AUD/USD recovered some ground to climb above 0.71 US cents, which sees gold trading at AUD$1,849 and silver just above AUD $22.10.
 
In the very short term, we’re watching to see if gold respects the recent uptrend line and stays above the $1,300 level. We could see some selling if we break south through there to provide a more meaningful pullback and perhaps an opportunity to top up.
 
If we bounce off this trend line in the short-term, the rally may continue, but it should give traders a level of technical significance to watch next week.
 
Gold chart 

This week saw some data out of the US weighing on the USD and supporting gold with retail sales recording their biggest drop in nine years in December, and weekly jobless claims registering an increase.
 
The worse the data is moving forward, the more likely the Fed is to backtrack on their tightening plans, which should be supportive of PM prices.
 
The raging bull that is palladium continued to charge ahead this week as Nornickel,  the largest producer of the metal, saw a 10% fall in output for the quarter, further sparking supply fears. Any crypto dabblers would know that parabolic moves usually don’t end well, but we watch in awe as the price keeps knocking out all time highs.
 
Palladium 
 
Platinum on the other hand is doing the opposite and knocking on the door of 10 year lows. The metal is a contrarian’s dream and one of the most disliked commodities on the planet at present. 
 
Platinum chart
 
Silver is at an interesting point from a technical perspective as for the next few months we will keep an eye on whether or not we breakout north of the recent range and trend line below. We talked about the area of support for silver around the USD$14.00 range as it seems impenetrable. If silver breaks out of this range, it should spark some buying by traders purely on the technical setup. For more on this, we talked about the very good chance of USD$14 being a bottom for the price in a recent update Silver’s Time to Shine.

Silver chart
 

S&P 500 Head and Shoulders Top?

 
We are watching the US stock market bounce back off the lows, but not yet convinced about this rally, as there is potential of the market forming a large head and shoulders top. The chart below shows the MACD momentum indicators signalling the rally is running out of steam, so this is something to watch closely in coming weeks. It won’t look good from a technical perspective if we see the market roll over in the short term.
 
US stock market 
 

Australia’s House of Cards

 
There are a number of concerning developments of late that are all combining at the same time to create a pretty bleak picture for Australian property prices and our economy. Some of these include the following:
 
  • Further crackdown on China’s capital controls
  • Heightened lending standards post Royal Commission
  • Interest only wall of 2020
  • Overdevelopment during the peak
 

China Boosts Capital Controls

 
This week saw IMF chief Christine Lagarde warned of ‘four clouds’ gathering for the global economy, which included the accelerated slowdown in the Chinese economy, making special mention of the potential ripple effect impacting Australia.

Then came news of China intensifying its existing capital controls by introducing potential jail time for anyone seen as operating an ‘underground bank’, or essentially involved in helping any mainland Chinese with illegally transferring money out of the country to buy property.
 
The strategy of China’s leaders to prop up their slowing economy is to prevent any significant amount of money leaving the country. Mainland Chinese have in recent years used the services of underground banks to funnel billions of dollars out of the country to buy property in New Zealand, Canada, the UK and Australia, with buyers usually not too concerned with the prices paid.
 
This provided us here in Sydney and Melbourne with some artificial demand and could have been one of the main contributors for property values settling far above reserves in years leading up to 2017 peak.
 
Now, any illegal foreign currency transaction of over US$1 million can result in 5 years jail time for offenders who are caught. So developers are getting concerned this could deal a major blow to foreign buyer interest in Australia.

 

Heightened Lending Standards

 
Since prices peaked in 2017, we have seen the result of the Royal Commission identifying some of the lending standards of our major banks in recent years. Since then, total housing finance has fallen off a cliff as it starts to become much harder to get a loan. Banks were willing to lend to almost anyone on the way up as rising prices gave a false sense of security. One can see the strong correlation between financing and house prices below.
 
Heightened Lending Standards 
 
 

Interest-Only Wall 2020

 
From now to 2021, there is approximately 200,000 interest only (IO) loans totalling $480 Billion that are due to expire and forced to reset to principal and interest (PI) loans.
 
For the average investor or owner-occupier, that means your interest expense could be set to rise around $7,000 per year. An amount which on its own may not look too ominous, but when compared to a national household savings ratio approaching 1%, it could be enough to send people broke and forced to sell.
 
Now imagine the number of IO loans made out to property investors who are negatively geared. So not only are you losing money each year, you’re watching your investment drop in value every month, then you have to fork out higher payments to cover some principle. All of a sudden property can move from the best investment decision to the worst in just a few short years.
 
In the chart below we can see the huge number of IO loans set to expire in 2020, then falling into 2021 as the banks are dishing out far fewer IO loans today to speculators than during the mania phase.
 
IO loans 

The percentage of mortgages originating on IO terms has dropped dramatically in 2018 as seen below and peaked in 2016 at a whopping 45% of loans.
 
The fact that IO loans accounted for 45% of all new loans during the peak is an indication of the sheer number of speculators in the market at that time, as the IO loan is a favourite for those maximising credit to buy a house for the sole purpose of selling it higher in a few years. 
 
% of mortages  
 

Overdevelopment During the Peak

 
The Austrian school of economics would argue that business cycles are caused by Central Banks’ distortions of interest rates, and that a misallocation of capital takes place if the interest rates are kept artificially low or high. It is a very common sense approach to economics which is why most economists would ignore it, but we see this play out all of the time, where countries that lower interest rates quickly often see an overcapitalisation in one sector of the economy, and it is usually the housing sector.
 
We saw this in Ireland, Spain, and mainly the US in the lead up to the GFC, yet Central Banks and Keynesian economists continue to ignore any possible negative consequences of modern monetary policy and only focus on the short term benefits. Something akin to a doctor prescribing drugs whilst not listing any of the negative side effects.
 
It is no coincidence that our housing bubble, which is mainly concentrated in our two largest markets of Sydney and Melbourne, occurred during the rate cut cycle from 2011 to 2016 where the RBA cash rate dropped form 4.75% to 1.5%.
 
Graph of cash rate 
 
Indeed, the past few years have seen a misallocation of capital into the housing sector as we had development approvals spike, and a huge number of unit developments planned in Melbourne and Sydney during the peak, that will hit the market in a few years.
 
Despite all of the commentators claiming prices were rising so rapidly due to limits on supply, we might actually see an over supply of units in Sydney and Melbourne over the next few years, similar to what we saw previously in Brisbane.
 
Cranes count 
Source: AFR 

The only difference between our bubble (and no – it’s not a ‘housing affordability crisis’ – it’s a bubble) and those that we have seen across other economies in the recent past, is that by many metrics ours is even worse.
 
In every housing bubble we see an explosion of debt as a percentage of income. In Spain, this peaked at about 135% before their crisis. In Australia, our household debt to income percentage almost hit 200%.
 
Morgan Stanley notes Australia’s debt level, debt gearing and debt servicing ratio is overall the worst of any other country.
 
Debt 
Source: ABC News
 
When it comes to what sets our oncoming housing crisis apart from the US crisis, is that the banks in the US were cunning enough to package up all of their toxic sub-par loans, have the credit rating agencies rate them AAA, and then sell them off as a premium investment.
 
As our banks aren’t quite as creative, all of the high risk toxic loans given out to those speculating beyond their means in recent years are sitting there on their balance sheets as ‘safe assets’ with minimal risk weightings.
 
 
Until next time,
 
John Feeney
ABC BULLION

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