The economic risks that lurk beneath

Child giving people a fright

I'm an optimistic guy, and even I am uncomfortable with how much we are talking up our NZ economy. There is still plenty of risk on the table, so it's quite possible for someone or something to ruin our 2014 party. As Lee Child said, "Hope for the Best, but Plan for the Worst."

As a small economy, bank economists largely dominate our media. They’re smart, articulate and often funny commentators. But they are bank economists and so with that comes conservative and orthodox views. Any forecast is based on the short-term relationship between production, exchanges rates, inflation, growth, and interest rates.

It is rare for us to get insight into the risks lurking in the dark recesses of our party. At the moment we are being told that New Zealand is the new economic success story. Buoyed by growth, we are told that interest rates will increase by at least 2.00% over the next two years. Then, somewhere along the line, the media translates this into mortgage rates rising to over 8.00%. I’ll touch on mortgage rates later, and in much more detail in this post (Mortgage Rate Strategies for 2014)

What makes me uncomfortable with the sole focus on domestic news is that none of the structural problems that led to the GFC have been solved. All major economies have done, is kick the can further down the road. We all know that if you ignore problems, they get BIGGER. We have a world awash with printed money. A lot of this has flowed into assets like property, shares and bonds and as a result dropped yields. It has become commonplace in big cities to buy properties at gross yields of less than 4.00% which is what happens when money has nowhere else to go. In a low interest rate environment, cheap money ends up chasing low yielding assets. It is LUNACY to expect property prices to broadly increase faster than incomes infinitely, yet that is how many investors behave. If debt grows faster than incomes, then borrowers have to borrow proportionately more of their income, until eventually there simply isn't enough income left.

Over the past ten years house prices have increased about 40% more than incomes. That would suggest that house prices have become about 25% over-valued in a relatively short period of time. This of course assumes they weren't under-valued ten years ago, which is a safe bet. There have been a number of drivers that have allowed this disconnect to first happen and now continue:-

  • Lower interest rates have improved servicing.
  • Easy access to credit.
  • Reducing rates of home ownership.  Investors have been prepared to top up rents to cover servicing shortfalls.
  • Landlords have been prepared to accept rents (or yields) below prevailing interest rates.
  • Babyboomers were in their income earning sweet spot.  With adult children their discretionary income was peaking.  Read anything by Harry Dent for in-depth discussion of this trend.

Meanwhile, the consumer middle class has been routed. Across the Western world, real wages have not increased for 20 years. We have an ageing population, and we have run out of capacity to borrow and spend. Luckily New Zealand is in a relatively good position.  We are a fairly stable food based economy with abundant natural resources.

Technology is reducing market barriers and allowing our small businesses to act bigger.  Mobility and NZ being a great place to live are becoming our biggest assets. That doesn’t mean along the way we wont get hit by an unexpected major economic event. That black swan could come from the potential collapse of the Chinese shadow banking system. It could also come from deflation risks, or from what happens when the United States stops printing money. Meanwhile we’re oblivious to any of these risks, and set to party like its 1974. Back in 1973-1974 we had a soft commodities boom. But ... the party was quickly ruined by the OPEC oil crisis and our economy tanked overnight.

So let’s have a party. But the lesson from last time is to not get too drunk, so when the party is gate crashed you can get out the back door with your shirt on.

 

World party doodle by yours truly, JB

 

My attempt at a cartoon. We party whilst a meteorite (unseen to us) hurtles towards earth. I couldn't decide if I made it a debt meteor or a deflation meteor so I made it both. You can't live life based on the small probability that something goes wrong. Life would be boring and you'd have to live like a hermit.

So buying an owner-occupied house is a perfectly fine thing to do, just don't over extend yourself and take a longer-term view. There likely won't be a miraculous increase in its value over the next 5 years. If you’re buying investment property make sure your numbers stack up and don’t over-leverage. If you can't find the right property, then wait. Be very wary of buying development projects (or trading property) at this point in the cycle. Accept you missed the boat, take the learning and be ready next time around. I don’t think house prices will fall (and if they did, then not by much.)

In all likelihood you’ll see a period of around 5 years of flat prices similar to what we've saw over the last 5 years before the current run on house prices. If prices significantly increase this year, and they might, then that will increase the size of any eventual correction. Right now, stable house prices would be a good thing. As for interest rates, I think the market is getting carried away with its growth story. I suspect that as interest rates increase (and with our strong dollar), inflation will stay low.

I think there is a tough time ahead for retail businesses, and a tough time for many industries grappling with disruptive technology - watch out banking, real estate, professional services. We are in an exciting, rapidly changing world that requires us to respond to change faster and faster. My final thought is that these headwinds, uncertainties and shifting sands will help keep interest rates relatively low for some time yet. For me, I still think we are in for a long period of relatively low interest rates.