Economic slowdown worldwide suggests caution is warranted with equities

After share markets globally suffered some significant declines in the December quarter, we have seen a very strong bounce-back in the first quarter of 2019, primarily in response to the US Federal Reserve telling the market that further interest rates are on hold for the remainder of 2019 due to some signs of weakening economic growth around the world. The Fed doesn’t want the US economy to slow too much. Unfortunately, I think the recent strength in share markets may be ending as the signs of weaker growth in China, Europe and Australia become more evident. High equity multiples can be justified based on lower interest rates but if profits don’t grow, significantly higher equity prices from here will be hard to justify.

The US bond market, where longer-term interest rates have been falling, suggest the hitherto booming US economy is slowing. The US 10-year bond rate has fallen from over 3.0% to 2.4%, almost the same as short term rates.

The all-important 10-year German bond yield is now at negative 1.5 basis points; yes, below zero. Japan & Switzerland are also negative. The UK is at 1.0% and the Australian 10 year Government bond rate is now around 1.8%, close to the lows of 2016. These are certainly not positive signs regarding the economic outlook.

With interest rates worldwide already so low by historical standards, if the global economic slowdown accelerates there is limited scope for central banks to stimulate by reducing interest rates. For example, the Australian cash rate is already at a historic low of 1.5% so the scope to cut rates in order to promote growth is severely limited. Fortunately, we do have close to a balanced budget so there would be scope for the Government to stimulate, if necessary.

While the risk of recession in the next two years seems to be increasing in numerous countries, selling higher yielding quality assets including shares is not attractive when the returns on bonds and cash are already so low and likely to go lower. Cash offers security but is not a good long-term investment with after-tax returns below inflation. What many sophisticated investors are doing is focusing on high-quality assets that will weather any downturn and keep providing income in the form of dividends. Already we are seeing some of the expensive (high multiple of earnings) stocks correcting. I think this cautious and measured approach is warranted.

Residential versus commercial property

Australian property management group Charter Hall has highlighted some of the key differences between residential and commercial property that investors should be aware of. While they may be biased towards commercial property, they make some important and valid points.

“Importantly, commercial property (being office, industrial and retail property) has different performance drivers to residential property. While Australia’s real estate sector benefits from accommodative (i.e. low) interest rates and strong population growth, commercial property performance is driven by different investor and occupier profiles.

“Commercial property has higher barriers to entry (due to the typically large investment required) – meaning there are less speculative purchasers. More importantly, though, commercial property has different types of tenants and demand and supply drivers. Commercial leases are longer (anywhere between three and 15 years), they usually have fixed annual rent reviews throughout their duration, and good managers do comprehensive due diligence on the companies they lease to. In fact, in the office sector, vacancy rates in Sydney are the lowest since the Sydney Olympics and in Melbourne vacancy rates are the lowest on record. A similar story can be found in the industrial property sector, which is benefiting greatly from the rise of e-commerce and online shopping.

“The net returns from residential property investment are too dependent on capital growth with not enough emphasis on the low levels of income they generate. Once transaction and holding costs are taken into account (stamp duty, legal expenses, repairs and maintenance, land tax, rates and sales commission etc) the average annual income yield of residential property investment can be in the low single digits and in some cases even negative. This means that for residential property, the whole investment is often a capital gains play. This is well and good in a rising property market but a less than attractive proposition in a stagnant or falling residential market”.

The factors that drive Residential Property

Consultant, Tim Farrelly, has written an insightful article on the key factors that have driven and will continue to drive the residential property market in Australia. Some of his key points include:

  • Demand for housing is inflexible and the supply response is slow.
  • How much the banks will lend is a critical factor for property prices in Australia.
  • Prices follow lending standards and affordability. This suggests lower interest rates have been the key driver of price increases over the past 20 years.
  • APRA is telling the banks to apply a 7.25% interest rate in assessing serviceability irrespective of where current mortgage interest rates are. This suggests moderate falls or increases in interest rates over coming years will have little impact on housing prices.
  • A more rigorous approach by lenders to assessing expenses has impacted how much they will lend. Industry figures estimate it has led to a 15-20% reduction in average loan sizes.
  • What we have currently is more a buyer’s strike than a seller’s panic.
  • Supply might be moderately excessive at present but lower new construction, evidenced by lower residential building approvals, will likely lead to shortages within a few years if the population continues to grow.
  • Developers currently can’t attract pre-sales leading to lower new projects in the next year or two.
  • Rents and inflation are largely unrelated to residential property prices: prices have risen much more than rents or CPI.
  • CGT changes proposed by Federal Labor will reduce transaction volumes and hence hurt state government revenues.
  • Changes to negative gearing & CGT unlikely to impact housing prices greatly (some analysts disagree with this strongly, as commented on in last month’s newsletter).
  • Investment in housing: 1/3 houses, 1/3 units and 1/3 renovations.
  • A. has effectively had a recession and significant falls in property prices – around 12% in recent years – but losses by banks have remained very low.

 Commercial Property

Tim Farrelly has also written an interesting article on the commercial property market which has quite different characteristics and drivers.

Federal Budget Update: coming next week

The Federal Government will deliver its annual budget next week with personal income tax cuts and a return to a budget surplus after a decade of deficits expected to be the highlights. We will send out a summary of key announcements and implications on Wednesday.

This newsletter contains general advice. It does not take into account your individual objectives, financial situation or needs. You should consider talking to a financial adviser before making a financial decision.

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