“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
So begins 2015’s The Big Short, the Hollywood blockbuster based on the global financial crisis. While the quote was wrongly attributed to Mark Twain, it does aptly describe how economic cycles end.
In the case of the global financial crisis back in 2007, investors knew for sure that sub-prime home loans, wrapped up as bonds and sold to investors rated investment grade, were low risk. But it just wasn’t so. As interest rates rose, the securitised bonds became high risk. The home loans started defaulting and investors in the bonds lost out.
In 2019 in Australia, and the rest of the world, the phrase is starting to look prophetic again (though not to the same extent it was 12 years ago).
How cycles end
Economic cycles come to an end when there’s a combination of leverage and mispriced risk. In other words, when you add significant leverage to something that appears low risk, but isn’t, future losses are magnified to the point where they can have an economic impact.
Locally that looks to be happening in the housing market. Since the global financial crisis, Australians have significantly increased their debt levels.
The chart below shows how Australia compares to the rest of the world. Since 2005 our debt levels have doubled, one of the largest increases in the OECD and above the corresponding increase in disposable income.
Most of that borrowing has occurred in mortgages. Notwithstanding the low interest rate environment, it is taking people much longer to pay off their house. More than half of all mortgagees are less than six months ahead on their repayments.
In addition to the significant increase in leverage it also appears that Australians are mispricing the risk in the housing market.
Despite a once in a generation increase in disposable income and record low interest rates Australians are now spending a larger proportion of their income on mortgage repayments than they were in 2005. Australians have implicitly assumed that interest rates will remain low and incomes high.
So when interest rates start to rise – and they eventually will – Australians will struggle to repay their home loans. Disposable income is already under pressure. Even if people do manage their mortgage payments, there will be second order effects, such as households pulling back on spending in shopping centres.
Implications for investors
These are the reasons why local economists are talking about the economy, and in particular the housing market, being late cycle or at the end of the cycle.
But this is not necessarily a negative. It is a fact of life that economies are cyclical and in down times they provide opportunities for investors just as they do in up times.
What is critical is knowing where in the cycle the economy is, because then the opportunities can be identified.
To learn more about our view on where we are in the market cycle, watch our recent webinar.
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