Australian Housing: At The Edge

The Gold Coast of Australia is blessed with so many wonderful attributes: miles of sandy beaches; clean air and skies; with clear, fresh water; lush vegetation in rich soil that will produce fine fruits and vegetables in abundance; and with year round sunshine and ample rain. The climate is warm in winter, a bit hot in summer driving the population to the sea breezes of the coastal beaches. The area is Lucky, much as Australia has been lucky.

The global financial crisis affected all parts of the world. In order to avoid a perceived systemic collapse, the major economies coordinated their efforts to stabilize and re-kindle commerce. Europe and America chose to pour vast sums of capital into the financial system to stabilize the banking system. The Federal Reserve expanded its reserve balance by over $2 trillion, plus trillions more were sent to foreign banks and financial institutions as well as sovereign nations in the form of currency swaps to help liquify and backstop a failing system. In Europe and Great Britain, huge sums of euros and sterling were used as enormous sovereign debt was created to flood the markets with liquidity in a desperate attempt at solvency. In the case of Germany, the nation expanded it's debt to prevent entire nations partners from collapsing; bonds were purchased and loans extended to basically bankrupt nations. Financial assets were saved for the institutions.

The US Treasury and Federal Reserve not only shored up the balance sheets at major US banks, but also underwrote the havoc created by the meltdown in US housing: guaranteeing loan losses at Fannie Mae and Freddie Mac along with guaranteeing failed lenders. Foreclosures and short sales of US housing created a black hole where capital disappeared in the destruction and deflation of asset prices created by the clearance sale of US homes, which demanded increasing amounts of capital. The central banks of Europe and America poured liquidity into the financial system to offset the losses faced by the lenders. A financial recovery of sorts ensued, but the massive debt had been used to replace lost capital and had not been used to enhance productivity or support job creation, resulting in the “jobless recovery”. Asset prices of equities rebounded, joined in the US by a bounce in the price of US real estate. This coordinated action was used to prevent a systemic collapse. China, the second greatest economy in the world approached the crisis differently.

China did not pour its trillions into banks, but into infrastructure and construction projects building massive commercial districts and enormous non-viable high rise residential units priced far above the purchasing ability of the average citizen. China went on a construction spree building more skyscrapers than any other nation on earth. Further, China built world class shopping malls sized for the record books, serviced by new roads and bridges; it all lacked in nothing but shoppers to fill the retail outlets. Millions of cubic yards of concrete; millions of tons of steel, coal, copper, aluminum, and iron ore to supply the vast construction projects that enriched a few, but gave work to millions. Factories and more factories were built to produce goods for export, but they are now starting to idle as their trading partners in Europe and Asia have slowed their purchases of Chinese imports, resulting in excess capacity. High rise residential units have been overbuilt, leading to high vacancy and the famous "ghost cities" of empty high-rise residential communities. Official lending through sanctioned lenders in China as well as the famous shadow banking system exploded the economy with liquidity driving the GDP to double-digit expansion. Some of those massive funds were exported to Australia.

Australia boomed! Mining operations expanded and workers were needed in the desolate mining districts of the Outback to supply the Chinese miracle. Truck drivers were reportedly earning $150K -$200K annually working 21 days on and 7 days off. Business activity for direct equipment sales, staffing and support, as well as marketing firms exploded. Indirect participants of the general economy benefited as well when miners returned home to enjoy their wages on new homes, furnishings, cars, and the relaxation toys of jet skis, vacations, and entertainment. The velocity of money moved through the Australian economy. Prices of homes soared. By late 2011, the boom slowed, imperceptible at first, but steadily slowing nonetheless.

Capital expenditures for Australia are projected to decrease in 2013 by 12-13%; 2014 CAPEX is projected to decrease by as much as 20%. Further, Credit Suisse (NYSE: CS) is forecasting a possible currency exchange rate of AUD/US of 0.75, which is portending lower demand for the Australian Dollar. One of the mainstays of Australian mining, premium grade coking coal has dropped from a high of $330/ton in 2011 to a current price of $135/ton. Iron ore has experienced the same phenomena, dropping from $192/ton to $130/ton. Mining projects are forecast to drop from a high of $350 billion for future projects to a possible low of $25 billion in 2018.

As the global economy slows, commodity rich Australia will be affected. In July, Woolworth's (Nasdaq: WOLWF) a national grocery chain was rumored to have begun a hiring freeze and a reduction in worker hours by 10%. Such management decisions are the result of slower revenue growth and will compound the affordability challenge. Prestigious custom home builders have been slowing and some are idle as projects have stopped. High rise development on the Gold Coast has slowed to almost non-existent. These are all evidence of less than optimal current conditions.

Since the global financial crisis, Australia has enjoyed strong economic activity that resulted in continually higher housing prices rising until 2011. Just recently, of the 34 nations comprising the Organization for Economic Co-operation and Development (OECD), Australia ranked 6th in over-valued housing when comparing both the price-to-rent and price-to-income ratio. Further, the 9th annual Demographia International Housing Affordability Survey of 2013 ranks Australia as the 3rd least affordable housing market behind Hong Kong, China and Vancouver, Canada. Australia had no affordable housing or moderately affordable regions in any of its 5 major markets, which compared to 20 Affordable and 20 Moderately Affordable regions in the U.S. out of 51; the US having already experienced the housing correction.

These ratios will drastically change for the worse if the global economy softens further; a slowdown will impact affordability which will impact price. The Australian government has pursued a policy of urban containment, releasing limited amounts of land in its 5 major markets, which has contributed to a limited supply of new housing. However, if other of the world’s economies may be used for comparison, as economies soften, the demand for housing drops precipitously. To proactively address these issues, The Reserve Bank Of Australia reduced the published rate to 2.5%; it was the eighth reduction since November 2011. This will give a boost to the general economy, and in particular, will help address the affordability issue for Australia’s housing. However, the projected forecast for unemployment has been raised from 5.75% to 6.25%, which will perhaps counter the rate cut.

Much of the published research indicates that Australia nationwide is extremely over-valued. That condition can remain the case for a very long time, particularly in world class markets like Sydney, London, New York, the Gold Coast, etc. But eventually the average person needs to be able to support the entry level and 1st and 2nd tier properties with a reasonable amount of their household income, or the market plateaus, or worse implodes, should there be an event or an external shock. I am afraid that is where Australia is! As an aside, a policy change of releasing additional land would help address the supply issue that is pervasive throughout Australia's metropolitan areas. Allowing for sector development along the freeways and demographic pressure routes would reduce the entry level prices and relieve some of the demand, further opening the market to competition from many landowners.

For better or worse, the globe is interconnected. Australia dodged the worst of the global financial crisis with the help of the Chinese economy; now if China slows or enters a recession itself, Australia will be deeply impacted. An over-priced, unaffordable housing market has the potential to implode; a steep housing correction is possible, as much as those that have corrected in Spain and the U.S. Once the tipping point is reached, a cascade usually follows that can have far reaching effects throughout the entire market. All eyes are on CHINA, let us all hope Australia's Luck holds!

This article should interest investors in the iShares MSCI Australia Index (NYSE: EWA), CurrencyShares Australian Dollar Trust (NYSE: FXA), Aberdeen Australia Equity Fund (NYSE: IAF), PIMCO Australia Bond Index ETF (NYSE: AUD), ProShares Ultra Australian Dollar (NYSE: GDAY) and the ProShares UltraShort Australian Dollar (NYSE: CROC).

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