The wealth effect… Do you know what the hell I’m talking about?
…it’s not a bad thing, actually a pretty good, more than just a warm and fuzzy feeling.
Please explain? I will shortly.
Everyone knows I’m bullish on house prices this year.
The cycle has already turned, and the housing market is quickly gathering steam. It’s a pretty common view now that 2013 will be a good year for capital growth, particularly through the second half of the year.
But at the same time I’ve been making it pretty clear in these posts that I don’t see interest rates going anywhere anytime soon.
Someone asked me about this the other day. How do you square these two away? Normally if house prices are rising the RBA is gearing into a tightening cycle. Won’t that be happening this time around?
That’s a very good question. I’m glad you asked.
The answer is, No. Not this time. Interest rates will start edging up at some point down the track, but by then, house prices will be long out the gate.
Such sweet conditions like these don’t come around everyday. House prices are rising fast and interest rates are stuck on a super-stimulatory setting… But this can’t go on forever either!
So how did we get here? To understand it, we need to pick apart the connection between house prices and interest rates a little bit.
In normal times, by which I mean the pre-GFC era, if house prices were rising quickly then interest rates were rising too. The lynch-pin was consumption.
It’s called the ‘wealth effect’. The basic idea is that if house prices were rising, households felt wealthier, and felt more inclined to consume.
And as consumption ramped up and the economy found another gear, the RBA started to get worried about inflation, and started pulling on the interest rate hand-brake.
That’s “normally” how it goes. (Though when have things ever been truly “normal”?)
The actual size of the wealth effect is difficult to pin down. However, researchers at the University of Sydney published an interesting paper a few weeks ago that found that for every $100 increase in house prices, annual household consumption increased by around $8. The Fed published some similar numbers for the US.
So, say you had a house worth $300,000, and it increased 5 percent in value. That extra $15K in equity would, by itself, increase annual consumption by around $1200.
So, in the old world, rising house prices were a solid plus for the economy, and sooner or later, the RBA would try and throw ice on the party.
But that’s how it used to be. It won’t play out this way this time round.
One of the key findings from the USyd paper was that rising house prices increased consumption because they helped “relax household credit constraints”.
That is, households who found they had more equity in their home often used it take on more debt, which helped fund higher consumption levels.
But following the GFC, attitudes to debt have done a full 360. Around the world actually.
People have become a lot more hesitant to take on more debt, especially to fund non-productive consumption of plasma tvs and so on.
In a speech a couple of days ago, RBA Assistant Governor Phil Lowe noted that Australian households were net dis-savers in the lead-up to the GFC, but are now saving more than 10 per cent of their disposable income.
That amounts to $90 billion a year that is now being saved, rather than spent.
This chart here, (taken from a speech by ex-BHP head Don Argus) shows just how much the game has changed.
Through the 90s and up to the GFC, household debt, as a percent of GDP, increased from a little under 50 percent to a peak of around 110 percent. Since the GFC though, it’s pretty much been tracking sideways.
But with a household to debt ratio of over 100 percent, Australia still has the most indebted households in the OECD, and where debt ratios have come down across the world, they remain elevated in Australia.
This suggests that households are likely to continue deleveraging into the near term. And if house prices are rising, households will be using this increasing equity to pay down debt, rather than funnelling it into consumption.
All of which makes the wealth effect a thing of the past.
So imagine that the RBA keeps rates at record lows, but Australian business doesn’t take the bait. Perhaps they’re scared of the damage the high Aussie dollar is doing, and are reluctant to invest.
In that case, record low interest rates are feeding straight into asset prices, as people take the cheap and easy money and invest it in profitable assets, like property. The wall of money creates a super-surge in property prices.
But without a wealth effect, there’s no pick up in consumption, and the ‘heat’ in the economy is unchanged.
The RBA then has no reason to raise rates, because there’ll be no signs that the economy is over-heating. And an uncertain foreign situation will make them extra wary of pulling the trigger too early.
So until households deleverage back to more comfortable levels, and consumption picks up again, the main beneficiaries of record low interest rates are going to be the owners of assets – particularly property.
And so what we have, and what I reckon we’ll see over the next 18 months or so, is a massive disconnect between property prices and interest rates…
… and this creates an incredible window of opportunity for investors.
You’ll be enjoying a massive ramp up in capital, while your funding costs, tied to interest rates, will remain on the cheap.
Who could ask for more?
These are uncharted economic times. The rules of the game are changing. But that doesn’t mean that there isn’t money to be made, if you know what you’re doing.
Stick with me. I’ll show you where these opportunities are hiding.
Signed with Success