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August 2017

The GFC and a decade of stagnation

“Dateline – 8 August 2007

France’s biggest bank, BNP Paribas, froze 1.6 billion euros ($2.2 billion) worth of funds on Thursday, citing the U.S. subprime mortgage sector woes that have rattled financial markets worldwide.”

So began the episode which we now call the global financial crisis (GFC). In the years that followed, the world was rocked, as one institution after another fell to its knees under the weight of toxic assets. Whilst the GFC had its roots in the U.S. subprime mortgage sector, it quickly spread far wider.

The banking and financial systems were the first to feel the pressure. The actions of BNP Paribas are often said to herald the beginning of the GFC, but markets had been rumbling for some months about troubles at firms such as Bear Stearns. By September 2008 the dominos were in free-fall. US Government lending enterprises Fannie Mae and Freddie Mac were put into receivership. On 14 September 2008 shockwaves were sent through the world with the announcement that the 167 year old investment bank, Lehman Brothers, would file for bankruptcy.

As the fourth largest investment bank in the world and a key counterparty across the global financial system, the knock-on effects of the Lehman collapse were immediate and dramatic. The large US insurer AIG suffered a liquidity crisis on 16 September 2008, after its exposures to the credit default swap market led to a downgrade in its credit rating. In response, the US Federal Reserve created a credit facility for up to US$85 billion in exchange for a 79.9% equity interest and the right to suspend dividends to previously-issued common and preferred stock.

From there, the developed world moved into a significant downturn. The US and Europe experienced perhaps their most severe recession since the Great Depression. Unemployment skyrocketed and fiscal pressures led inexorably to sovereign financial crises. Australia escaped the worst of the effects of the GFC, thanks largely to well capitalised banks, a mining boom, low government debt, a growing population and a close trading relationship with China, but we did not emerge unscathed. Ten years on, and post the mining boom, and we still see an economy struggling to return to trend growth or produce inflation in the Reserve Bank’s target range of 2-3% p.a. Government finances are stretched too, with deficits commencing in 2009 and not projected to end (on the government’s own figures) until 2020.

What lessons can investors draw from the GFC?

Perhaps the single biggest lesson to be learned from the GFC is that conventional thinking and traditional strategies are not always enough. Like life, investment inevitably involves risks and these risks cannot always be predicted or managed. Take, for example, the conventional thesis that share markets provide the best returns in the long run. The reality, however, is that they do not – at least not for many investors.

The ASX200 reached its pre-GFC peak of 6828.7 in November 2007. What followed has been remarkable. Not only did the market collapse by circa 50% in the wake of the GFC, but even now – a decade later – it remains down by 15-20% before inflation. It must be remembered, of course, that investors have received dividends through this period, but that is small consolation for those forced to close out positions and crystallise losses to generate income on which to live. The market might recover in the long run but, as John Maynard Keynes famously said, in the long run, we’re all dead.

So when will markets recover all of this lost ground? No one knows for sure, of course, but we can look at some key drivers to get a sense as to why the market is behaving as it is. The chart below is from Cuffelinks. It shows the All Ordinaries Index against aggregate company earnings per share and aggregate dividends per share since 2005. As you can see, the 2008 peak was on the back of record profits.

As the GFC began to bite, these profits dropped and have been unable to recover. Indeed, aggregate earnings per share fell in 2015 and 2016 and company earnings remain 30% lower than they were 10 years ago (once again, before inflation). Until we get some investment and genuine earnings growth back into Australian companies, the market simply does not, in our view, have a sustainable basis for a significant increase.

House prices and non-residents

In the meantime, the conversations continue in relation to house prices. A recent ABC 4 Corners special on the housing market shed little light on the subject. It made the point that household indebtedness levels are high, that households are sensitive to significant interest rate increases and that some regions of Australia have experienced house price decreases in recent years.

All of this is true.

Yet chronic historical under supply and population growth, the envy of the developed world, does support house prices in our major cities. It seems unlikely that immigration settings will be reversed in the near term and accordingly there is support for property prices in established metropolitan suburbs.

It is also true that some property purchasers experience difficulty in servicing their debt and are ultimately forced to sell their property at a loss. Where this is the result of malfeasance by their professional advisers or lenders, there are avenues available for compensation. Most often, however, the cause is the loss of a job or personal issues, such as sickness or family breakdown. None of this is new, or surprising. Property purchasers should always enter a transaction with their eyes fully open as to the risks, as well as the potential rewards, of a given investment.

In a similar vein, we are often asked for our views on the effects that non-resident purchasers have on the Australian property market. In response, we make a few points.

The first is that non-residents are restricted in their right to purchase residential property in Australia. Under our federal foreign investment regime, non-residents are generally prohibited from purchasing existing houses, except in the case of temporary residents purchasing a dwelling to live in during their period of residence. They can only purchase new dwellings and then only after receiving approval from the Foreign Investment Review Board (FIRB). Single dwellings built on a demolished existing dwelling will generally not be considered to be a new dwelling.

On a demand/supply analysis, these arrangements are very sensible. By prohibiting non-residents from purchasing existing properties, we reduce demand in the domestic residential market. By permitting investment in new dwellings, we utilise foreign capital to finance the construction of new dwellings, thereby adding to supply. Both measures act to contain the price pressure that could otherwise be unleashed on the Australian property market.

On the other hand, there is substantial evidence that these sensible measures were, for many years, not policed effectively. In late 2014, a joint parliamentary committee on affordable housing found that “… there has been a significant failure of leadership at FIRB… [and that] no court action has been taken by FIRB since 2006.” Given this finding, it is not surprising that there was considerable public unease about the effect of non-residents on house prices, particularly in Sydney and Melbourne where house prices growth was strong. The federal government has since undertaken a number of steps, including increasing resources to FIRB and making some very public divestment orders to non-residents who purchased dwellings outside the FIRB framework. By FY16, a significant change had occurred. The FIRB Annual Report for FY16 shows that 1,637 completed investigations of potential breaches of the residential investment framework had resulted in 260 findings of breaches. The feedback from most market participants is that this newly-active watchdog has ended the worst abuses in the sector, but that continued vigilance is warranted.

With that in mind, the appetite by non-residents for Australian property continues to grow. FIRB statistics show $72.4 billion in approvals for the purchase of residential real estate in FY16, up 19% year on year. Unsurprisingly, the big eastern seaboard cities are receiving the majority of the applications, with Victoria (44%) and NSW (32%) together comprising 76% of applications.

The likely aggregate effect of all this additional demand is still small. A working paper by Treasury released in December 2016 estimated that foreign demand increased prices by between $80 and $122 per quarter in Sydney and Melbourne for the period 1 July 2010 and 31 March 2015. Whilst it is reasonable to assume that the effect has increased somewhat since then, it is still unlikely to be material in size.

One issue that has attracted some attention is the number of properties held vacant after purchase by non-residents. A recent UBS survey found that as many as 25% of Chinese purchasers may fall into this category. Whilst this is a common practice in China, it does to some extent defeat the purpose of adding new supply into the Australian market (at least in the short term). This issue is being addressed by “ghost” taxes and it would not be unexpected if it were to receive further attention from state and federal governments over the coming months.

New superannuation sector statistics

Finally, the Australian Prudential Regulatory Authority (APRA) has just released its quarterly report for the superannuation sector. It showed that, as of 30 June 2017, total superannuation assets were sitting at $2.3 trillion, an increase of 10% year on year. The self-managed superannuation fund (SMSF) sector also continued to grow and now sits at an extraordinary $696.7 billion in assets under management. A clear testament to individual desire to manage their own investment destiny!

Whilst the performance of the superannuation sector generally has been strong over the last year (up 9.2% year on year) there continue to be grounds for concern when it comes to asset allocation. As at the end of June, a massive 49.8% of system assets (ex SMSF) were invested in equities. Just 20.9% was invested in fixed income. Members of superannuation funds should be carefully considering whether this type of allocation suits their own circumstances and investment strategy.


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The GFC and a decade of stagnation

Whilst the GFC had its roots in the U.S. subprime mortgage sector, it quickly spread far wider.

What lessons can investors draw from the GFC?


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Copyright 2017 La Trobe Financial Services Pty Limited ACN 006 479 527. All rights reserved. No portion of this may be reproduced, copied, or in any way reused without written permission from La Trobe Financial.

This publication does not constitute financial advice and should not be relied upon as such. It is intended only to provide a summary and a general overview on matters of interest and it is not intended to be comprehensive. You should seek your own financial or other professional advice before acting or relying on any of the content.