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"Intelligent Insight"
An edited edition of the live Q&A as I discuss the challenges of investing in the current climate with Damien Klassen, Head of Investments and Tim Fuller, Head of Advice, at Nucleus Wealth. https://walktheworld.com.au/
Original version with live chat here:https://youtu.be/IV-Ev2Sriqw
Go to the Walk The World Universe at https://walktheworld.com.au/
Join us for a live discussion on investing in the current environment. I will be joined by Damin Klassen and Tim Fuller from Nucleus Wealth. You can ask as question live via the YouTube Chat.
What are the forces pulling the market higher, versus lower, and which will likely win out?
An excellent piece of market analysis from Damien Klassen from Nucleus Wealth.
Investment markets have a host of both positive and negative factors fighting for supremacy. The real question is whether central banks and governments will engineer a continued suspension of capitalism. I was sceptical six months ago. I’m less sceptical now that capitalism will return anytime soon. On balance, however, there is still plenty of room for caution.
Short-term government policies to suspend capitalism (increased hurdle for bankruptcies, mortgage holidays, eviction moratoriums, banks not recognising bad debts, etc.) have morphed into medium-term policies. And, it is hard to see any government ready to exit. There is a quiet extension to each policy that lapses.
We took advantage of pre-election weakness to increase our risk exposure a little. But given the rise in markets since the election, the positive factors have mostly been reflected already. And, the positive factors tend to be short-term, the negative aspects tend to be medium-term.
Government stimulus: Global governments continue to add stimulus. The US has some question marks, and the stimulus won’t be as large as if Biden won Senate majority. But it would seem additional stimulus is highly likely.
Low probability of US tax hikes: Subject to the Georgia senate run-offs, it looks unlikely the US Senate will pass Biden’s company tax rate increases. If passed, these would have reduced US earnings by around 10%.
Earnings very good: 3rd quarter earnings were much better than expected. Analyst forecasts haven’t changed much, but that is better than usual! Typically, later year forecasts are far too optimistic and get revised down as they get closer. Forecast growth is 24% for 2021 and then 15% for 2022.
Inequality to remain high: No changes to taxes in the US = economic inequality likely to remain high. In Australia, there are tax cuts for the rich, reduced support for the poor. Travel limitations depressing spending for the rich. Plus stimulus tends to be relatively indiscriminate; some ends up in the right hands, some in the hands of those that don’t need it. Net effect: the rich have more money to put into investment markets.
Bankruptcies, evictions limited: in many countries bankruptcies are down 30%+, driven by a mix of stimulus and rule changes. Businesses feel richer if they haven’t had to write down bad debts. Not fixing the problem, just delaying the pain.
Mortgage repayment holidays: as above.
Wage growth very low: helpful to company profits.
Productivity: forced change/digitisation often results in better outcomes. Having to fire staff usually results in the least productive going first, increasing overall company productivity.
Low oil prices: keeping transport costs down.
Vaccine hope: successful trials give hope to an end of the virus.
Policy certainty: President Biden is far less likely than Trump to be unpredictable.
COVID in the Northern Hemisphere: It is ripping through populations. Importantly, hospitals are reaching capacity, which means lockdowns have begun again in Europe and seem highly likely in the US.
Valuation: Share market valuations are extraordinarily high.
Latent bankruptcies: Changing the rules so that companies and individuals who are otherwise bankrupt are allowed to increase their debt does not fix the problem. It also runs the risk that the bad actors not paying their bills start to pull down the good actors.
Low genuine credit growth: credit growth has been poor; banks are still tightening lending standards. But the credit growth also includes mortgage holidays. And companies borrowing to survive rather than to make productive investments. Which means genuine credit growth is lower than the already weak headline numbers. Economic growth has been tied at the hip to credit growth for the last decade. It is difficult to see what will replace easy money as the only thing holding economic growth up.
Short term gap in US economic conditions: There may not be stimulus until Biden takes power. If so, there are three months with limited government support while the virus sets new records. This might be enough to tip the economy into a funk and result in more job losses.
Inequality longer-term effects: the short term effect of increased inequality increases savings and investment and (probably) increases stock market valuations. The longer-term impact is depressed demand and profits. And more political upheaval.
Australian stimulus badly targeted: supply-side rather than demand-side.
Structural change: leading to weak demand, higher unemployment. There are industries like travel and tourism which will have to deal with lower sales and employment. The means job losses continue as former employees have to give up on finding a job and retrain for a new industry.
It bears repeating: the positive factors for investment markets tend to be short-term, the negative ones medium-term. Will there be “clear air” for a few months before the consequences begin? Maybe. The stock market has had a lot thrown at it and is still holding up.
On the flip side, the risks are not symmetrical. The upside appears more limited than the downside.
Damien Klassen is Head of Investments at Nucleus Wealth.
We recently discussed the current conundrum created by low interest rates – many deposit accounts are paying close to zero, but what to do?
In response we have extended our Walk The World YouTube universe:
We take the discussion forward by announcing a new relationship with Nucleus Wealth.
This is driven by a shared philosophy as to how to navigate these uncertain times.
Note this is not financial advice, and you will need to undertake your own due diligence as to whether this is a suitable alternative.
I caught up with Damien Klassen Head of Investments, at Nucleus Wealth to discuss their investment strategy in the current uncertain climate – ahead of some important announcements coming later in the week.
Finally some of the commentators are seeing though the Government spin to the underlying ideology, and are highlighting the weaknesses and risks in the massive proposed spending. And it’s not so much the quantum, as the direction of fire…
This is the edited edition of our latest live stream with Damien Klassen.
Join us for a live Q&A as I discuss the current market environment with Damien Klassen from Nucleus Wealth. We will also discuss their property calculator, which I think is one of the best out there.
https://nucleuswealth.com/property-calculator
Original show with chat replay is here: https://youtu.be/GSTYE7WK92o
This is the edited edition of our latest live stream with Damien Klassen.
Join us for a live Q&A as I discuss the current market environment with Damien Klassen from Nucleus Wealth. We will also discuss their property calculator, which I think is one of the best out there.
https://nucleuswealth.com/property-calculator
Posted on by Damien Klassen
Before COVID-19 hit, Nucleus Wealth launched a property calculator. The idea I wanted to illustrate is that house prices are very sensitive to interest rates. So, with interest rates so low, property was going to be stuck in purgatory:
if the economy improved and interest rates increased then higher interest rates would cap property prices,
if the economy didn’t improve, then weak growth and already low interest rates would see property prices fall
I’ve changed my mind. Desperate times call for desperate measures. I’m pretty sure mortgage interest rates are going lower. Much, much lower.
In our house price calculator, we had a minimum mortgage rate setting of 2%. It should have been much lower. We just changed it to 0.5%.
Impossible? Japan has mortgage interest rates below that. So does Germany. Ditto France. And there is a decent probability the rest of the developed world is destined for the same.
The mechanism is already set up in Australia. The Reserve Bank of Australia has begun providing three-year funding to banks at 0.25% for mortgages. Banks can probably use this money to go below 2% for three-year loans. And that is just the beginning.
It started in April with an “initial” funding allowance for banks. Then an “additional” funding allowance. Now there is a “supplementary” one.
There is clearly a risk of running out of adjectives to describe the bank funding. But there is no risk of running out of the desire to keep the property market ticking over with low interest rates and oodles of credit. The Treasurer’s announcement last week requesting banks to start lending irresponsibly confirmed that for anyone who still doubted.
Europe has already paved the way. The European Central Bank started with 0.1% funding for banks in 2014. By 2016 the rate was -0.4%. Now, -1.0%. Yes, the central bank will pay commercial banks up to 1% if they can just find someone (anyone!!!) who will just borrow the money.
Nope. It is the flat yield curve problem smashing bank profitability, I’ve posted about it several times.
Don’t think of it as free money for banks. Think of it as life support so that the banking industry doesn’t collapse.
Keep in mind that I’m talking about forecasting residential property in aggregate – not individual houses or suburbs.
There are significant links between property prices and the availability of debt. The financial crisis showed this internationally. The Royal Commission into banking showed this in Australia. When the amount of debt available rises, so do property values. When debt slows down, property values fall.
The Federal Government is hellbent on forcing more debt onto borrowers. The Reserve Bank of Australia is providing the funding. Credit is available.
I’m going to argue four other factors also constrain how high or low property prices can go. These are the four factors you can use to forecast property prices in our online calculator:
Strap yourself in for moral hazard. We already have the world’s 2nd highest consumer debt, about double most Eurozone countries. If interest rates can fall further and the shackles are off the banks for responsible lending, then who knows how much more indebted we can become?
It is a fascinating showdown.
On the one hand, we have plummeting immigration, massive unemployment, eviction moratoriums to deal with, bankruptcies to deal with and a larger private debt burden that just about any other country.
On the other, we have a burning political desire to keep house prices high, pump more debt into the economy and a roadmap to much lower interest rates to help.
As a reminder, in Perth from 2014 to 2018 we saw free credit (pushing prices higher) meet rising unemployment (pushing prices lower). Rising unemployment won:
The best hope for housing bulls is that the interest rate falls come before the rent eviction moratoriums, interest repayment holidays and bankruptcies hit full stride. This might spark a mini-house price boom. The worst outcome for housing bulls is that the interest rate falls don’t come until after house price falls gain too much momentum. I think the negative outcomes are the default setting at this point, the burden is on the Reserve Bank and the government to do more. Either outcome is possible, but a negative outcome seems more likely. Keep in mind that we have already locked ourselves into low interest rates for the next decade. If the government gets its wish for more household lending and lower interest rates, there may not be another interest rate increase for a generation. Or until a Modern Monetary Theory loving politician is elected.
The net effect (see individual city data below for more info) is:
The cost of a mortgage relative to the cost of rent is about average in Sydney and Melbourne. In Brisbane and Perth, the cost of a mortgage is cheap relative to the cost of rent. Both rents and mortgage costs are likely to continue to fall, but mortgage costs can fall further, improving affordability.
The cost of a mortgage relative to wages is about average in Sydney and Melbourne. It is cheap in other cities. The problem is two-fold: (a) wage growth is not going to be high (b) unemployment is high. A positive longer term sign for house prices, a negative shorter term sign.
House price to wages are close to historical highs in every city except Perth.
Rental yields are close to historical lows in every city except Perth. Eviction moratoriums and rental declines are not helping investors.
PS: I will be on the Digital Finance Analytics YouTube channel with Martin North in a livestream on at 20:00 on 29 Sep 2020 to discuss these factors and more: https://www.youtube.com/watch?v=GSTYE7WK92o
The chart on the left shows how each of the ratios used for forecasting in the property calculator have changed over 40 years. The histogram on the right shows the distribution of the same ratio over the 40 years.
Nucleus Wealth has compiled this data using a range of different sources.
For property prices and rents we use a Domain for more recent data quarterly data, cross checked with SQM and Rismark to fill any short term moves. For older data we use Australian Bureau of Statistics data to fill timeseries.
For economic data we use either Reserve Bank of Australia or Australia Bureau of Statistics data. For older data we have had to estimate some factors due to differing definitions over time.
Damien Klassen is Head of Investments at Nucleus Wealth has penned an excellent article which is reproduced here with permission:
Investment markets are in the eye of the storm. The initial storm danger came as COVID-19 hit, decimating jobs and smashing demand. Governments and central banks ably stepped up to stem the damage, and investment markets calmed. But insolvencies and bankruptcies have only been delayed, not avoided and the employment recovery is unlikely to be quick. The eye of the storm is not as safe as it appears.
At the risk of sounding like a broken record, the dynamic at the moment is as strange as it has ever been. I have spoken before about the best argument for buying stocks is the ironic case that capitalism is dead, and therefore buy equities. Disconcertingly, there continue to be signs that this is the case.
Governments around the world made significant changes to bankruptcy and property eviction laws.
When the crisis was expected (hoped?) to last for only a few months this was good policy – there is was no sense in shutting down companies due to short term demand issues or kick people out of homes for short term job losses. And the changes have worked:
Which is where the disconnect lies. Australian bankruptcies in the June quarter were down 42%. The US is down around the same. Europe is seeing similar effects. The number of unemployed is 50% higher than the start of the year in most countries. There is clearly a tension that needs to be resolved.
It should be clear now that COVID-19 is not a 3-month “blip” but rather a longer-term structural issue. Now it becomes a question of whether the cure actually turns into the problem.
A Melbourne based specialist delivery company has a niche delivering to hospitals and hotels. Revenues down 75%+. Profits up 50%. Most of the profit increase is JobKeeper. But the owner has also torched middle management and worked out clients are just as happy with larger deliveries less often rather than smaller deliveries more frequently. And so productivity is off the charts. As revenues recover, the middle managers will not be getting their jobs back.
This is just an anecdote from one company, it is not data. But economic history shows a similar effect with businesses across the world. That is what recessions show us – jobs lost take a long time to re-appear. Many older workers will never work again.
There is a good reason for bankruptcies and evictions. When people or companies get into financial difficulty, bankruptcy gives them breathing space by cancelling interest and allowing them to resolve the problem. It forces them to reset their obligations and to come up with a plan to extricate themselves.
Just as importantly, it alerts suppliers, employees and other partners to the problem. The reason this is useful is that without bankruptcy, companies and people can simply use up credit with one supplier and then switch to another. If this is allowed to go on, then the suppliers start to go broke, and it creates a domino effect of economic issues.
Evictions are similar. Say someone cannot afford a $1,000 a week rental/mortgage because of job changes but could afford $600 per week in a different suburb. How long should they be allowed to stay in the $1,000 per week house? The longer that person is allowed to stay, the more likely it is that the landlord also goes into financial stress. Or, the bank has to reduce lending elsewhere, creating another domino effect.
Keep in mind that for the most part, rental debts or interest is still accruing, the burden is getting larger and the capital smaller. These are highly emotional issues, and in both cases, we absolutely need a safety net. But, a small debt can conceivably be paid off through a restructure. In contrast, larger debts become all but impossible to pay.
Say you have someone who is bankrupt, owing $25,000 to a range of credit card providers, utilities and landlords. If they go bankrupt or are forced to sell their house, then it can be a devastating event. But if the jobs are not coming back quickly then if you give that person six more months, then compounding interest and more bills might turn the amount into a much higher figure.
For the borrower, it is far crueller to be under six months or twelve months more emotional and financial stress. During this time they go from a small debt to a far larger debt while hoping for “something to come along” to fix the problem. Better to bring the issue to a head earlier.
For the debtors, an early resolution is also much better as each debtor has a lower exposure and might get paid out something. At high debt levels, individual debtors end up with almost nothing.
So there are two competing macroeconomic effects.
Governments were hoping for a short sharp shutdown and recovery, or a cure or a vaccine. It didn’t happen.
Governments are tempted to pull the first lever again and hope. The issue is that the second grows bigger every day. By pulling the first lever again, if we don’t get a cure or vaccine, then there is now a much larger problem.
If the last ten years have taught us anything, they have taught us that given a choice between:
That politicians will take option (b) way more often than more sober observers would prefer.
The rules are rolling off around the globe, my expectation is that this will create at least some sense of normalcy. But there are already countries extending provisions until the end of the year or beyond. Which makes it difficult to assess when the eye of the storm will pass, and the second half will begin.
There is an alternative possibility: that markets are now entirely dependent on central bank support, so economics and fundamentals no longer matter. We have a checklist of a dozen decisions that governments and central banks can make that will eventually suspend capitalism.
A few of the items have already been checked off the list. The more that get implemented, the closer we get to a genuinely new paradigm. But, we do not believe this to be a likely outcome. The steps taken must become increasingly radical: effectively central banks and governments bailing out and propping up most failing businesses, turning the world’s capital markets into a herd of state-owned entities that will ‘kill the village in order to save it’.
The economic and virus progress has mainly been as we expected. So, our asset allocation and superannuation portfolios remain conservatively positioned.
In the direct holding stock portfolios, our virus-sensitive positions have driven outperformance. Since the crash, we found value in commodities. First oil, then iron ore, and now gold miners. We remain very wary of banks. However, the economy and the stock markets have disconnected. The stock market is at valuations that discount no risk.
We changed most of our quant models a few months ago to put much less focus on the last 12 months of earnings, or the next year. The focus instead is on a mix of inflation-adjusted historical earnings and the earnings from the second year of earnings. The problem with this is:
Which is an indication of the environment. You have to understand the limits of your models. The key to navigating as we exit the eye of the storm will be to not lose track of the principles of good investment while changing models enough to reflect that times are not normal.
We have a shopping list of high-quality companies that we want to own for our investors at lower prices for the very long term. Which is easier said than done. We picked up a few in March, but the problem with these companies they also bounce back the fastest once panic subsides.
Given a toxic mix of low-interest rates, volatility and expensive markets, investors will need to be significantly more nimble than in the past.
D
Here is an excellent article from Nucleus Wealth which spells out the true issues around property investment. So many investors have their heads in the sand!
The net effect is that at current prices, finding scenarios where property won’t lose you money over ten years is not that easy. Which means most buyers in today’s market should be doing so as a lifestyle choice rather than as an investment choice.
Recently, we have seen a few Nucleus investors cash in their capital and profits and take the real estate plunge. This, of course, is sometimes more a lifestyle choice than an economic one. Being locked five months in a small flat with a partner and boisterous progeny while working off a kitchen table can often change one’s perspectives.
Given this is more about sanity than economics I start from the position that I am happy to walk away with no real profit after 10 years but I want to at least retain close to my initial capital.
To look at the various implications we will use the Nucleus Wealth Property calculator. To start I need some initial details. Let’s take the case of my son as a working example. Say he is in Melbourne, has $100K saved for the deposit and has found his dream house available for $1m. The banks are willing to lend him the balance – no mean feat in this credit environment. Let us assume he intends to live in this house so there are no negative gearing tax benefits and he intends selling it in 10 years to move to the Bahamas as he expects to be an empty nester (a true dreamer).
Thus using our Property Calculator and given we are optimists expecting a recovery from the COVID downturn we choose “Good Economic Conditions”, and use all the designated defaults to get:
Gulp!.. that’s not good… The problem with good economic conditions is that interest rate rises will limit your capital growth, and with 90% debt load the interest payments hurt. Note we are using rent received as rent “avoided” in these scenarios.
Perhaps we need to be even more optimistic so we choose “Property Paradise” conditions…which yields:
That’s more like it!! he can now afford a jacuzzi and a seaview. However a quick look at the underlying assumptions for Property Paradise yields …
While we are optimists, alas I am also a realist…. I tell him it is highly improbable he can lock-in 2.75% for 10 years, nor do I believe a 6% nominal Rent Growth year after year is realistic.
Thus we decide to input our own assumptions.
The first thing to note about the calculator is that by default it is designed for property investors that intend to rent their property. Thus as an owner-occupier (and as we are misers) we can reduce the re-investment in the property (depreciation rates to $600+halving repair assumptions) and dial down the other costs. The rental income should be viewed as money saved not paying rent, so the variables about lost rent/vacancies can be dialled down to 0.
That done, now we come to the key assumption for the calculator (and the investment outcome). What is my expectation for property prices? Investing in property implies we have an expectation property prices will recover over the next 10 years. This expectation of a property price rise can be incorporated into the calculator in a number of ways:
We choose to alter the ratio of Mortgage Cost to Rent ratio as it is probably the easiest ratio to get a handle on. Data suggests this ratio is currently at 134%, but the long term graph suggests the 10-year average is closer to 160%.
With our expectation of post-COVID economic recovery and a resumption of Immigration to drive property demand, we take the view that this ratio should retrace toward its 10 year average of 160% (I chose to use 148% a rough midpoint between these values).
With that key assumption locked in, it is time to pull the various economic levers (inflation, rental growth, mortgage rate) to find a breakeven investment such as:
As a good cross-check, using the “Compare Renting vs Buying” function in the calculator, we can confirm we are near break-even (with an assumed 0% return on the $100K over the period).
The calculator also highlights how the benefit of a geared property is mostly achieved at the tail end of the investment. i.e. if he only stays in the property for 5 years, he will be about $60k worse off than if he rented for the same period. i.e. on the assumed property with stamp duty, mortgage insurance and other entry costs he will be out over $80k. Add in $20k to sell the property on the other side and his $100k is gone, relying on capital growth to make up the difference.
Using the calculator we can thus find other scenarios that achieve break-even property result (1.5% inflation, 2% real Rental growth which then means I can lock in a more attainable 4.5% mortgage rate). Alternatively, a more aggressive property price forecast of 160% (i.e. the 10-year average) mortgage cost to rent ratio means inflation could be 3%, rental growth of 3.5%, and my mortgage interest rate can now be a very achievable 5%.
Armed with these base-line cases a user can now test the sensitivities of these assumptions or explore their own expectations to assess the risks/benefits involved in not persevering with living and working on that kitchen table.
The net effect is that at current prices, finding scenarios where property won’t lose you money over ten years is not that easy. Which means most buyers in today’s market should be doing so as a lifestyle choice rather than as an investment choice.
