Written by The Investor
29 June, 2020
Is the world disconnected from Covid-19 and will property collapse in 2020 as immigration evaporates?
Since last writing in April we have seen the human devastation of Covid-19 unfold. The seemingly unbelievable death tolls that were forecast have unfortunately become a reality. In April they were predicting US deaths of 82,000 by August 2020. They got there in May and exceeded 100,000 by June 2020, and now 120,000 plus deaths. This pandemic has kept surprising on the upside and it would seem foolish to believe that this chapter is behind us.
In light of this we take a look at who is exposed and at who will become enabled from the changes in the environment. There has been visible impact on the industries of finance, construction, manufacturing, hospitality and travel. There has been invisible impact on the entertainment world and the great unwashed world of events, conferences and business networking.
Consequently, the hit to immigration and employment trends has been significant while the disruption to consumer preferences and spending patterns is yet to unfold. Just last week Qantas announced 6,000 job losses reacting to international travel restrictions for the next twelve months.
All of us have had to make significant changes to survive this pandemic. Some changes will be lasting and many of the changes provide legacies the world must now deal with.
Most obviously there is a new pile of debt created from bailing out of the world. While it seems invisible now it will have a significant impact in future years once the deflationary effects of disruption and dislocation fade and the world gets back to some sort of normal commerce.
Money base – only in times of war have we seen such change
The increase of money in the world as a result of the rescue packages has been massive. Normally when there is a significant increase in money in the system the value of money is eroded. One dollar is worth less as there are so many more dollars in the system. It may not occur immediately, but it has to occur eventually unless there is a reduction in the number of dollars in the system.
In previous chapters of quantitative easing the impact on inflation had been muted as the funds were really only available to the banks and the institutional trading community. This time around the transmission has been far more wide spread. Benefits to the unemployed and struggling businesses has meant that billions of dollars was available. Unlike the GFC bailouts, funds have been thrown to the consuming public and businesses.
They had no choice – those with the levers had to choose the lesser of two evils
Governments and central banks created more money to make sure that the system did not fall over when the world stopped for Covid-19. This money was to help businesses and people that needed money when everyone stopped spending, went into isolation or just lost their jobs.
But will this money base expansion be inflationary? They measure the level of spending and call this the speed of money (economists call it the velocity of money). At some stage the speed of money will increase and with it will come inflation. Short term the financial system has soaked up this money and the share market has bounced back. Shares have regained more than half of the losses resulting from Covid-19 as traders speculate about how the word will recover and which companies will benefit. Ultimately companies have to deliver. Investors expect profits and dividends otherwise they will be disappointed and sell their shares.
Ironically some inflation is what the world needs?
The cycle may ironically help the governments inflate away the massive debts they have taken on to support the economy in 2020. The downside for joe public is that interest rates will rise once inflation kicks up in 2022. Typically interest rates are one to two percentage points higher than inflation; the real interest rate.
Right now, we have deflation and interest rates of near zero implying real interest rates of 2 percent. The RBA and other central banks like the US Federal Reserve have indicated they will “do what is required to return the economy to growth” i.e. keep interest rates at zero for possibly two years. This is not a long-term play and ultimately, they must go back to their objective of managing inflation to a band (current RBA band is 0-2%).
Exposed are those with too many debts. What will happen? Central banks will raise interest rates to manage inflation and people and businesses with high levels of debts will pay more interest, sell assets to reduce their debts, or go bankrupt.
More recently, it is ironic that in this environment the Australian government is encouraging households to take on more debt by way of subsidising home renovations.
Consumer behaviour and society’s preferences – demand
Covid-19 has also raised the issues of who to trust, who we can rely on and who we should believe and follow. The suppression of information by many has cost the world dearly and China and others will pay the price in some shape or form in future years.
Isolation has also provided time for reflection with many making changes to simplify their lives and focus on needs as opposed to wants. Whether these thoughts become new trends is yet to be seen. “Buy Australian” has emerged in our world and may see a shift away from price being the only consideration when shopping.
What has also emerged is society’s intolerance for racial inequality. The riots that followed the death of George Floyd sparked a bomb in activism. No doubt these social views will unfold in the US elections in November and there may be a change in government. It was not lost on the world that Joe Biden spoke at Floyd’s funeral in Texas. Trump’s handling of the pandemic and his own deflective behaviour could well be tested as people reassess who to trust. Meanwhile he is ramping up his election machine when the rate of Covid-19 cases is accelerating in many places in the US. As restrictions are lifted across the US, signs of a second wave of cases have been raising alarms. More than two million people in the U.S. have been infected so far and the localised surges have raised concerns among many experts and the politicians seem to be turning a blind eye.
Australian residential property continues to defy gravity.
Well known contrarian investor Chris Joye stated in April 2020 “House values are unlikely to fall materially and will either move sideways or at most fall by up to 5 per cent over the next three to six months.” So far, he has been right and other commentators predicting 20 to 30 percent falls in property prices were wrong.
Long term, the property market is driven simply by supply and demand.
On the supply side there has been a chronic deficit for years. Builders simply couldn’t keep up with the demand for property and as such the prices have gone up, up, up…
But let’s examine the drivers of demand. Number one is the stability of the economy. Number two is the growth in the population, number three is the cost of money and finally there are tax concessions and incentives that support the property market.
Let’s start with the last item. Scott Morrison will attempt to provide Australia’s economy with a renovation rescue, with $25,000 cash grants for new homes and renovations.
The $688 million stimulus initiative will provide Australians money to spend on building or upgrading their home in a bid to support Australia’s struggling construction sector.
The third item relates to interest rates. It seems clear that these will be supportive for the foreseeable future. The RBA stated that it “will not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band” May 5, 2020
The second item is a little less positive. Population growth in Australia has been twice that of the OECD economies, roughly 1.4 percent pa. However, two thirds of this has been driven by net immigration.
Population growth has been about 400,000 annually for many years. Net overseas migration has accounted for more than 60 per cent of it this population growth.
Net immigration not surprisingly was zero due to closed boarders
Macro trends have forecast that this is unlikely to change as the following chart shows.
If the population growth were to slow to one third of the historic rate we would see a dramatic drop in demand for housing.
Lastly, the rate of employment growth will no doubt recover as the economy recovers. Unemployment has been cushioned from hitting double digits this year due to Jobkeeper. Some analysis suggests it would be 18 percent without the government’s plan. These programs are due to expire in September 2020 but may be extended.
Will support from the government, interest rates be enough?
What is unclear is the trend in economic growth towards 2025 and 2030. It seems that this will be slower than the decade we just had and suggests we could have a sideways property market for a while.
In the decade just gone we had strong economic growth fostered by globalisation, strong ties with China and a resource boom, falling interest rates, and population growth twice that of the OECD average promoted by strong immigration to name a few tailwinds.
These are no longer in play and we now have a pile of government debts to repay implying higher taxes at some stage. Add to this the possibility of a sustained spike in inflation and we would see a significant headwind emerge for property. Property would benefit from higher rental growth with inflation up, but it would be swimming against the tide of weaker employment growth and patchy immigration.
To close with the words of Chris Joye.
“let me reiterate that if Australia was about to experience a multi-year downturn precipitated by China imploding or high inflation and rising interest rates, I would expect a 20 per cent to 40 per cent drawdown in the value of our bricks and mortar powered by the mother of all deleveraging processes.”
This scenario is not off the table just yet given the uncertainty of Covid-19 and the lack of respect leaders are showing towards new infections.
Please consult your advisor for specific recommendations. This general advice does not take into account the client’s objectives, financial situation or needs as we do not and cannot provide personal advice. Any views written about in this article are the views of the author who has no holdings in those companies or investments mentioned in this article.