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Buckle up Dorothy. Kansas is going bye-bye.


Buckle up Dorothy. Kansas is going bye-bye.

The warnings of an impending financial crisis are starting to come in from all corners.  So, maybe they’re worth listening to.  If the warnings materialise, Australia looks to be lining up for something much worse than anyone is anticipating, and we may not escape quite as easily as we did during the GFC.

According to Carmen Reinhart and Kenneth Rogoff – who studied eight centuries of financial crises in their New York Times bestseller, This time is different – there are four leading indicators of a crisis. I have also recorded a video which you can access here.

The first is a rapid inflation of asset prices, particularly residential housing.

The second is excessive debt accumulation, either by the government, banks, businesses or consumers.  The accumulation of debt almost always poses greater systemic risks than it seems during the boom, and the injection of cash makes the growth that results look more sustainable than it really is.

The third is outsized borrowing from abroad and reflected in a sequence of gaping current account and trade balance deficits.

Finally, the occurrence of slowing economic output.

Reinhardt and Rogoff studied eight centuries of financial crises and the above four factors are a strong signal of an impending financial and or banking problem.  Of course nobody is talking about the possibility of a crisis in Australia right now but three of the above four factors are in place. And if you believe the oversupply of apartments will be followed by a decline in residential construction activity, then deteriorating levels of economic activity are almost certain.

That would make four from four.

It goes without saying that property prices are going a little bananas in Australia. We have warned investors about the housing bubble now for a year and it’s getting worse.  Even the Reserve Bank of Australia is telling apartment investors to be very, very cautious.  Of course the bulls believe house prices cannot fall (factually incorrect), that Chinese buying will support prices (flawed weight of money argument) and that we are running out of land (high rise residential developments ensure millions of people can all live on a smaller piece of land and Singapore, the Middle East and the gold coast have demonstrated an ability to reclaim land from the sea.

The history of financial crises also reveals that borrowing binges occur. In Australia today, household debt to GDP is rising inexorably.  In 2014, household debt to personal income in Australia was a record 206% and has risen since.  Household debt to GDP is approaching 130%.  In the United States this ratio had been stable at 80% of personal income until 1993 before jumping to 120% in 2003 and 130% in 2006 – the year before their crises began.

It’s worth noting that work conducted by Bordo and Jeanne (2002) and the Bank of International Settlements (2005) confirmed that when housing booms are accompanied by sharp rises in debt, the risk of crisis is significantly elevated.

Over two decades, Australia’s household debt has increased more rapidly than household income. In 1990 household debt to income was 56%, by 2002 it had reached 125%. By April of 2014 it reached 177%. And according to the OECD it now sits at 206%.

And the inexorable rise in credit card and mortgage debt means that Australians have simply taken on more debt, typically to chase more expensive houses, and have less money to pay for it all.

The third criteria is a rising current account deficit.  Those who might suggest ‘this-time-is-different’ will point to globalization, for the rising current account deficit, that allows much larger surpluses and deficits to be carried.

Investors should remember, however, that a current account deficit simply means revenue from exports is insufficient to meet the cost of imports.

An examination of all 19 bank-centered crises since WWII reveals that the average current account deficit increases from 1% of GDP four years before the crisis to 3% of GDP in the year prior to the crisis.

In 2015, Australia recorded a current account deficit of 4.6% of the country’s Gross Domestic Product, compared to an average of 3.24% since 1960.

In the US, prior to the GFC, outsized financial returns were in fact greatly exaggerated by capital inflows.  In Australia today it could be argued that property returns are also greatly exaggerated by foreign capital inflows and for stock market investors the returns from dividends might also be exaggerated by the unsustainable dividend policies of companies that are failing to reinvest for future growth.

From the 19 post war banking-centred crises studied by Reinhart and Rogoff, they conclude that markedly rising asset prices, slowing real economic activity, large current account deficits and sustained debt accumulation (whether public, private or both) are important precursors to a financial crisis.

A week or two ago, in a report entitled Debt, Use it Wisely, the IMF’s Vitor Gaspar warned Australia over its soaring debt, alongside Canada and Singapore.  Mr Gaspar also warned Australia’s policy makers against complacency. “History has taught us that it is very easy to underestimate the risks associated with private debt during the upswing.”

Australia’s residential property construction boom is helping Australia’s economy but it is also masking a problem it is itself creating.  When an oversupply of apartments causes the prices of those apartments to fall there will be a slowdown in production (just as there was when iron ore became oversupplied and many thought that boom would last forever too).  When production slows down, fewer active construction sites means people lose jobs, spending contracts and the banks may find themselves holding mortgages whose profitability was built on hot air.


Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. Once upon a time, a man jumped off the top of the Empire State Building. Another person happened to be looking out of an open window on the 12th floor. As the man passed this window he shouted out ” so far so good”

    Your article Roger reminded me of this story!

  2. Thanks Roger,
    So, in response are you increasing your cash weighting in the Montgomery beyond the artificial floor of 30%?

  3. An interesting and thought provoking article, thanks Roger. And whilst I agree with you re the general direction of the argument I sense that inflation is still a long way off before it becomes a major concern and the same goes for interest rates. If property is overvalued (I agree) and cash isn’t providing a return where else would you put your money apart from equities and indeed those with a bias to yield?

  4. Hi Roger,
    Interesting indeed! I have clients who are now sitting on cash and are contemplating in buying property in Italy or France where they don’t seem to have the property bubbles we have. they are also doing it for a lifestyle investment. What do you think????

    • Hi Stef,
      I have contemplated it myself. The real estate and country side is magnificent in France and prices seem like a bargain compared to Australia so I do expect it to rise over time. A volatile immigration environment however makes owning property in a foreign domicile, especially Europe, a venture that requires very careful thought.

  5. Brett Stevenson

    Thanks Roger. Very helpful, and I agree that this is in line with most of your recent warnings re the ‘sizzling’ property market.
    Just a quick question in relation to the value of property in general as we look at the economy. We all can see that property has been the solid foundation of many peoples wealth over the last 30 years especially. It provides a solid base for loans etc.
    But is property a good indicator of economic strength? I can recall Adam Smith hinted (or perhaps stated clearly) at this by saying property (as in rental and residential property) is a very passive economic activity which doesn’t employ people, it just increases without anyone doing anything etc compared to other forms of economic activity which do require activity. In other words property increases are not necessarily related to strong economic foundations. Clearly you can argue with the way I have expressed the question but hopefully you catch the drift. I would appreciate your thoughts.

    • We all look back at how property has been the bedrock of wealth accumulation over the last 30 years. But keep in mind during the last thirty years interest rates have declined and been a huge tailwind for asset prices. With rates at all time lows and property prices at record highs one can only be dazzled by the possibilities if rates start rising for 30 years.

  6. Hi Roger! do you think small cap food related stocks like CKF, RFG and RCG (well they’re not food unless you end up eating sneakers!) will be as hard hit as , say, the banks? How about generral retail stocks like JBH?
    Sharon Hurst

  7. Very eye opening artical, i agree completly with your thought process.The one question you do not adress is HOW DO WE PROTECT OUR WEALTH BEFORE THE CRASH COMES. If you could give a detailed artical on this subject i think most of your followers would be greatful. Thanks

  8. Thank you Roger for the powerful analysis. Having agreed with your opinions here, could you please dig a bit deep into the forces that may turn Australia luckily away from the coming crisis? Or why Australia had its last financial crisis? What didn’t it do last time and what it can do this time?

    • Great queries Gang, Previously the government’s pink bats program, and school building revolution, helped keep Australia out of the worst of the global crisis but it didn’t help those who lost millions on their homes as entire streets (in Mosman for example) were listed for sale.

  9. Hi Roger
    Are you of the opinion that this is starting to play out in the Western Australia and will eventually move to the East?
    On another note, do you believe that Australia is at the end of Ray Dalio’s Long Term Debt Cycle?
    I look forward to your reply.

  10. Great article Roger. I suppose the alternate scenario is a rebound in resources and a bump in services industries fill the unemployment gap left by the construction boom in 3-4 years, and we potter along at near zero interest rates and low growth/inflation.

  11. Hi Roger,

    I had a question regarding this bit of the article

    ” … and the banks may find themselves holding mortgages whose profitability was built on hot air”.

    Wouldn’t the banks (try to) take the risk away from themselves by reselling the debt as RMBS packages to other investors and some Superannuation Funds buy into these products just for the yield?

  12. Easy money and easy returns have created a dangerous confirmation bias in my opinion. If you had a dollar for every Domain or Newspaper article showing sky high property returns for doing nothing as if it were some kind of genius or it was the status quo.
    With household debt at 206% that’s reaching a solid ceiling. The newspapers, media and general population seem to think it is like Charlie and the chocolate factory where the lift breaks through said ceiling as it drifts blissfully ever higher.
    As others have said it doesn’t take much to bring the fairytale back to reality.

    As a wise coke quaffing investor said:
    “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball.”

  13. Hi Roger

    this ‘end is nigh’ property crash talk has been going on for decades

    can I please ask for the purpose of objectivity;
    do you have any direct residential property investments?

    • Yes Simon. We have not been warning property investors for decades. Our property warnings have emerged relatively recently. Our previous warning was directed towards the iron ore bulls who said China would grow at double digits for 100 years. We see similar conditions now in property; record prices and an impending supply avalanche. How’d that work out for iron ore prices? We have not had to run semi-naked up Kosciusko!

  14. I used to work for Australian and New Zealand business that used to produce goods for sale, now look around you and both countries have been forced to move to a service orientated facility. Sadly this does not employ too many people and I guess no blue coloured workers. It used to be said about these two countries that the house and the car were the main attribures of living plus the freedom both still enjoy. But who do we blame for drying up our productive capacity and handing it over to countries with cheaper labor?

  15. Roger,
    Your recent warnings for conventional big-cap/blue-chip investors have me thinking is it time to cash in my chips,walk away from the table and retire to the sanctuary of the bar.

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