Every year around this time, the Bank of International Settlements (BIS) delivers its Annual Report on the state of the global economy. It is always worth reading, in our view, and is full of a number of really important insights that investors need to be mindful of.
One such insight is the difference between those advanced economies that have de-leveraged since the Global Financial Crisis (GFC); and those that have not. On page 44 of the Annual Report, the following charts on credit and house price trends are displayed. These show (i) the cumulative change in annual private non-financial credit relative to GDP; and (ii) the cumulative change in real property prices – both over the most recent 11 year period.
The two colours to focus on are the red and blue lines.
- The red line represents the major advanced economies of the US, Europe, UK and Japan; and
- The blue line represents other advanced economies, including those of Australia, New Zealand and Canada.
Following the GFC, there was a significant divergence between the cumulative growth rates of the private credit between the major advanced economies and the smaller ones, including Australia. The difference is that the major advanced economies went through a multi-year deleveraging process; while the smaller ones did not. The smaller economies have simply continued to add leverage to their systems.
And what has been one of the by-products of this difference in leverage profiles? In the major economies, property prices reset. In the smaller economies, property prices have continued to inflate. Indeed, the smaller advanced economies are no different to emerging market economies, including China, on these metrics – which are represented by the yellow line.
The ongoing build-up in household debt is clear in Canada, especially when contrasted against the US, as shown below. Remember, credit is the change in debt. (Credit is a flow, while debt is a stock). So when debt growth accelerates, the flow of credit into the economy is growing. But when debt growth decelerates – even if it is still growing – the flow of credit into the economy declines. This decline in credit can cause recessions.
And Australia is no different in terms of household debt build up. Some have fairly asserted that Australia and Canada did not survive the last recession, it is just that their respective recessions have not yet happened.
What does the BIS have to say about build-ups in household debt? Well skip down to page 48 of its Annual Report and you will see an outline of a forthcoming research paper that finds that “an increase in the household debt-to-GDP ratio acts as a drag on consumption with a lag of several years.” The BIS confirms this finding based on a study of 54 advanced and emerging market economies over the period of 1990-2015: “Rising household indebtedness boosts consumption and GDP growth in the short run, but not in the longer run.” The simple intuition is that, while borrowing allows households to bring forwards consumption, it also creates a higher debt-service burden in the future.
The Australian economy is now in a precarious position, as illustrated by the chart below. Any increase in the cost of financing and household debt-service burdens could becoming unbearable. And remember, Australia’s banking system is largely financed offshore – therefore, the cost of financing is governed more by the Federal Reserve (Fed) and less by the Reserve Bank of Australia (RBA).
The Australian economy has a noose around its neck. It is not to say that a recession is imminent, but the risks have not been this high for quite some time. We remain cautious on the outlook for the Australian economy on this basis.
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.