THE RETURN OF THE ECONOMIC CYCLE
"To each season, turn, turn." Bob Dylan
WE are all conscious of the cycles of nature and seasons. Until quite recently, the economic cycle was regarded as another one of life's certainties.However, the prolonged expansion of the last decade has fostered the belief that central bankers have now become so skilled in managing the global economy that cyclical ups and downs are a thing of the past... Perhaps, not:
In many countries, old fashioned "saving" has largely been replaced by a philosophy of borrowing to invest - whether it be in the stock market or in property. AND in a world of rising asset prices, this HAS BEEN the most lucrative strategy to pursue.
BUT such a strategy is dependent on two things:
- Relatively low interest rates; and
- Rising asset prices.
If either (or both) of those two factors changes, then this strategy might not be the cleverest move. (If the rules of the game are changing, it is time to rethink.)
Recently, I was having a discussion with a real estate agent whom I knew. He was the proprietor of a large agency and was on the verge of retirement.
He was dumbfounded by what was going on: he had two valuers employed to value primarily owner-occupied properties. The owners of these properties were using the higher value of the properties to borrow against them - for investment or for consumption.
In the course of more than 45 years in the real estate business, he had seen many booms and no shortage of busts. In his opinion, the behaviour of many of his clients was excessively risky.
The major risk was that the value of their properties could move downward, because he felt that the rental returns available were lagging way behind the rise in purchase prices.
Many of his younger clients had never experienced a significant property downturn and believed in "the safety of numbers" - they were just behaving as many of their friends were behaving. Since they lacked the older agent's life experiences, they judged their behaviour as merely "the norm". With his far longer experience in the industry, he saw things differently.
One unintended consequence of an extended period of economic expansion is this altered
Psychology; if you have never seen a rainy day, why would you need to invest in an umbrella?
Many younger people have no memory of a downturn, and therefore have a reduced recognition of risk. From their point of view, the economic sun always shines - because that is their personal experience.
The older man knew that prices could move both ways and was far more cautious. His clients just saw property prices rising rapidly and a major boom in the stock market from resource investments. They were acting correctly in light of their experience, and he was assessing it in light of his experience - the only difference was in what they had each seen.
However, Globalization is two-edged sword. We can reap a massive boom from exporting our resources to rapidly growing countries such as China (and India to come). And we can be similarly affected by a mess in subprime mortgages in the US.
But previously, if some American banks or non-bank lenders made some risky loans to people who could not pay them back, it was their problem. But now the problem isn't just restricted to individuals, or even America. It's gone global.
What has happened now is that those loans have been packaged up and sold to financial institutions across the world - with problems emerging in German and French banks, large Chinese banks holding $10 billion of the subprime loans and some Australian hedge funds ending up in a mess.
The other side of the deal was that the people making the loans were mainly interested in getting their fees, since they knew the loans were going to be packaged up and sold. So far less care was taken to make sure that the borrowers could actually afford the mortgages they were taking on. Once interest rates rose in the United States and house prices started to fall, a large number of people were in trouble. These loans started becoming more and more people's problem.
The problems were worsened because in some areas such as Florida, there was major speculation going on. Large numbers of apartments were built for "flippers" - people who never intended to live in the apartments, but were buying them off the plan with the intention of selling them on completion for a profit. This type of market has collapsed, and when it did there were large numbers of empty apartments up for sale, and the formerly eager buyers were looking to see if they can get out of their contract.
Most of the American commentators seem to be forecasting a worsening of the housing crisis, and a recession in the United States seems to be a likely possibility. In this chain of events, further fallout in all sorts of markets across the world is on the cards.
September 9, 2007
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