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While most investors today probably understand that Europe isn’t exactly a poster-child for prudent government spend-
ing or budget planning, we’re not sure that the consensus is bearish enough on the spillover effects from a prolonged
European Debt Deflation. Exports are still the foundation of the China story, but with their largest customers still lying
in intensive care, we doubt appetites for cheap Chinese goods will be quite the same. At the same time, strategists today
are still debating whether or not the massive, credit-induced spike in Chinese real estate prices is in fact, a bubble. We’ll let
investors answer that one for themselves, but consider that the ratio of residential real estate to GDP in China looks a lot
like California in 2006, while levels in Beijing and Shanghai match the Japanese peak in 1990.
Market participants around the world have obsessed over every blip in Chinese economic data for the better part of the
last decade; and rightly so, as China has been a rare source of strength in a fragile global economy. This year, the Shanghai
Composite is among the world’s worst performing equity markets, as the government’s visible hand has taken measures to
curb speculation, dampen money growth, slow loan growth, and launch an aggressive attack on housing prices. Leading
indicators of Chinese growth have responded accordingly, and have been slowing along with the stock market since last
fall. We view this speed bump in the high-growth China story as an important leading indicator for global markets and
explore one such consequence Down Under, in this letter.
The recurring theme in every case is that housing bubbles are almost always justified by “new era” thinking, land shortages,
and are considered unique right up until the moment they pop. Most bubbles around the world have at least partially de-
flated in the wake of the Great Contraction, yet the property market Down Under continues to chug along ignoring the
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gravitational forces of mean reversion as Aussie consumers continue their American-inspired credit binge. US housing
prices nearly doubled in the decade leading to their ultimate peak as shown in the above chart. Australian real estate kept
pace with these gains until US home prices lost nearly a third of their value as US home owners deleveraged their balance
sheets. Since then, Australian households have watched their home prices appreciate by at least that much, while they con-
tinue to feast at the trough of easy credit.
Here We Go Again
Whack A Banker
Demand for new home loans fell to a nine-year low in April as rising interest rates dampen enthusiasm for housing. The
number of new home loans has fallen 26 percent since its recent peak in June 2009, a leading indicator for housing. With
a lag, you would expect these numbers to flow through to building approvals, housing starts and ultimately prices. Higher
interest rates are starting to bite with new home sales dropping by more than 6 percent in May 2010 and average loan prices
declining, according to Australia’s Housing Industry Association (HIA). Sydney’s most recent auction clearance rate fell
below 50 percent and remained flat in Melbourne, with both posting their lowest rates since December 2008.
struggling to meet payments, with 40 percent of those who took advantage of government subsidies reporting some de-
gree of financial stress. Initial mortgage payments for a home in Sydney or Melbourne absorb more than half of the aver-
age family’s disposable income. Yet, the potential for even a pause in ascending real estate prices is seldom considered as
the local media often maintains that Australia completely dodged the Great Contraction. It appears that the great majority
of home owners in major cities discount the possibility of a bubble in their own backyard, despite warnings from Jeremy
Grantham, speaking in Sydney and Melbourne last month, that the housing market is a “ticking time bomb.”
Investment Implications
Australia’s housing market have aggressively increased housing loans in recent years, such that residential real estate expo-
sure now represents more than 11 times tangible equity. Not exactly what we’d call a Margin of Safety.
Stress tests are all the rage in the wake of the Great Financial Crisis as central banks around the globe rush to assure inves-
tors that the balance sheets of their nation’s banks are sound. In early 2009 results in the U.S. sparked a monster rally in
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risk assets as market participants blindly accepted the promise of regulators. By the end of this month, we should also hear
similar promises out of Europe, although we would encourage prudent investors to view said “strength” with a healthy
dose of skepticism. This is simply a public relations program. Similarly, we find it a tad suspect that the industry-wide tests
conducted by the Australian Prudential Regulation Authority concluded that not a single bank would have breached their
minimum capital requirements under their “severe but plausible” scenario. Upon closer inspection, perhaps this shouldn’t
come as a surprise considering the very banks that are being “stress” tested, applied their own models to the tests. One
particular management team even assured investors on a recent conference call that, “Nothing is likely to have an impact
that would cause us to have to raise any capital.” We are not as confident. Our analysis indicates the potential for severe
stress should housing prices revert to normal, let alone overshoot. We wonder how the currency would react should Aussie
officials be forced to recapitalize the banking system, given investors’ current optimism on the AUD as reflected by this
CSFB survey.
Bottom Line
A disorderly unwinding of China’s credit and property bubble may well be the principal global macro risk today. While
all eyes are on Europe, it would certainly have the potential to catch investors by surprise. But such an unwinding is not
necessary to have a noticeable impact on its largest supplier. In macro, what happens at the margin matters most. Many
argue that a slowing of Chinese GDP growth from 12% toward 8% still represents an exceptional growth rate for the
world’s second largest economy. We suggest that investors focus instead on the 33% decline in the rate of growth, which
will have a comparable effect on China’s demand for (Australian) commodities. Any significant reduction in said demand
could easily provide Australia’s property bubble with a Chinese Pin. Then again, bubbles of this magnitude often collapse
under their own weight as gravity pulls valuations back to earth over time.
One of the ways we seek to earn superior returns on our capital is by developing thoroughly researched macro themes that
are different than the market’s general perception. We are often looking at the same information, but different conclusions
provide us with an opportunity to position accordingly - and wait for the market to play catch up. Mean reversion is always
a good bet, although timing is always uncertain. Today, the consensus remains whole-heartedly in the bullish commodity
camp based primarily on China’s insatiable and uninterrupted appetite for resources. We have invested considerable time
exploring cheap hedges to profit from a speed bump in Chinese demand and another deflating property bubble (or two).
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While we remain constructive on the long term prospects for commodities and other real assets, buying a little insurance
in the face of near term cyclical risks seems like the prudent thing to do, particularly since market participants have again
forgotten that prices are capable of moving in a direction other then up. Since last October, the Reserve Bank has raised
interest rates 6 times. JPMorgan and others are forecasting Australian cash rates to move from the current level of 4.5%
to 6% by next year. We think this is highly unlikely in light of the risks noted above and especially while the rest of the
developed world hurdles towards deflation. The odds of at least one of these bubbles bursting increase with every central
bank tightening. This sequence of events would have interesting consequences for Australian interest rates, currency and
highly leveraged home lenders.
The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The author’s opinions
are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice
or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of
any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not
guaranteed.