28 Sept 2022
Some have described Australia’s record run of 28 consecutive years of economic growth, prior to the covid shock in 2020, as an economic miracle. Unfortunately, such runs of economic success rarely come without a material misallocation of capital and resulting imbalances. This has certainly been the case in Australia, and similarly in other dollar-bloc economies like New Zealand and Canada, with the loose monetary policy and massive government stimulus during the Covid pandemic further amplifying these imbalances.
Our research shows that these economies face material structural headwinds to growth and inflation, with potentially negative implications for their currencies. As a result, we see an opportunity to exploit prospective policy divergence between the US and these dollar bloc economies over the next 6-12 months. We have therefore moved short these currencies versus the US dollar.
It was the prospect of policy divergence that drove our long US dollar positioning versus European (SEK, EUR & CHF) and Asian currencies (TWD & CNH), implemented in Q32021, which we subsequently closed in June once markets repriced. At the time the Federal Reserve was materially behind the curve on inflation, and we expected them to tighten policy swiftly. Conversely, we expected the People’s Bank of China to move into an easing cycle given deteriorating Chinese growth. European central banks were stuck somewhere in the middle.
We have avoided currencies within the dollar bloc (Canada, Australia and New Zealand) over the past 12 months due to aggressive hiking cycles by their central banks and supportive terms of trade dynamics (strength in commodities). However, in our view these dollar bloc economies are now vulnerable given large imbalances within their household sectors and housing markets.
Post 2008 the US saw a household deleveraging cycle with leverage as a percentage of GDP falling to 80% of GDP, from 98.4% in late 2007. However, within dollar bloc economies household debt to GDP continued to rise and has now reached 100% or more.
Total Credit to Households and NPISHs (%GDP)
Source: Federal Reserve Bank of St Louis, Ninety One, August 2022
Real House Price to Real Disposable Income Ratio
Source: Federal Reserve Bank of Dallas, Ninety One, August 2022
Fiscal handouts and the low interest rate environment of the pandemic years further exacerbated already inflated housing markets, with real prices appreciating over 50%1 since December 2019 in Canada, for example. These elevated prices, coupled with the easy availability of credit, mean that not only has mortgage lending grown quickly but also the size of this lending relative to incomes and property values has increased. In Australia, over 25% of new housing loans have been to individuals with debt-to-income ratios over 6x in recent years, according to the country’s central bank.
A higher proportion of floating rate mortgages in these economies also accelerates the impact of higher rates, which is a key consideration for Australia and New Zealand in particular. Central bank data shows they have 60% and 35% of mortgages, respectively, that are either floating rate or set to be refinanced within the final half of 2022, while in Canada over 50% of mortgages taken out since mid-2021 have been on discounted variable rates. Therefore, the feed-through of higher mortgage rates to consumption patterns is more imminent than in the US, where 90%2 of mortgages are fixed rate.
Considerable leverage, higher mortgage rates and stretched affordability increases the risk of a property market downturn. Given the large proportion of property assets within consumers net wealth in these economies, housing market weakness can also inhibit consumption and growth through the negative wealth effect. The IMF estimates that a 19% reduction in housing wealth in New Zealand could decrease private consumption by 2% and GDP by 1.3%.
Ultimately, these structural imbalances and vulnerabilities will make it difficult for these economies to sustain higher interest rates versus the US, which looks far healthier from a structural perspective.
This increases the likelihood of policy divergence over the next 6-12 months, with dollar bloc economies and their central banks more likely to come under pressure first as a function of higher rates.
Policy Rates (%)
Source: Bloomberg, Ninety One, August 2022
There is evidence that housing markets are already beginning to weaken within these dollar bloc economies as the impact of policy tightening feeds through. Mortgage rates have moved higher across these economies reducing individuals’ ability to borrow, dampening demand for new purchases, and increasing the cost of servicing current debt when refinanced. This will impact growth through the above noted wealth effect and weakness in property related services and construction. On the latter, extremes are also present with residential real estate construction in Canada now standing at over 10% of GDP versus its 70-year average of c.6%3. The equivalent number in the US, at the height of the nation’s real estate bubble in 2006, was about 7%, according to the National Association of Home Builders.
House Price Growth (%mom)
Source: Bloomberg, Ninety One, August 2022
An additional headwind for these currencies appears to be emerging as central banks continue to take interest rates higher and recession risks increase globally. It’s becoming increasingly likely that slowing global growth will place downward pressure on commodity prices and terms of trade for these commodity exposed nations.
These dynamics also have implications for rates markets within these economies and, where we are adding to duration, we maintain a preference for these markets as well as South Korea, which has similar domestic challenges.
General risks: The value of investments, and any income generated from them, can fall as well as rise. Where charges are taken from capital, this may constrain future growth. Past performance is not a reliable indicator of future results. If any currency differs from the investor's home currency, returns may increase or decrease as a result of currency fluctuations. Investment objectives and performance targets are subject to change and may not necessarily be achieved, losses may be made. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
1Federal Reserve Dallas Real House price growth 31/12/2019 – 31/03/2022
2Mortgage Bankers Association
3 Statistics Canada: Canadian Residential Investment as a share of GDP