News } Tabak

Caution offshore – good to be home

TBK View Newsletter: September 2010

Home, home again.
I like to be here when I can.
When I come home cold and tired
It's good to warm my bones beside the fire.

To see the Pink Floyd video click here

Caution offshore

In a previous newsletter Mixed messages from offshore I said “According to a Bloomberg survey of users on six continents, confidence in the world economy rose as an acceleration in manufacturing and service industries signaled a sustained recovery from last year’s recession.”

And later under the heading Bubble, bubble, toil and trouble I said “We’re now starting to see concerns about a negative side to the massive economic stimulus program introduced by governments to shield their economies from the fallout of the global financial crisis.”

Well now it looks like the international economic scene is starting to falter. The European and U.K markets are still struggling and here is talk of the U.S. economy slipping back into recession.

Other than the currency, the effect on the New Zealand economy probably comes down to two things – export volumes and prices, and the reliance on our banks for offshore funding.

Rodney Dickens’ Ravings covers these in depth. As far as exports are concerned he points out that the leading indicator analysis he follows is “starting to ring warning bells. There is a real risk that stalling U.S growth, which could turn into a double-dip recession, will send negative multipliers filtering around the global economy over the next few quarters.” His charts show international - and New Zealand specific - commodity prices are showing hints of weakness.

His analysis of the situation in the U.S. includes an in-depth discussion on their housing market where the Global Financial Crisis first started. He says “Residential building activity impacts on a wide range of other industries (e.g. a host of manufacturing industries, a wide range of trades and lots of other service industries). Cycles in existing house sales impacted on a number of service industries (e.g. lawyers doing conveyancing, valuers and bank lending), but more importantly drive cycles in house prices that impact on the wealth and spending of a large proportion of the population. If the number of existing house sales and residential building activity turn up it sets in motion positive economic multipliers that filter around the economy, with this being a part of the U.S. growth story over the last year. But if housing activity turns down, as it is starting to do in the U.S. because the “steroids” have run out, it will set in play negative economic multipliers”.

The “steroids” Rodney refers to are the U.S. government tax incentives introduced to boost economic activity.

He points out there are other things to be worried about in the U.S. including the banking sector problems from falling house prices where banks own millions of houses that have been foreclosed, and the constraint they are “still having on especially small and medium-sized enterprises (SMEs) that are largely reliant on bank funding.”

The implication of the persistency of the financial crisis is the ease and cost of access to overseas funds for New Zealand banks which rely significantly on overseas funding. “We are not predicting another meltdown in the international financial system, but if the U.S. economy experiences a double-dip recession rather than just a growth slowdown, there will be negative implications for the U.S. banking sector, which will have some implications on NZ financial conditions” he says.

To read Rodney’s Ravings click here.

But is it bad here?

For all the negativity out there we’re starting to see signs of things looking better here. Some examples:

As mentioned above the housing market leads the economy, and I have recently seen some serious sales in the high end residential real estate market here in Auckland. Buyers holding back for bargains are being disappointed as the house is simply taken off the market, and those who are serious buyers are making sound purchases.

South Canterbury Finance going into receivership finally gives some certainty to a question that has been hanging over the market for many months now. The receivership triggered the retail deposit guarantee, and the government extended it to include all deposits in the lender. This includes technically “ineligible” foreign and other depositors, on the grounds the government wants unimpeded first ranking status to help sort out the SCF mess. The immediate payout is a massive infusion of equity in the market. The government will ultimately become the sole beneficiary of the firm giving it full control over any sell off or recapitalisation. To read the NBR article on the positives click here.

If I left the office at 5:30 a few weeks ago it was dark. Now when I leave its light. It’s September. Spring is here.

How interest rates are determined

We all know how important the housing market is for the economy and how it leads an upturn or downturn. We also know how important interest rates are in determining residential and commercial property prices and business activity. So let’s look at where interest rates seem to be going.

The Westpac economists Brendan O’Donovan and Dominick Stephens have published a series of articles on interest rates which should be compulsory reading for everyone who is in business (or owns a house). And it’s of particular interest bearing mind the implications of how our banks rely on offshore funding (as mentioned above) and the shortage of debt funding as a result of the demise of the finance companies.

They discuss the conditions before the Global Financial Crisis and after. Here’s my view of the most important conclusions from the four published so far.

The first article “Before and after” explains how the banking system operates (obtains the funds to lend). Banks here obtain funding in three basic ways, retail deposits (only 60% of funding) and the short and long term wholesale markets. Short term wholesale funding is volatile and exposed to rollover risk so banks will now have to pay more for retail deposits and long term wholesale funding.

The second “A matter of interest” examines the practical implications of the new interest landscape. The New Zealand Reserve Bank cannot permanently alter the market determined interest rate while simultaneously keeping inflation stable. So lowering the Official Cash Rate will not reduce the banks’ cost of funds and consequently the cost to borrowers. Over time New Zealand lending and deposit rates will be higher than they would have been previously.

The third “Neutral about neutral” examines the ideal rate for the OCR. There is a yawning amount of spare capacity in the economy and the OCR should be low for a while. But whatever neutral is or isn’t we are a long way from it.

The fourth “Average borrowing costs” predicts more people will migrate to fixed rate mortgages. The OCR will have to be pushed harder to get the desired traction on average borrowing rates. It will ultimately have to head towards 5.75% over the next few years if the objective was to get borrowing costs back to their historic average of 7.7%.

To see these pick on the articles under NZ Economic Bulletins here.

So what’s all this mean? Bearing in mind the international troubles mentioned above, expect no increase in the Official Cash Rate until next year but interest rates to gradually rise.

Opportunities are here now

About a month ago Anne Gibson wrote an article in the NZ Herald entitled Surviving when the money dries up. She quotes Property Council chief executive Connal Townsend mourning the lack of cash for investors, let alone developers. “It's really, really, really difficult to get money. Development depends on finance and we don't have any finance companies left any more. The property market's access to capital has been challenged by the collapse of mezzanine funding and the reluctance of banks to provide debt financing to developments.

"Banks are looking to fund quality deals but are applying a more conservative approach than previously, given the high cost of capital in the short to medium term. Some listed property vehicles are turning to alternative funding models, including the corporate bond market. Others will no doubt look to sovereign wealth funds, offshore investment and KiwiSaver."

"However, property is performing well on the NZX compared with other portfolios", Townsend said. "Wealthy, long-term property investors with cash stockpiles remained the main influencers on real estate. Big purchases by fellow multi-millionaire investors John Sax of Auckland and Tim Glasson of Christchurch are some of the few big deals."

To read the article click here.

However the lack of debt and equity available brings opportunities. So if you’re interested in talking about them, reply to this email or call me on 021 902 001 any time.



John Paine
TBK Capital Limited


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