Is there another asset price bubble in the making?

Matt Drennan asks whether events in the market today are, inadvertently or otherwise, paving the way for another asset price bubble sometime in the future.

Asset price bubbles pose a vexing question for for any central bank - to intervene or not. 

Alan Greenspan strenuously argued at the turn of the century that monetary policy should not try to lean against asset-price bubbles, but rather should just clean up after they burst.

Basically there are two sources of asset price bubbles.

The first is driven by excessive credit growth and a lowering of lending standards - such as in the lead-up to the Global Financial Crisis (GFC).

The second is just pure irrational exuberance from investors driven by the fear of missing out (the TMT bubble).

While the second type is typically supercharged in the latter stages by credit growth, this is not its genesis.

Despite the generally benign view leading up to the GFC, the "clean-up" process now underway across the world (and to a much smaller degree locally) may well be sowing the seeds of the next asset price bubble, at least locally.

Due to a panicky series of belated interest rate cuts by the Reserve Bank of Australia in the second half of 2012, the local equity market is beginning to look very attractive on both a yield and a valuation basis.

Local forecasters are falling over themselves to upgrade return expectations for 2013, with a 5,000 handle on the All Ordinaries by year end becoming commonplace.

The vast sums of cash which have been sitting on the sidelines for so many years are now beginning to flow back into stocks as other investment opportunities lose their lustre.

What about the real economy?

Most concerning about the current state of the local economy is the subdued level of business confidence and productive investment outside mining.

The "she'll be right" attitude of the government to the mining boom as a cash cow and sugar daddy of Australian investment has been exposed for what it is: a short squeeze which has now been largely addressed by global investment here and elsewhere.

As Australia became increasingly complacent about global investment into our mining industry, other more cost-effective destinations were being sought.

Adding impetus to this trend are our complex approval processes for new projects, a deteriorating industrial relations environment, and the discovery of large-scale shale gas reserves in the US.

Suddenly  we find ourselves in a situation where the only boom industry Australia had is shelving multi-billion dollar investment plans and shedding labour. 

While recent interest rate cuts are aimed squarely at reviving investment and confidence in the real economy, almost without fail the first port of call in such an environment is to push up asset prices.

The beginnings of this were evident in the second half of last year as the equity market finally experienced a meaningful recovery and housing prices began to stabilise.

In time this will flow to consumer and business confidence and help bolster the key stalwarts of the economy - investment outside mining, consumption and employment.

The real fear though is that any recovery in confidence will be largely blunted by counter-productive government policy.

Witness the ANZ Job Advertisement series signalling unemployment is likely to rise towards 6 per cent over the year ahead.

Until recently, the most blatant example of counter-productive policy was the fantasy of returning the Budget to surplus in 2012/13.

As the harsh accounting realities finally hit home and this "no ifs, no buts" promise was abandoned, other equally worrying issues have become the focus.

Working days lost per thousand employees due to Industrial disputes were 302 in the year to September 2012, an increase of 41 per cent on the previous period.

While still well below the nightmare years in the 1980s, surely this is not our benchmark in the 21st century. In addition, wage demands in many sectors are unrealistic and well above inflation.

Compounding all of this is a myriad of well intentioned but often misguided government policy initiatives.

Large-scale spending commitments with no visible means of funding support abound - the National Disability Scheme and the new school funding program are among the more expensive examples. 

Even initiatives which don't cost billions are being mishandled and undermining confidence. Nicola Roxon's ham-fisted attempt to consolidate and streamline national discrimination laws is a prime example. 

While it is clear that the mining industry will not be the messiah for the Australian economy going forward as it was during the GFC, the chasms which its largesse hitherto papered over are now exposed for all to see.

It's the currency, stupid

With the Australian dollar now having been fairly consistently above parity with the US dollar since 2011, whole industries are being decimated and will never return to their previous glory days.

The traditional retailing model is broken, while local tourism is on the skids.

The currency is merely compounding the well-established woes in what is left of our manufacturing industry. Announcements of forced redundancies are now virtually a daily event.

Initially of course the main drivers pushing the the Australian dollar higher were the inter-related factors of the mining boom, no GFC-induced recession and Australia's low public debt.

Ongoing foreign direct investment to fund previously approved LNG projects and the like remains a dominant force keeping our dollar at elevated levels.

Now, however, additional drivers include the elevation of the Australian dollar to reserve currency status, along with competitive devaluations elsewhere as governments seek to monetise their debt.

Although foreign central bank holdings of Australian public debt peaked at around 30 per cent in 2011 (ANZ Bank study), they are still well above the median holdings for the rest of the world.

Adding to the Australian dollar's attraction is an anticipated resurgence in the world economy, with the US once again "kicking the can down the road" (rather than addressing any fundamental problems); the Chinese leadership transition complete; and yet another massive $109 billion pre-election stimulus package from Japan.

None of the these measures are particularly convincing, but at least they break the negative news cycle and provide some positive momentum for the global economy and markets.

The most unproductive asset of all

While most of the tidal wave of foreign investment into Australia has found it's way into mining projects and Government bonds, there is increasing evidence that real estate and selected listed assets are gaining attention.

House prices in major Australian cities are already wildly overvalued by global standards.

But given our higher home ownership levels, strong immigration flows and the continuing under-supply in new dwelling construction, is this a bubble likely to burst any time soon?

The vast majority of us who have the majority of our personal wealth tied up in housing certainly hope not.

Local buyers are being lured back into the housing market by record low interest rates which make it attractive relative to renting.

Prices have begun stabilising in most capital cities and 2013 could see significant upside - providing unemployment doesn't spike aggressively. 

The bottom line

My money is on a pretty good year in 2013 for both local equities and real estate.

Unfortunately, if you are running a business that depends on a sustainable pick-up in the real economy, you might be waiting a little longer.

Matt Drennan is a principal at Clarence Advisory.