Weekly Broker Wrap: Property Investment, Regulation Reform And Bond Proxies

This story features HARVEY NORMAN HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: HVN

-RBA worries about SMSF property
-Is regulation the answer?
-Housing boom led by investment
-Residential developers best placed
-Bond proxies as an Australian strategy

By Eva Brocklehurst

There is little evidence of a broad based recovery in Australia's economy, yet the market has been buying domestic cyclical stocks with some enthusiasm. Valuation multiples for domestic cyclical stocks are not low, with the average price/earnings ratio now at a premium to the broader market. UBS argues for caution, given the combination of high P/Es and little evidence of an economic turning point. Better employment prospects and sustainable business investment need to be in evidence, not just as a knee-jerk reaction to a change in government. Having said that, the broker is still favourably disposed to some domestic cyclicals and includes Harvey Norman ((HVN)), JB Hi-Fi ((JBH)) and Asciano ((AIO)) in this grouping. Housing remains attractive given the clear turn-up in housing data but elsewhere the domestic cyclical trade is seen running ahead of the economic reality.

There are risks in the property market. Citi notes the RBA's latest financial stability report highlighted growing concerns about property, in particular the growth of property investments by self-managed superannuation funds (SMSF). The RBA voiced concerns that the SMSF sector represents a vehicle for speculative demand for property that did not exist in the past. One that could potentially exacerbate property price cycles. SMSFs represent one third of Australia's $1.6 trillion in superannuation assets and they allocate around an average 15% of a portfolio to direct property. Legislation drove some of this concentration but low interest rates also played a part.

In Citi's view the RBA's report sets the bar higher for further official rate cuts. The central bank cannot raise the cash rate because of the strength of the Australian dollar and the potential for a further rise in unemployment. But equally, the strength of the property market inhibits further cuts to the rate. The only option for the RBA, in the broker's view, is to stay its hand. Despite the RBA's concerns about banks needing to maintain prudent lending standards and the growth of property investing by SMSFs, there is no mention in the report about drawing on macro prudential tools to manage these risks. For now, jawboning is the cure. Citi thinks the new government's foreshadowed inquiry into the financial system could consider the merits of past legislative changes that are helping drive SMSF asset allocations down a potentially risky path.

Macquarie has taken a look at macro prudential regulation as a way to limit gains in house prices and credit, while at the same time keeping interest rates low to support weak economies. A number of countries are doing this but the broker does not think it is likely to be introduced in Australia, at least in the short term. Firstly because the officials don't think there's a house price bubble. Secondly, the introduction of such rules would be the responsibility of the Australian Prudential Regulatory Authority (APRA) rather than the RBA. In Macquarie's opinion, APRA would prefer to work behind the scenes to change lending practices rather than introduce hard and fast rules.

If New Zealand's adoption of macro prudential policy is deemed a success, and Australian house prices accelerate further, the authorities may start to consider adopting rules here late in 2014 or 2015. Over recent years several economies, including Canada, Sweden, Norway, Israel, Korea and Hong Kong, have introduced macro prudential regulations, mainly by restricting lending with high loan-to-valuation ratios. What attracted these regions to such policies, in Macquarie's analysis, was reducing the banks' ability to play the system, rather than the impact on overall financial stability or the credit and asset price cycle. The concept is gaining merit internationally and the IMF recently argued that such policy is highly relevant for those authorities in both advanced and emerging economies seeking to offset some of the effects of extremely accommodative monetary policies.

Record low rates, improving confidence and tight housing supply provided the platform for house price inflation in Australia. UBS notes house prices are up 6.4% in the year to date, led by Sydney where prices are up 9.4% and auction clearance rates are at 85%. This scenario is likely to continue. The housing boom continues to be led by investment property which has seen both stronger lending flow and credit growth. UBS thinks this is not unusual at this stage of the cycle but the heavy exposure of the banks to this segment is more worrying.

Australian banks have a lot more investment property than they do in New Zealand or the United Kingdom. UBS compares all three, noting the similar culture, demographics and home ownership. Investment property contributes 32% of Australian mortgages, 20% of NZ mortgages and 12% of UK mortgages. Bank data implies 57% of Australian landlords are leveraged compared with 28% in NZ and 3% in the UK. Negative gearing tax deductions may explain some of the difference, as this is not permitted in the UK, but differences to NZ are harder to explain. Moreover, NZ does not have capital gains tax. Statistics from the Australian Tax Office and the run-off in line-of-credit mortgages suggest the vast majority of Australian landlords are low-to-middle income earners. For UBS, this implies Australia has a much higher proportion of investment properties purchased for speculation and tax minimisation, rather than for rental income as seen in other countries.

This is the one area of Australia's economy where the evidence for a  recovery is stacking up. Housing finance, building approvals and house prices are all heading upwards. From this, Citi sees upside for the listed residential developers such as Australand ((ALZ)) Stockland ((SGP)) and Mirvac ((MGR)), underlining a recovery in operating profit margins. It was the narrowing of margins, not price or turnover, that had the biggest negative impact on developers in recent years. It won't be all smooth sailing. The broker thinks a recovery in operating margins in FY14 and FY15 for both Stockland and Mirvac will be impeded by an accumulated capitalised interest balance and the working down of impaired inventory. This will dilute some of the return investors would otherwise have enjoyed. Australand looks to be the best placed of the three. Australand benefits from a lower level of impaired inventory and lower accumulated capitalised interest, with the most leverage to a recovery in price and volume.

The consensus view is that the US Federal Reserve's tapering of bond purchases would have signalled a durable recovery. Mere talk of tapering caused bond yields to rise sharply and the negative effects of the rise in yields on housing and consumption began to surface. Credit Suisse thinks policy makers must either stay behind the curve, and allow the slowdown to materialise, causing wholesale asset re-allocation out of equities and into bonds, or they get ahead of the curve by lowering bond yields and expanding fiscal deficits. Either way, there is room for bonds to rally.

The broker is positioning for a rally in bonds. Therefore, in terms of Australian strategy, Credit Suisse likes defensive bond proxies such as A-REITs, utilities, telcos and consumer staples. If the US policy makers run ahead of the curve, the broker also sees a case for exposure to large cap resources stocks on the back of resulting US dollar weakness. From an Australian perspective, each time US real yields fall, the AUD/USD tends to appreciate. Credit Suisse notes this undermines the Reserve Bank's policy, because recently, the RBA has been relying on AUD/USD depreciation to help the economy to adjust to slowing conditions in the mining sector. Faced with a currency that is moving in the wrong direction, the RBA may be forced to cut rates even further to either bring down the currency, or compensate for its perverse movements. Australian interest rates and bond yields are likely to remain highly correlated with US bond yields, and domestic cyclicals, banks and US industrials have all become quite expensive in the broker's view.
 

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