Kuta Beach

Kuta Beach

Saturday, 17 April 2010

Double Dip Recession and the Housing Crisis

The future is very uncertain. I have lately become increasingly worried about the economy, mainly worrying about the possibility of a double dip recession or a house price crash (or both).

I will first talk about the possibility of a double dip recession, which I think may be likely to happen because the miraculous recovery we have seen lately in the world economy may be the product of government stimulus, which involves nothing but the movement of money. Moving money around from the people to the government and then back to the people doesn't actually do anything. If governments around the world go into debt trying to stimulate their economies, these debts will have to be paid back in the future, which means governments will have to increase taxes, which stifles economic growth. (Imagine if income tax increased to 70% to pay for government debt. Would anyone bother working?) There are also worries that the Chinese economy may be overheating. I happen to think that much of Chinese economic growth is real because, based on my understanding, Chinese competitive advantage is in cheap labor, which is a real form of productivity enhancement. If you can halve your labor costs, that makes a real and significant difference to profitability. However, even is China is genuinely growing, perhaps investors have been too enthusiastic, which is why I am worried.

Based on the previous Great Recession and credit crunch, only one or two years ago, stocks are the worst place to invest. Stock markets all over the world went down peak to trough by about 50 per cent on average. The safest place to be was in cash or bonds. Since my portfolio is currently 77 per cent stocks, I think it's time to start buying more bonds!

A credit crunch results in falling asset price values as people with massive debt need to sell off assets to raise cash to pay off their debts. This is why we saw during the Great Recession prices of stocks and property fall and why cash was king. This occurs when private debt is high. But what happens when government debt is high? One worry is that private debt can be absorbed by the government, e.g. with bailouts. Citizens can go into massive debt and a credit crunch hits. Government can respond by stimulating the economy by giving money to people, which helps them pay off their debts. The problem is that government itself goes into debt. One way to fix this is to tax heavily, which retards future economy growth. If you think this is likely, going into cash and bonds is safest. However, some people suggest that government pays of its debts by printing money, which is quite dubious but not entirely unbelieveable. This will reduce the value of cash and bonds, leading to inflation, which increases stock, property, and especially gold prices. In my opinion, the threat of inflation is best countered with hard assets like land, resource stocks, and precious metals. Land and precious metals are very expensive now and perhaps overvalued. Resource stocks are historically cheap but buying resource stocks is not necessarily the same as buying the resource itself. E.g. buying shares in a gold mining company is not the same as buying actualy gold since the value of the gold mining company depends on many factors other than the price of gold. However, this is something I'm willing to risk. I have no physical precious metals or land. Approximately 30 per cent of the ASX200 is made up of resource companies, so investing in Australian shares I hope provides partial protection against the possibility of inflation. If you want to be fully invested in resource stocks, there is a new ETF now listed on the ASX with ticker symbol RSR, which invests in all the resource companies in the ASX200.

Another issue that needs to be addressed are house prices in Australia. House prices here are very expensive. If house prices plunge, many governments may be unwilling to lend to Australians, which can cause the Australian dollar to plunge. This won't necessarily be a problem for Aussie miners like BHP whose products become cheaper for overseas buyers if the Aussie dollar depreciates. Hence I think a good way to hedge against a plunge in Australian house prices is to once again go into resource stocks, so buy RSR! But suppose house prices do not plunge. Suppose they continue to go up or stay where they are for a long time. I think that if this happens then private debt levels will be huge because higher real estate prices mean buyers need to go into massive debt in order to afford their dream homes. More mortgage debt means more profit for the banks. The banks in Australia with the greatest exposure to mortgages are the Commonwealth Bank and Westpac. The big banks are the biggest winners from a property price rise. Many landlords think they are screwing renters because renters are throwing money at them. Landlords are indeed screwing renters but banks are screwing landlords. Unless the landlord buys out the house outright with cash (which is rare) then the landlord will pay a large portion of their rental revenue to the banks. In fact, many landlords love to negatively gear their property, which effectively results in a transfer of money from taxpayers to the big banks. It is highly unfair system with the big banks at the top, but the big banks in Australia are public companies, so anyone can become shareholders. If you think house prices will boom, I think investing directly in the banks or buying a financial-sector ETF like FIN is the way to go. Since the ASX200 is about 40% financials, 30% resources, and 30% other sectors, I happen to think that buying an ETF that invests in the broad Aussie stock market (e.g. STW or VAS) prepares you for both a house price crash and a house price boom. You're covered either way.

To wrap it all up, I am worried about a double dip recession, but because I think the government will try to avoid a double dip recession by artificially creating a boom, it is a good idea to bias your portfolio a little bit towards stocks rather than bonds and cash, and if you are comfortable then adding precious metals is a good idea (ETPMPM on the ASX buys a mixture of gold, silver, platinum, and palladium).

I am not entirely sure where the economy is heading. I recommend that people be skeptical about people who claim to be able to predict the economy. I prefer to think about the possible problems and then work on trying to preserve purchasing power based on possible future problems.

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