One market that will be absolutely crushed by higher interest rates

Australia has not had a recession since 1991 – the tech bust and 2008 financial crisis left it unscathed. But now a crash could be coming. John Stepek explains why.

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Sydney has suffered an epic house price bubble
(Image credit: © 2016 Bloomberg Finance LP)

I was at the Sohn Conference in London the other day.

It's a clever idea. A series of experienced investors go on stage and each gets 15 minutes to outline the case behind one or two of their "best" investment tips. Their peers pay handsomely to watch them and network afterwards, and it all goes to charity.

And a lot of interesting tips come out of the show. I discussed a few of them this time last week in MoneyWeek Unlimited (our subscriber-only email).

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But there was one interesting "short" idea that I wanted to knock about today. It's not necessarily something you'd want to attempt yourself. But the background to the story and why it's failed before is an interesting one.

We're talking about the land of the apparently indestructible economy.

Australia...

The (as yet) impervious Australian housing bubble

You could almost hear the collective eye-roll from the audience. And the speaker was prepared for it. He proceeded to outline a pretty convincing case against the bubble that just won't die the Australian housing market.

Here's a quick recap. Australia has not had a recession since 1991. That's an investment lifetime for many of the people reading this. It's a period that has included both theAustralia has not had a recession since 1991. Quite impressive.

Like many other countries around the world, Australia has also enjoyed an epic house price bubble. Unlike most other countries (including even Britain, albeit briefly), it hasn't suffered anything that could be described as an equally epic crash.

According to various measures and indices, Australia's major cities are among the most expensive in the world. In the UBS Housing Bubble Index, released in September, for example, Sydney is the fourth-most likely city to suffer a big correction (Vancouver was top, followed by London (naturally), and Stockholm).

As a result, a recurring theme since at least the financial crisis has been: "How can I profit from a collapse in Australian house prices?" And the most obvious answer is: "Short Australian banks".

So it's the sort of idea you often see thrown out as an "obvious" sell. And yet, while it's all very logical (everyone else's bubble has popped, surely this one must too), so far, that's not worked.

Hence the eye-rolling in the audience.

Why it's different this time (or rather, it's not)

Australia's boom really started with China joining the global economy and effectively using Australia as a petrol station. China pulled up and bought every chunk of raw material that Australia had to offer. That model nearly collapsed in 2008, but China then pumped vast amounts of money into infrastructure spending, which saw the party continue.

Come 2011, that particular bubble the commodities bubble burst. The question now was: how do we keep the party going?

The answer is to do what Alan Greenspan did in the US slash interest rates and encourage an even bigger real estate bubble to pick up the slack in the economy.

And that's what happened. The Reserve Bank of Australia cut interest rates. Low interest rates pushed up demand for property. That in turn drove up construction work, which pushed up supply.

The Aussie dollar by now was collapsing along with commodity prices. But that didn't matter because consumption was propped up by every homeowner feeling like a property tycoon.

Trouble is, you can only take this so far. The whole market is stuffed with extreme statistics. For example, apparently, buy-to-let or investment property now accounts for a staggering 45-50% of the Australian market.

Meanwhile, the construction and engineering sector accounts for 14% of Australian GDP, compared to 16% for Spain at the peak of its own building boom (and we saw how that one ended up).

The average effective mortgage rate is now above the average rental yield too in other words, housing is in effect, a negative-yielding asset which its owners are buying purely on the hope of capital gains.

If you think it's irrational to buy a negative-yielding yet low-risk government bond (and it is), then think how much more irrational it is to buy a negative-yielding yet high-risk property asset.

Now sales volumes are down. Foreign purchases are down. Delinquency levels (bad debts) are starting to rise. Construction is easing off. That in turn will mean falling employment.

That's a nasty combination, and promises to be painful for the Aussie banks, which remain relatively expensive compared to their global peers, despite having had flat profits for the last couple of years.

And this is all coming at a time that global interest rates are starting to perk up. Doesn't look good, does it?

Why this is worth paying attention to

The honest truth is that unless you are directly exposed to Australian property or the Australian banking sector, then it probably doesn't. For most of us private investors, shorting anything is a hassle, and the methods open to us spreadbetting mainly are too risky to bother with. As for the threat of "contagion" Australian banks aren't especially important to the global financial system, so whatever happens to them, it's likely to stay Down Under.

However, it does provide a useful insight into how artificially low interest rates and rising debt levels can keep an economy limping along for far longer than you might ever expect.

It also demonstrates at least one way in which rising interest rates are going to inflict damage on specific pockets of the global economy. The Australian housing bubble is one obvious symptom of the distortions caused around the world by low interest rates. There will be many more - not all of them as obvious, and not all of them as unimportant on a global scale.

All bubbles burst. It just takes time.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.