The RBA has cut interest rates to a record low, so is it time to buy cyclicals as growth picks up? Builders, retailers and media stocks often go for a run around rate cuts as expectations of growth pick up, but can fade away again quickly. This is because the RBA is usually cutting rates when growth is weak and if policy isn’t getting traction then growth will continue falling. You may want to consider buying these stocks close to the last rate cut as that’s the one that is usually followed by a strong rebound in activity that drives profits.
So, are we at the turning point in the economy? There are reasons to cautiously approach the idea that the economy is about to take off. The RBA doesn’t seem very confident with references to further easing and unconventional policy measures. To date, we’ve seen lower mortgage rates drive a rebound in auction activity and prices for established homes and there has been a rebound in sentiment post the coalition electoral victory. It’s fair to say that significant downside risks to the economy have been removed. Challenges remain though and the most significant of these is the fall in housing construction activity. Recent building approval numbers show further weakness ahead and this appears to be getting worse.
The myth that housing prices were being driven by a lack of new housing supply, as opposed to investor activity fueled by cheap finance and increasing leverage, was clearly exposed by the Royal Commission. As soon as credit availability was tightened house prices rolled over and speculative new development activity went with it. High house prices driven by investor speculation kills housing demand by driving down the household formation rate. This impact is difficult to measure directly, but there is clear evidence in the increasing vacancy rates and weak rental growth in the market. With a solid pipeline of completions still to come, and given the amount of negative housing equity that still exists for investors and developers, it is likely to be quite a while before we see a rebound in housing construction and the risk is that it continues to decline further.
This is the real reason that the RBA is cutting rates, not some vague reference to underachieving on our employment potential. From here it likely to get worse as the time to construct high rise apartments, where a lot of the speculative activity has occurred, is quite long so current construction activity is still near record highs. As new starts vanish, there will be significant employment impacts in the construction sector which could feed back into the broader economy through weaker spending. It’s the RBA’s hope that lower interest rates will stimulate the broader economy and absorb this weakness. We are skeptical that this will work.
In Australia interest rates have stimulated mainly through increasing house prices, driving some wealth effects and construction activity. Firstly, we are hitting the lower bound of policy effectiveness as banks are simply unable to lower their funding costs enough to pass on all the rate cuts. Secondly the low rates need to be viewed in the context of the record high household debt that has been built up to support high house prices. Those with debt, particularly those that have found themselves with negative equity, will be more inclined to pay it down in times of uncertainty while those with assets may be cautious in spending their capital given the low rates of return available.
Given the strong rebound in cyclical stocks so far, we suggest caution with owning them going forward. The housing construction stocks like CSR, Boral and Brickworks are moving into shorting territory given the likely pressure on earnings. Some of these have significant commodity exposures like CSR to aluminium and Brickworks to coal, which also look weak. For a building stock it’s better to look further afield. We like James Hardie which has good exposure to improving trends in US housing, a stronger structural growth story through market penetration and trades at multiples not too dissimilar to the domestic builders.
As published in the Australian Financial Review, 3 October 2019.
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