The year ahead

Deposit rates may be stronger than anyone thinks in the months ahead, while apartment prices are buoyed once more by China.

PORTFOLIO POINT: There’s good news in store on deposits rates, and on property prices.

It’s great to be back writing in Eureka Report about key investment topics and strategies for 2012. In my readings and thinking down at the beach, three themes really caught my attention. The first is that, I don’t think Greece is going to make it and Portugal will struggle. Obviously, anyone who makes European predictions is taking a high risk and I could be wrong but the Greek mess is extremely difficult to fix and should have been tackled much earlier.

Casting off Greece will cause large European bank losses and erode the trust we have in banks. But the rest of Europe will be then be protected, including Italy and Spain, and in due course the Europe that comes out of this will be a lot stronger because a lot of the bad practices that led to this crisis will have been eliminated.

If there is a deepening of the European crisis then the cost of wholesale funding in Australia is likely to rise even further. Readers will know that my colleague Michael Feller has a different view and his view is in line with the message European stockmarkets are delivering. I respect Michael and it is always dangerous to call against markets but, as always, I write it the way I see it.

In Australia, everyone is predicting official interest rate cuts from the Reserve Bank during 2012 and it is generally accepted that most of these cuts will be passed on by Australian banks. Demand in parts of the Australian housing market is showing signs of life in anticipation. Unfortunately, I don’t think the banks will pass on most of the rate cuts; and, acting through their favourite journalists, the banks are trying to soften up the market for much lower cuts in mortgage rates than the housing market expects.

You cannot ignore the simple fact that the cost of wholesale funding is now slightly above the cost of term deposits in Australia. This is obviously an approximation because there are many different currencies that stud the term deposit market. In past years the big banks were tardy in promoting term deposits because overseas wholesale funding was much cheaper.

Even now the banks rarely take out big advertisements promoting term deposits. If the Greek crisis further boosts wholesale funding costs it will increase the gap. Under that scenario, many banks would be tempted to lift their deposit rates because they will represent cheaper money. Clearly there will be enormous political pressure on the banks to reduce mortgage rates in line with the RBA official rate, but if they do lower their lending rates then they will do so at the cost of profits.

Because the market has priced in interest rate cuts in many areas, if the banks don’t make the interest rate reductions then it will cause some turbulence. It will lessen the demand for bank funds because there is a layer of potential dwelling buyers who will need a rate cut to come into the market. Banks will be aiming to hold their profit and dividend rates.

However, it is truly ironic that overseas hedge funds are scrambling to invest in Australian bonds that carry yields well below what banks must pay to borrow overseas. When the Gillard government understands that banks can’t reduce interest rates sharply because the Reserve Bank official rate is a relatively minor part of their cost base they will begin to look hard at these borrowing differentials. The government might even become effectively a bank funder by borrowing via Australian bonds and lending to our banks at lower rates than those banks can borrow from overseas.

This concept is not in the marketplace and will only be talked about when the market understands that there is limited room for interest rate cuts in the present scenario.

In the term deposit section of my portfolio, I took out a lot of five-year money but, of course, kept a portion of the interest bearing securities section in short term. I have been tempted to put some of that short-term money into longer-term rates because of the interest rate falls that the market is predicting. But given the recent rise in the overseas wholesale rates, I think I will leave the short-term money where it is just in case banks need more term deposit money and the federal government takes too long to wake up to the options available.

All this sounds a little depressing so now some good news from my third theme. And it really is good news. You will remember that in November mainland Chinese began cutting back their purchases of inner-city apartments in Sydney and Melbourne. Given they dominated the buying of Sydney apartments and were vital to the Melbourne market, if 2012 opened with further cutbacks in Chinese buying we would see further falls in inner-city apartment prices, which would spread across the whole housing market. And the problems that were causing that back home in China might affect the demand for commodities.

A lower apartment price trend was apparent in the final months of 2011. It is difficult to gain a reliable trend from the Chinese during January because we have both the Western and Chinese new years.

Nevertheless Meriton’s Harry Triguboff tells me that all the signs are that the Chinese are coming back and buying inner-city apartments in Sydney. At the same time, Sydney apartment rents are rising again (Melbourne is soft in many areas). The Chinese buying is important, not just for the Australian dwelling market but as an indicator of what is taking place in China.

All the signs are that Chinese credit is now more liberal and the property value fall, which looked serious in 2011, seems to have moderated, giving the Chinese confidence about buying in Australia. They are of course concerned about the rising Australian dollar but our currency is now the flavour of the month and their advisers will be telling them it is more likely to rise than fall.

Accordingly, if these early January trends in China are maintained then the effect on Australia of the European problems will be muted. Treasurer Wayne Swan is absolutely right in pointing out the importance of China to reduce the impact on Australia of Europe’s problems. These early good signs are contributing to a stronger stockmarket.