Australia: The Land of the Undiversified

Researchers from MIT Sloan have come up with new findings that the GFC (2008 Financial Crisis) was not caused by subprime mortgages.

MIT Sloan may be a little late on this one as most major market participants are aware of “Correlation Equals 1” and how the reliance on cheaper short term borrowing and overnight liquidity drove the entire financial system before its near-collapse. Much of this has also been covered with increased liquidity requirements, such as higher reliance on sticky deposit funding and leverage limits via the 3% equity to asset ratio.

This additional regulation has attempted to plug one potential weakness in the financial system. Do other risks exist, particularly in Australia?

Looking more deeply at the construction of assets across Australia, it faces its own “Correlation Equals 1” problem in that the entire economy has gone long on housing, is reliant on variable rate financing (prices can adjust upwards quickly and at a bank’s choosing), has become over-exposed to Australian equities and Australian financial services. We explain this via 3 charts

Chart 1 via OECD: Super Fund Asset Allocation (Shortage of Non-bank Fixed Income)

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Chart 2 via OECD: Household Debt to GDP, Leading Nations (Over-exposure to Mortgage Debt)

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Chart 3 via S&P: Industry Weighting to Financials (Over-weight Financials)

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Australia has created for itself one of the most correlated economies on the globe that could be exposed to deep risk if any of the following happens:

  1. A need to significantly increase interest rates, most likely due to imported inflation
  2. One of the 4 Majors banks comes under pressure
  3. The momentum in house price growth or credit supply slows

Alternatively, 44% (35% Financials + 9% Real Estate) is based mostly on the well-being of the real estate market in Australia. The financial reward from real estate is tied to the ability for the future to pay higher prices, so well functioning financial markets assist this reward and hence lead to the high correlation (from a mathematical risk perspective, there is only really a time delay between the outcomes).

I am less pessimistic on the housing market but a number of products need to be created to reduce the risk to the system and ultimately leave households in much better financial positions.

  1. Where are the Fixed Income Investment Products:

Australian deeply suffers from a lack of high quality non-bank investments that can complement the equity exposure in super fund portfolios. Moving the weighting of Non-Bank Fixed Income asset weighting from 8.8% to 20% will increase portfolio Sharpe ratios, reduce downside risk and may even offer high lifetime returns even in optimistic scenarios (as well as downside scenarios). The ultimate goal is to ensure retirees will be able to cover their retirement needs in as many future economic scenarios as possible.

This is also a fantastic way for the banking industry to diversify its funding sources further, leading to a more secure financial system (note: there would need to be deconsolidation processes to create non-bank exposures).

  1. The housing market needs to move away from variable rate financing:

Over exposure to the RBA cash rate means that the economy is reliant on what the RBA does and how banks pass those movements on (remember, banks can independently change the interest rates on the variable home loans that make up 85% of the house financing in Australia). Short-term fixed rates, such as 2, 3 or 5 years, do protect for a short period but they quickly move to either variable products or borrowers need to find a new fixed rate. Those newly fixed rates could also increase, as happened in Australia in the last few weeks:

If we can achieve these 2 things, we may be on the path to reducing the overall high correlation the Australian economy currently faces.

This is the biggest opportunity in Australian Financial Services and we are working with banks to make this a reality.

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