The Joe Walker Podcast - Housing Bubble Week: Speculation And Unchartered Waters - Chris Joye

Episode Date: May 16, 2019

Chris Joye manages $3 billion as the Co-Chief Investment Officer at Australian fixed-income manager Coolabah Capital Investments, and...See omnystudio.com/listener for privacy information.

Hello there, ladies and gentlemen, boys and girls, swagmen and swagettes. I'm your host, Joe Walker, and welcome to the Jolly Swagman podcast. This is episode four of Housing Bubble Week, and my guest is Chris Joy. Chris manages $2.5 billion as the co-chief investment officer at Australian fixed income manager, Coolabar Capital Investments. He's a contributing editor with the Australian Financial Review, and he has a long history with the Australian housing market. In 2003, then-director of the Menzies Research Centre, Malcolm Turnbull, commissioned Chris, fresh out of Cambridge University, to be the principal author of the 380-page Prime Minister's Home Ownership Taskforce report. Chris is a formidable intellect,

but we broadly disagree on the housing market. I think a crash is likely. He thinks a correction is more likely. Nevertheless, I think we reached new ground in this conversation. We recorded it on Wednesday, the 27th of March, 2019, a couple of days after Chris's heated debate with economist John Adams on Peter Switzer's show Money Talks. I felt like Chris won the debate for the housing correction side, but in the same way a good lawyer might be able to get a guilty client off for free. When I watched the debate, I decided I had to talk with Chris. I had two reasons. The first is this. In the debate, Chris's key piece of evidence was a chart produced by

economist Alex Joyner, showing that you can explain virtually 100% of Australian house price rises by indexing them to incomes and interest rates. As I point out to Chris in this podcast, you're about to hear. The problem with fundamentals explanations such as that one is not just that they constitute post hoc rationalizations fatally vulnerable to emitted variable bias. It's also that they've been unsuccessful before. As I mentioned in the following conversation, in July 2004, New York Fed economists Jonathan McCarthy and Richard Peach published an article titled, Are Home Prices the Next Bubble? You'll find it in the show notes to this podcast. In the article, they argued that there was no national US house prices bubble because,

and I quote, home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates. Of course, we all know how that analysis turned out. Now, part of the problem with it, as Bob Schiller pointed out in footnote seven of his bestseller Irrational Exuberance, is that they chose to base their analysis on an index of new homes, which biased the results. But that wasn't the full story. They were also inherently weaving an after-the-fact explanation that neglected something incredibly important.

This brings me to the second reason I wanted to speak with Chris Joy. Before we started recording, I said to him that I find his position on the Australian housing market to be bipolar. On the one hand, he brands it a bubble. On the other, he chides us that there won't be a crash. But don't bubbles entail crashes? I had a sneaking suspicion that I knew the reason for Chris's seemingly paradoxical position, and I wanted to put it to him. You see, crashes are stitched into bubbles by the hand of speculation. If many of the marginal buyers of an asset are speculators, and if they become invested only for capital appreciation,

eventually the bubble runs out of fresh speculators to sustain price rises. At this point, it becomes a race to see who can sell first. In game theoretic terms, economists could describe this stage as a sub-game perfect equilibrium with the most optimal strategy, sell. That is the key reason why speculative bubbles are inherently unstable. As a result, any take on the Australian housing bubble that omits or minimises or forgets or neglects the role of speculation is bound to underestimate the downside.

Animal spirits are as difficult to quantify as they are vitally important. Notice how the whole tenor of the following conversation changes when I put these points to Joy. Enjoy. Chris Joy, thanks for joining me. Joy, thanks for joining me. Joe, thanks for having me on the podcast. This is actually my first podcast, aside from our own, which is, of course, the Complexity Premier Podcast

that Callabar now publishes. It's a very technical podcast. It's not really for the layperson, but, yeah, fantastic to be able to engage with you. Yeah, great to have you on. I've been trying to lock you down for a while. Of course, we'll put a link to the Complexity Premier podcast in the show notes to this episode.

I want to talk to you about housing bubbles because I think you have a very interesting view on Australia's housing market. I've heard you argue that the Reserve Bank of Australia was sort of complicit in blowing a huge housing bubble through sort of recklessly slashing interest rates beginning in 2012. Do you still hold that view? Yeah, certainly if I recall correctly, from 2012 through 2015 or 2016, the RBA on the record repeatedly said, don't worry about these interest rate cuts. They will not ignite another big housing boom.

We will not see sharp jumps in house prices and they categorically ruled out the possibility of a big significant re-leveraging of household balance sheets and or double-digit credit growth. And I actually called Christopher Kent at the RBA in 2013 after one of their rate cuts and said, listen, you're now, I believe, going to precipitate a significant period of very strong double-digit house price growth. Now, no one was forecasting a big housing boom in early 2013 when I had this conversation. You've got to remember that house prices in Australia had been falling for years. People forget about this.

Between November 2010 and circa January 2012. That was actually one of the biggest corrections on record. Ironically, because the RBA had lifted rates from April 2009 to a peak in November 2010. So we'd had this long period of very sluggish housing growth. I should say I actually was one of the co-developers. My team built the CoreLogic house price indices that we now all reference, which are the only daily house price benchmarks in the world. And they actually revalue the entire housing stock every day. So about 10 million homes using a hedonic regression-based index

that controls for compositional biases in the housing stock. So I wrote, I think, a column that was on the front page of the AFR in 2013 and said, listen, guys, we've got a bubble that's going to emerge as a result of this super stimulatory monetary policy. And my point in 2013 was that at that juncture, the housing market, I think I would use these words, was priced for perfection. I thought the housing market, based on our analysis, was in or around fair value. And we couldn't cope with a period of abnormally high returns, which is, of course, what we got. I also warned the RBA that APRA would be forced to introduce macro prudential controls to cool credit growth,

which had never happened here in Australia, and they were very dismissive of that. In fact, Malcolm Eadie, who was head of the financial stability area at the RBA in late 2013, described my references to the risk of a bubble emerging as a quote-unquote alarmist. And obviously, the passage of time has proven us right. Now, while you describe the housing market as a bubble, you don't forecast a crash or an Armageddon scenario. What do you think is the likely outcome for house price falls? Yeah, our views have been crystal clear. I mean, one of the things that I think is a struggle sometimes for folks

is they write a column every week in the AFR. They don't necessarily read every single column. crystal clear i mean one of the things that i think is a struggle sometimes for folks is i write a column every week in the afr they don't necessarily read every single column and so one of the reasons i like to reference what i've said in the past in my column is so that i can just establish that consistency so people know exactly what i've said in the past and what i'm currently saying and we and by which I mean euphemistically me, I like to depersonalise things a little because people, whenever you start talking about housing, it's like this John Adams debate that we'll talk about later.

But whenever you talk about housing, it gets so emotional and so incredibly personalised. One of the reasons I don't try and do big public debates. So you've just got to point the mic at yourself, don't you? Yeah. And so my view was that every year, 2013, 14, 15, 16 and into 17, that Australia would record very strong house price growth. And every one of those years where house prices appreciated more rapidly than disposable incomes

basically meant the market was becoming more and more overvalued. And my view had been that we had a very large bubble by 2017. Not back in 2013. But, you know, Aussie house prices appreciated 50% between those two points. Sydney house prices appreciated 75%. Everything the RBA assured the public wouldn't happen, happened. We got a massive re-leveraging, significant re-leveraging of household balance sheets. That specific debate hinges on whether you look at

the RBA data that strips out so-called mortgage offset facilities, so we can come back to that later. But it was clear to me that, you know, come 2015, 16, 17, valuations were becoming increasingly stretched and in april 17 i wrote a column declaring the boom over and i forecast that house prices would experience excuse me house prices would experience their biggest ever fall on record of circa 5 to 10%.

Now, this was before the Royal Commission. It was before Malcolm Turnbull had been enrolled. At that point, it was a toss of the coin between the two political parties. And my view has been that if Labor is elected and they remove negative gearing and increase capital gains tax by 50%, house prices will fall appreciably more than the alternative. So when Turnbull's role and also following some of what I judge to be the more irrational apparent recommendations of the Royal Commission around responsible lending. This is a complex kind of side issue. But basically, in the

interim report, it looked like the Royal Commission was going to find that most Aussie banks had breached the responsible lending laws. My view was they hadn't. And the federal court provided extensive analysis of this issue and embraced our perspective. And the final Royal Commission report backed dramatically away from this subject. So Haynes said it was a matter for the courts. So now that that risk has been removed, the key issue is politics. But with all of that in mind, a year later, so in early 2018,

I think it was May, we upgraded our forecasts and I said that rather than a 5% to 10% correction, I was expecting a 10% to 15%, which is quite a dramatic reduction given the largest fall on record in 40 years had been about 8% in 2008. Now, within a month of me publishing that forecast, well, firstly, no mainstream analysts in 2017 were forecasting big house price falls. I was the only analyst that had that view. Secondly, when we revised our view in 2018 to reflect the likelihood of a Labor victory, I think pretty much every economist in the country within a month changed their view as well. And they all went to circa 10% falls. Folks like Shane Oliver went a step further. But I guess I would challenge the view that you've expressed.

I mean, we are experiencing the biggest correction in modern Australian history in house prices. This is a very big deal. In big conurbations like Sydney, prices have already fallen 14%. My 10% to 15% view, and it's 15% if Labor comes to power, is a national view. That basically means that Sydney prices will have fallen circa 20%. So that's a big deal.

If you think about the US housing market, house prices in the United States fell 33% peak to trough, and their unemployment rate went to 10%. So I think this is unambiguously the bursting of the bubble, but I suspect it has two phases. The first phase is a dramatic repricing of the asset. So this is the 10% to 15% drawdown. And the second phase will be a period

where incomes likely outperform asset prices for some time. So you'll get further normalization in the house price to income ratio and other key metrics. I mean, I would like to talk about Alex Joyner's analysis that I've referenced for years. Yeah. Valuations, because that does provide a different perspective. Yeah, I think we'll naturally come to that in a couple of questions, but I just want to ask something first. So, that was a really good introduction, because while there's probably some different complex

branches to the topics you've raised, I think people have a good overview now of your history on this issue and what you think going forward. Because your view is, it does fall, while you do project a very significant and historic correction for Australian house prices, it does fall just shy of what most people would classify as a crash, which would be price falls of more than 20%. Obviously, those definitions are sort of arbitrary. Is that fair to say? Yeah, so that's actually a really important point. I've consistently argued this will be an orderly correction.

That is frankly the best thing that's ever happened to the Australian economy in years. And we desperately needed this correction. That's why I'm also arguing that I don't think the RBA should cut rates. Because the RBA's own research suggests that if they cut the cash rate by 1%, house prices would actually jump back up 28%.

And the RBA's research actually, you know, the tulip paper that was published in the last month vindicates my view that the RBA was the key driver of the great Aussie housing bubble of circa 2017 through that multi-year period of cuts between 2011 and 2016. The last cut was, I think, August 2016. And they cut in twice in 2016. I was very they cut in twice in 2016 I was very aggressively critical

of both my argument at the time was that they would reignite the boom but I think this is a

certainly Moody's and Standard & Poor's the credit rating agencies their view is this is credit positive for the Aussie economy

because we're slowly but surely cauterizing the single biggest financial stability threat the economy has faced. I think a lot of people around the world would agree with your view as well. I think, you know, for example, Ray Dalio has argued that central banks can too myopically focus on things like growth and inflation and in the process inflate asset price bubbles in things like property, which seems to have happened in Australia. Yeah, I think that another view I've expressed is that central banks can be the source of financial instability. And a classic case in point is that the RBA blew this big bubble. And in a credit where it's due, APRA, and I think, frankly, off the record, I think

there was a gap between APRA and the RBA on this issue. I detected it in 2014. And the RBA was out there saying there are no financial stability risks consistently, whereas APRA was much more exercised and started crushing lending in December 2014 to their credit. And I think APRA has been fantastic. And this correction was engineered exclusively by APRA.

The first wave of it. The first wave of it. The first wave of it. That's a very good point. The second wave was the Royal Commission. I think that's going to be unwound because I think the banks will lose some lending standards. And I think there's also a resurgence in non-bank lending in Australia because the RMBS securitization market is booming. So they can get money, lend that money. They're not really regulated by APRA.

And I think that'll put a lot of pressure on the banks to cut rates. So I want to take a step back and ask a more philosophical question and then we'll come to the graph that you mentioned, which you showed in the debate with John Adams on Peter Sw peter switzer's show so firstly the the philosophical question is uh how do you define a bubble chris joy yeah i think that's a good question um to be honest i haven't really thought about it for a while um i mean the simplest definition is that it's a situation where you get a material divergence between observed prices and fundamental estimates of intrinsic value. And so one example of that would be the house price to income ratio if

you can measure this many many different ways it's not so much about the levels it's about the movement in the ratio over time if you take UBS's data, and we actually years ago, a decade ago, sort of designed a methodology to measure the price to income ratio as accurately as possible. But UBS has between 2003 and today at about five times. And the Aussie ratio surged to a record high well above six times. I actually predicted this would happen, I think, in 2013 or 14. I said the debt-to-income ratio would break all-time highs and the price-to-income ratio would break all-time highs. And they to income ratio would break all-time highs and they were kind of technical points at the time by the way in 2013 the household debt to income ratio had been moving sideways for years since circa 2007 and no one talked about it I remember when I first started writing

about the household debt to income ratio increasing in the AFR I mean we sound like a bit of a wonkish term. Of course, everyone talks about it now, you know, because it hit 190%. But I think, so the simplest definition of a bubble is an asset price or an asset class has experienced price action that is moving significantly away of most conventional estimates of value. Now, the RBA attaches a rider that, you know, you need to be worried about debt-fuelled bubbles. And Glenn Stevens was fond of saying, oh, but we don't have double-digit growth in housing credit. And so, therefore, the surge in prices in 2013 and 2014 wasn't a big deal.

And my counter to that was, if your debt-to-income ratio is sitting at 50% compared to circa 190% today, and you've got double-digit credit growth, who gives a rat's ass? You know, the leverage is very low. So strong credit growth isn't a big deal. But if your debt-to-income ratio is 160%, and you've got credit growth that is running at, say, three times incomes, but it's still single-digit, high single-digit, my view was that's a real issue. And the RBA kind of argued that it wasn't for many years until it was.

So I think we had a bubble. Again, there are measures on which, funnily enough, it doesn't look like a bubble. Can I talk about joiners analysis now? I'm going to insert one thing in between yeah so yeah i think we had a bubble and it was a bubble fueled by not ultra high rates of credit growth but a period in which credit was expanding at multiples the rate of incomes at a time when leverage was already very high. Yeah.

Actually, you know what? Now, let's turn to that analysis now. I think it'd be better to ask my question after. So, you brought up a chart in the debate against John Adams, which is sort of material to the question of whether we're facing correction or crash. Now, the chart was produced by an Australian economist and it was indexing Australia's house prices to interest rates and to income.

Do you want to just take us through that, just sort of describe it for people listening? Yeah, so Dr Alex Joyner at IFM published this actually originally when he was at ANZ. I reckon the best part of 10 years ago. And what he did was he took the median house price in 1980 and he indexed that up by the growth of disposable incomes on a per household basis through to 2018. And he also indexed it up by the change in purchasing power resulting from changes in mortgage rates between 1980 and today. And he kept the LVR constant. So LVRs have actually increased. You can borrow

more today than you could in 1980, but he ignored that. And what he actually finds is that incomes and interest rates explain 100% of the change in house prices over the last 40 years. And in fact, the theoretical fair value is actually about 3% above prices today. Now that theoretical value assumes the RBA cash rate today will stay at 1.5% forever. If you adopt a more normal of, I've actually got the table in front of me here. Yeah. If you adopt a more normal RBA cash rate that is, say, 1.5% higher than it is today, so a 3% cash rate, that implies that even after the decline in house prices, we're still confronting an asset class that's 8% overvalued.

So prices would need to fall another 8% in order to go back to that theoretical fair value. The RBA has argued the neutral cash rate is actually 3.5%. So if you use that number, then house prices are still 13% overvalued. And I think it's an extremely good fundamental model to use to think about valuations. So on that basis, valuations are about right today and the market's not overvalued. But if, like me, you think in the medium term, the RBA will have to normalize the cash rate, the market's still a little bit expensive. So my default reaction to analysis like Joyner's is skepticism.

And the reason is we've heard this before. So, for example, if you go back to 2004 the new york fed and ben benanki were using the same arguments to say that categorically there was no bubble in in the u.s so they were using income and interest to to model house prices the what i think joiners analysis misses entirely and i guess with that maybe the definition of bubbles that you gave us is the question of speculation and i just want to mention a couple of things on that and then get your reaction chris because if you if you look at the literature on bubbles there are usually two components to the definition and you know very eminent economists like Bob Shiller, Joseph Stiglitz and Charles Kindleberger all

share this definition. It's the divergence between market prices and intrinsic values, which you spoke about, but it's also speculation driving that up. And the reason speculation is so important, it's internally consistent with the definition of a bubble, is because for most people, bubbles go hand in hand with crashes. And the bubbles followed by a crash, because as soon as expectations flip like a pancake as to price rises and capital appreciation, that in and of itself is incentive for the speculators to sell, which drives prices down and the correction bleeds into a crash. Now, if you look at the evidence for speculation in Australia, we can sort of mosaic a few things together. For one, there was a huge phenomenon of property flipping. So, I was looking at the CoreLogic data last night, they did a flipping report in 2017. And in the 2000s, so this is properties that were

bought and then resold within 24 months, 20.4% of Australian property sales were flipped properties. In 2017, that came down to something that was a bit more modest. It's about 7%. That's one piece of evidence. The other piece of evidence is, I guess, negative gearing. And on the latest data we have, the ATO tax data for the 2015, 16 financial year, which they put out in 2018, we know there's about 1.26 million Australians

who have at least one negatively geared investment property. Now, 67% of them are people on $80,000 or less a year in terms of their income. So, if you're negatively geared, you're only invested in the property like that you're losing money on the carry that only makes sense in a context where you're expecting to make it back on the capital appreciation. If you suddenly tell all these Australians that prices are going to severely correct, 4 by 8%, automatically, that becomes a reason for them to sell. And then the animal spirits can take the correction into the crash. So, that's why I'm a bit more concerned. Bubbles are about speculation.

Speculation implies a crash. I just want to get your reaction on that. I don't really disagree with much of what you said. I'm very sympathetic to the logic. I just offer a few leavening observations. Please. I guess the first is, I mean, all asset classes have speculation. I mean, I know Bob Schiller. i've presented with bob schiller before but this notion i mean all investing

is speculation i mean every single investment you know what warren buffett's you know warren buffett is speculating on a mispricing he's saying it's worth a uh it's trading at B, and he's hoping for mean reversion in the capital value of the asset. So I think speculation is a nebulous term. I think perhaps a better description would be investing on the basis of entirely unrealistic expectations of future capital gains. So expectations that are not founded in any real empirical evidence. So that would be the first point. There is absolutely no doubt that the bubble where we experienced post 2012

was i think primarily fueled by speculation and we saw an unprecedented i'm actually not your flipping statistics don't really resonate with me i created a lot of data sets called Logic Publishers. I think better data is probably, if you look at the share of investors as a percentage of all borrowers in the market. In this cycle, we hit unprecedented levels of more than 50% of all borrowers seeking finance for investor and therefore speculative purposes. So I agree with that. Again, north of 50% at one point in time. Famously, Westpac reporting that just over 50% of all of its loans on its balance sheet were interest only. Thankfully, APRA crushed that. It's now down, I think, around 30%.

Yeah. Which is still high. And then overlaid on top of that, we had an unprecedented influx of foreign, mainly Asian buyers. And I think that during this bubble, absolutely, there was that, you know, to use Schiller's phrase, irrational exuberance that was predicated on entirely unrealistic capital gain expectations. And I would like to say that I think I originated the expectational argument

in the context of Aussie property. For so many years, for over a decade, I have had countless arguments with all stakeholders to eviscerate the view that you could only have a big fall in house prices if there was a big increase in unemployment. Every economist in Australia has peddled this entirely fallacious perspective. And I've sat in a million meetings saying that is absolute BS. Yeah, well, the causation flows the wrong way.

Yeah, I argued, I used to use the UK example where in the GFC, house price falls led rising arrears. In the US, rising arrears led house price falls. Yeah. But it's all about expectations. You're 100% correct in that respect. And I used to make the point, I remember sitting in Citigroup's offices talking to a US hedge fund that with record levels of investor participation, from, say, 10% capital gain annually over their holding period to, say, an annual 5% capital loss, I mean, that fundamentally and very radically changes downwards

their view on what the intrinsic value of that asset is. And that's what has happened this time around. What happened in this episode was we had waves of APRA constraints introduced, climaxing with the limits on interest-only lending. Investment loan rates increased by 25 to 50 bps. And that really, really i think coupled with basically credit rationing um that that burst the bubble and then that was amplified by the heightened risk aversion from the banks um post the royal commission so i more or less agree

with everything you said but i'm not convinced by your comments on Bernanke. I can't remember. I've actually not seen Joyner's analysis anywhere else. And I think it's entirely appropriate to think about valuations in the context of affordability and therefore incomes and interest rates. And the empirical fact is a joiners' analysis and that model explains, you know, within 3% of today's prices, all of the change in the value of Aussie housing over 40 years, which is pretty remarkable. So I think it's an incredibly powerful construct.

I don't think we've, yeah, I don't think we've seen that analysis before, but I'm sensitive to your concern that folks dismissing the gravity of this bubble are sort of reaching for it's different this time style paradigms. I think this bubble is a unique bubble. Well, sorry, it's not a unique bubble in the sense that, you know, I think it echoes many experiences that we've seen in the past. I think what's unique about the unwinding of this bubble, which is, I think, you know, where you and I possibly arrive at slightly different conclusions,

is that we have no extreme economic adversity that has precipitated it. What's happened is we've had an exogenous or external influence, APRA, burst the bubble. And we have a situation where the jobless rate's fallen from 6.4% to 4.9%. The federal budget, amazingly amazingly is in surplus. I just looked at the numbers this morning. I mean, over the last 12 months, the fiscal balance has got a surplus

to February of more than $10 billion. And the economy is doing okay. So at this point, I'm relatively sanguine about an orderly unwinding. I get much more nervous, and I can see much graver outcomes if you can convince me that commodity prices are going to collapse, that the U.S. is going to experience recession, and that China will follow suit? I don't think I need to do that.

I think if you look at the history of housing bubbles, if you look at Sweden, Finland, Norway, even further back, Spain in the 70s, if you look at Japan, if you look at Ireland and Spain, we know that bubbles can turn into crashes endogenously when those expectations flip. And given everything we've just discussed with each other about both the evidence of speculation in the Australian housing market and how speculation, when it flips, can lead to a crash. I wonder whether those economic fundamentals which you've advocated are sort of irrelevant in the face of that. Like, I mean, Ireland and the US had strong fundamentals as well. I think Ireland and the US, each of those case studies is very, very different. I mean, we're quite fundamentally and radically different

to what we're experiencing here in Australia. There are some commonalities, but the Irish economy was predicated on this huge tax arbitrage. It was a tax haven. A quarter of their GDP was multinational royalty payments. I mean, the EU or the European Commission has said that real GDP was, or the reported GDP was 130% of their actual GDP. If you look at the default rates on mortgages in Ireland from 2000 through to today, they've averaged about 20 times higher than ours. But my point is this, I'd ask you this question, Joe. Yeah. I think, I mean, it's pretty hard to disagree with the statement that the correction thus far has been orderly.

Yeah. Right? So I would argue, you know, over the last two years, what I have predicted has almost exactly come to pass. But there's no, I mean, credit growth is positive. Arrears remain very low. Economic growth is sitting between 2% and 3%. The budget is in rude health. Commodity prices today are 30% above their average since 2003 and 70% higher than their levels in 2015. So the correction has been benign thus far.

I think it's an empirical question as to whether this morphs into a death spiral of the kind that you're describing and it becomes a crisis or a crash. And, I mean, who knows? I mean, you may be right. I'm not sitting here saying I'm infallible. I could be wrong. But I think in my central case, my modal case,

where global growth is strong, commodity prices stay high, there's heaps of fiscal and monetary policy ammunition that will endogenously support any acceleration in the housing downturn. So, you see, one of the reasons I think you're very likely to be wrong is if there was any evidence that the correction was becoming disorderly. The RBA is going to floor the cash rate. Treasury is going to start spending money like it's going out of fashion. We'll see the return of the first-time buyers boost or bonus,

and the housing market will react very quickly, precisely as it did in 2009-10. I mean, house prices surged over 2009-2010 after an 8% drop in 2008 because of the fiscal and monetary policy reaction function. Yeah, but this time, will those things be sufficient to overcome the responsible lending? Because really credit availability is the issue.

Yeah, so I am an expert on the responsible lending issue. I mean, it's something that I've studied in immense detail and we've taken substantial legal advice on. And at this point in time, the responsible lending issue is more or less a non-issue. Okay. I agree with you, though. If, I mean, there is a test case before the courts between Westpac and ASIC,

and if the court were to find, as effectively ASIC argued, that every loan written by Westpac, Let me put it differently. If the court finds that a bank relying on the household expenditure measure breaches the responsible lending laws, one, and or if a court finds that a bank that takes a borrower's submitted expenses at face value and doesn't go one step further and seek to independently verify those expenses

results in that bank breaching the responsible lending laws and therefore that their loans are non-enforceable, that would be cataclysmic for the Aussie banking system in the housing market. And if that was the court's interpretation of how the responsible lending laws work, then my view on the likely path of Aussie housing would be very different to my central case. But I've taken legal advice on this. And we've had the benefit of a federal court judge opining on this. And then he appointed a friend of the court, or a so-called amicus, former Solicitor General Gleeson, to also opine on this. And they have both concluded emphatically

that a bank can comply with the laws and rely wholly on him, and a bank can comply with the laws and rely wholly on him and a bank can comply with the laws and not verify a borrower's expenses. So, you know, I think I was worried about the responsible lending laws before anyone. Yeah. But having done the DD on the issue, at this juncture, I'm okay. But if you're right, I'm happy to change my view. Equally, if John Adams is right and we're going to have economic Armageddon and we're going to have a great depression because of elevated debt levels, I'll change my view. But at this point, I think he's going to be wrong, and I certainly believe that the folks who watched that heated 30-minute debate

that's now on YouTube, I think the unanimous consensus was it was a very convincing TKO. I think I knocked him out. I mean, what was your sense? I mean, honestly, what did you think of the debate? I thought you won. Thank you, Joe. Why don't I go? As a very impartial adjudicator, I think, I mean, everyone wants to be the next Michael Burry.

I thought that you marshaled more facts and were just more convincing. But, I mean, there are a couple of things I didn't agree with that you said. One of them you've mentioned again in this discussion, I'll come to just quickly. Because, I mean, we can go back and forth all day talking about similarities and differences between Australia and Ireland or Australia and the US. But the question is whether those similarities and differences are relevant. And you mentioned that in Ireland, the default rate since 2000 was over 11%. But that's the

average. And let's be honest, Ireland's default rate was actually very low, between 1% and 2% in the years preceding the housing crash, and even when prices started to fall so it only really kicked up similar to the US around 2008 2009 in Ireland prices started falling around March 2007 now we know that defaults are as you also said are a lagging not a leading indicator for house price crashes and we know that defaults are primarily caused, the likelihood of default is caused by two things. One, falling prices and two, unemployment. If you look at Ireland, Ireland had a big construction boom like Australia and bigger, but Australia's is still big. In Ireland, when construction came down, it almost perfectly mirrors, inversely,

unemployment rates going up. So that's something which is relevantly similar for Australia, which I think could be a concern as well. Because a lot of people tend to put the cart before the horse and say, well, for prices to properly fall and default rates to kick up, we need high unemployment. High unemployment can come from the fact that the bubble begins to burst and construction declines. Could I get a comment on that? Yeah, I'd make a few points. Yeah.

Again, not to be too pedantic, but the average Aussie mortgage default rate between 2008 has been about 0.4, 0.5%. So even if the Irish default rate over that period was 11%, but even if preceding that period it was... But 11% on average. Yeah, but even preceding that period, your point, it was 1% to 2%. That's still between two and four times higher than our observed default rates. That's one point. The second point I'd make is one of the useful things about

the Aussie housing market is we have had some pretty big interest rate shocks. So in 2008, mortgage rates were 9%. And notwithstanding those interest rate shocks, we had 10% plus mortgage rates in the mid-1990s. Notwithstanding that, we have seen house price falls, but we haven't seen increases in arrears. We obviously do have a case study here in Australia in 1991, which you conveniently have not referred to, and the unemployment rate went to, it peaked at 10.9%. Again, we didn't see big increases in mortgage arrears. I think that's because we have very tough bankruptcy laws in Australia. There's a big, big cultural stigma in Australia towards bankruptcy.

Same as Ireland. That doesn't exist in the US. And so there's just no evidence at this point. If we get a big increase in unemployment, which we'll come to, and we get a deep recession, I personally think the next recession will look very, very different to 1991. And I do think we'll see much higher arrears than we've ever seen before, 100%.

I think we'll see bigger house prices, sorry, house price falls than we've ever observed before. A decade ago, I said that I expected much higher levels of housing volatility because of the big buildup in household leverage, and that has materialized. We had an 8% fall in 08, a circa 7% fall between 10 and 12, and now we've had a 10% decline thus far between 17 and 19. I think you're unconvincing though on the drivers that are going to precipitate

this big increase in unemployment. So if you look at, you mentioned the importance of housing construction for Australian labour. If you look at simply the increase in Australian infrastructure spending plans for 2020 next year, they more than offset the GDP impact of lower construction. So the reality is iron ore is at over $80 a ton. Coal prices are very high. We're about to become the biggest LNG exporter in the world. We're seeing mining companies starting to reinvest in CapEx. And the jobless rate has been falling, not increasing. People say it's a lagging indicator. Not really. mean it's it's a monthly data series um we also have survey data from um the nab survey that's quite reliable and um i mean it wouldn't i think the real question here is the wealth effect which we haven't spoken about yeah the rba argued there was no wealth effect on the way up. The problem with that argument, because

consumption seemed to be subdued between 2012 and 2017, the problem is we didn't observe the counterfactual. So I suspect there was a wealth effect and consumption would have been even lower had it not been for the housing boom. And we're probably seeing a little bit of a negative wealth effect. And I think we probably will experience potentially some lower activity levels and maybe the jobless rate may stabilise, it may stop falling or it may even tick up a little bit. But I'm not concerned about any of these things. I think fundamentally the Aussie economy will be driven by the global economy.

Ian McFarlane, the former governor, used to say that his most important forecast variable for Aussie interest rates is global economic growth. And that's what I'm focused on. And we have, in the next 12 to 24 months, particularly with the Fed taking hikes off the table, with Trump running massive budget deficits, there are clearly huge infrastructure deficits in the US. Australia needs a massive amount of infrastructure spend because of our population growth and

the demographic changes that have occurred over time. And I think the CCP is going to maintain its maniacal commitment to stable growth outcomes. And I think the EU will follow whatever happens with China. So unless you can construct a compelling case for a recession in Australia, I don't see the housing downturn becoming disorderly. I am, though, I want to stress the original proponent of the view that investor expectations

can precipitate big changes in house prices. I'm immensely sympathetic to that perspective and it is something I'm watching very closely. So I'm watching vendor discounting data, auction clearance rates, listings data. One of the interesting things is, once again, listings tend to be highly cyclical, and when house prices fall, people just don't sell their homes, and that's occurring again.

So new listings have not increased significantly, and we're not seeing any stress in the housing market yet on a systematic basis. There are pockets. So I think you made this point that everyone wants to be a hero, but I find that these doomsays like John Adams and Steve Keen and my good old mate David Llewellyn-Smith at Macro Business, they tend to have incredibly one-dimensional views of the world.

They're always negative on the Aussie economy, commodity prices, house prices. And unfortunately for them, they've been wrong for 30 years. They've been particularly proven wrong in the last 30 years. They've been particularly proven wrong in the last 10 years. They're what Phil Tetlock would call hedgehogs, not foxes. Correct. And I think that I'm actually a very short-termist in my view. So people often say, I can get the long run right,

I can't get the short run right. But volatility and uncertainty grows with the square root of time. It's much easier to forecast the short term than the long term i know where you're going to be in the next 20 minutes but i don't know where you'll be in the next 20 hours and so in my investments strategy i run about three billion And in our investment process, we really focus on statistically modelling the short term and getting asset prices right in the next day, week or month. It's much harder to predict anything over the next 6, 12, 18 months. Absolutely. So my orderly, benign unwinding of the great Aussie housing imbalances case,

which I've held since early 2017, has been proven right over the last two years. But, you know, I'm happy to change my view if there's conflicting data that comes to pass. Yeah. So I think where we've sort of got to, and I'm glad we had this conversation because this didn't come out at all in the debate with John Adams, is that we should be very exercised to the question of speculation and its effects on the downside you said that you've been one of the champions of the expectations model where where have you written about this in the past like can we find it yeah so i think um if you trawl through

my afr columns at 100 should be sure in my af columns. I've definitely eviscerated in numerous public conversations and I'm sure in my AFR column this idea that, I mean, every freaking bank economist under the sun has always said, house prices won't fall unless unemployment rises. Wrong, wrong, wrong. And I'm glad to hear you arguing the case. I think probably others others are well now as well now but um but back when i was arguing the case it was incredibly unfashionable um and in the sense i've never heard anyone else make the point that you can have a big big decline in house

prices um and uh in the absence in actually you know quite positive uh economic conditions i mean so the investment banks for years have rolled me out to global hedge funds to go and speak to them. And I've always made this point to the hedge funds that I can see a big – I mean, the drop we're having in Aussie house prices is massive and unprecedented. I'm not sure I'd call it a crash, but it is a – Not yet.

And there's also something else I've argued actually on expectations whilst we're talking about it yeah um because one of my other hypotheses has been that aussie housing expectations have been heavily distorted by a very very unusual period in history so kind of 40 years of a one-way bet. And the first real drawdown was in 2008. And I think what will happen as a result of this current shock, and I would describe it as a shock, not a crash, you're having a massive recalibration of expectations

that will be permanent. So this is why I said to you there's likely going to be two phases to the cycle. The first is the initial regime change in asset prices. So we have this big move down in the order of 10 to 15% plus or minus. And I would say there are strong statistically serial dependencies or persistence in house price changes, which means the asset class is quite statistically predictable. Set that aside. What that means is that investors in the future, having endured this shock,

are likely to have very different perspectives on that future than they have in the past. So they'll no longer be working with a mental model that is extrapolating out from 40 years of near constant capital gains. And so I think that you will see potentially diminished investor participation, particularly obviously if Labor mitigates some of the tax advantages associated with the asset class. I think the other thing that makes this shock very different is we have, as we discussed,

had a regime change in the level of investor participation. So we've had this unprecedented influx of investors. And one of the points I've made for years with hedge funds has been an owner-occupier will trade a home for very, very different reasons than an investor, right? They want to live in their local area where their friends are located, you know, their neighbours, the kids play with the other kids in the street, the home's located close to the school, close to key transport amenities, and so on. An investor, on the other hand, doesn't give a rat's ass about those variables.

An investor's just focusing on, as we discussed, their carry and their expected capital growth. And what that means, and the hypothesis I've had, is that, and this was from five to 10 years ago, I used to say that the next housing correction is likely to be very different because it'll be an investor-dominated correction. Because all the chumps that bought during the boom are going to be unwinding those positions. Yep. And the marginal buyer and seller will be investors, not owner-occupiers. Now, this is crucial for expectations because you're not talking about, I think you've got

two quite discrete cohorts here. You've got an owner-occupied cohort and the value they get from the home is very different to the value they get social capital from the home. Yep. And if you have, in contrast to past drawdowns in the Aussie housing market or past downturns or periods where we've gone through a deceleration in activity, if this drawdown, which it is, is dominated by investors, then the expectational impact could be much, much greater. And that's why I think kind of Labor's – Labor argues that they're

grandfathering existing property investors. So the negative gearing and CGT impacts only affect future buyers, so future property investors. But that analysis is totally bogus. Because if I own two investment properties today, Labor tells me I'm grandfathered, but I'm actually going to be selling to Joe, who's a new investment property buyer, who can't negatively gear and who pays 50% higher CGT.

And Joe's going to be determining the price I get for my asset, not me. Right. So actually- The marginal buyer. Well, all assets are going to be affected by Labor's policies. So there's no consideration for the second order effects. Yeah, and to me, I have never said this before, so this is a bit of an exclusive for you. Yeah. I am nervous.

I've slightly under-clubbed the 10% to 15% if Labor comes to power. I'm worried it could be 15% to 20%. I'm pretty comfortable with the forecast. The forecast is certainly playing out as expected. But I think there are big tails around the distribution in terms of the standard errors around my forecast. And what I would say is, I'm mitigating is that I think if it looks like it's getting disorderly again, the RBA is dead sick in a cut.

And that cut will be capitalized right back into house prices. Yeah. So I think the RBA, if in the first order I'm wrong, as in if it looks like directionally we're kind of cruising for a 15% to 20% national drawdown, I think the RBA is going to ensure I'm right. So the old fill low put will pay out quite nicely. So I think I'll be right. I'm pretty confident I'll be right.

But messing with expectations at a time when the market is dominated by investors which we've you know to a level we've never seen before at a time when expectations are experiencing their biggest shock in modern australian history you know it's pretty dicey yeah should we end on that sure chris joy thank you so much for joining me thanks for having me matt that was good fun this podcast is not over chris and i are such nerds that after we finished we kept talking about the unique dynamics of housing markets and we decided to switch the mics back on for another 10 minutes enjoy Enjoy. This is a bit of a name drop, but on the weekend, I was having an email exchange with Daniel Kahneman, and I was giving him a hypothesis I had for why housing market corrections and crashes tend to be more drawn out than stock market corrections or crashes.

We've had Black Monday in the stock market, but even the dot-com bust of the Great Depression lasted 2.5 to 2.75 years. In contrast, if you say, except Reinhardt and Rogoff's analysis, if you read their book, this time is different. The average duration for a major housing bust peak to trough is, you know, four to six years. So I was trying to think through why that might be the case. Why would housing markets be more drawn out? One reason, obviously, is, you know, the high transaction costs. You know, you've got things like stamp duty, tax, legal fees, settlement fees, real estate agent commissions, which mean that housing markets are naturally more illiquid whether they're booming or correcting. But another interesting reason, which is why I was speaking to

Kahneman and he confirmed this, is the endowment effect. So, for the cohort of buyers who are owner-occupiers, the house doesn't have exchange value. It's also a consumption good. And if house prices are falling, the endowment effect brings loss aversion to bear. And these owner-occupiers anchor to the peak nominal value of the house. And so when prices are falling, they set an unrealistically high asking price. The bid-ask spread widens, which we know happens in every falling market and liquidity further dries up that way.

Thoughts, feelings, emotions? dries up that way thoughts feelings emotions yes so i mean kahneman and tversky won the nobel prize for their work on asymmetric value functions and documenting the fact that we feel losses more than we do gains and certainly something that we think about a lot in my business i've written extensively in my 2003 report to the Prime Minister, which I co-authored with Edward Glazer at Harvard and Andrew Kaplan at NYU. I talked extensively about the indivisibility of the housing asset and the fact that it's both a consumption good and an investment good.

And I think what you said is very interesting. On the liquidity point, I'm not as convinced because whilst the housing market is sort of similar to the stock market in the sense that a correct comparison would be to say, look at the free float of companies on the ASX in contrast to the stock or shares that are not part of the free float. So only a minority of the equity is actually trading at any point in time. Sure. There's a lot of, you know, the bulk of owned equity in ASX or any listed entity is not traded. You're only observing a tiny fraction on any given day

of the equity that's owned. In the housing market, we see about 5%, 5% to 10% of the stock turnover each year. So the analog is there, but we do observe here in Australia about 50,000 sales a month. And certainly in the CoreLogic daily hedonic home value indices where we revalue the entire stock using that daily flow of transactions, that is exactly the same as, say, the ASX S&P 200 index, which is revaluing CBA each day based on the observed flows of CBA share sales. So there's no reason that if expectations are shifting dramatically

in those 50,000 homes that we're observing in Australia in the month, and then we're using those to mark to market the entire stock, there's no reason why housing expectations couldn't move as quickly as expectations in any other asset class. However, I have some alternative hypotheses. The first is we have never had daily house price index data before. So prior to us releasing that information, it doesn't exist anywhere in the world.

And even to this day, in most countries around the world, the data that's released is released on a monthly or quarterly basis. So a huge propagator of inertia in housing expectations is the fact that you can't observe prices. You don't have an instantaneous revelation of information. We do have in Australia, but it's not really reported. Even the daily index is only reported in the papers normally monthly. Yep. And so I think the opacity and non-transparent nature of the asset class means that the price discovery process is much more inert compared to US or Aussie equities where you're seeing live prices intraday all day and the ASX S&P 200 is being updated intraday. So that's the first point.

Yeah. Sorry, and that's not to be – a lot of people conflate that with the high transaction costs reason but they're actually two quite separate issues yeah and i'm glad you've yeah um recognize that the second point you make i think is a very important point i probably agree with you um i probably express it a little bit differently and simply say that um that the consumption value of the housing asset and the fact that the owner-occupier is consuming a whole range of non-priced services from that asset. So forgetting the price, the owner-occupier is getting value out of the fact

that the property is located where it's located. There's a tremendous amount, I think, of satisfaction owner-occupiers get from having complete control over that asset. So being able to renovate it, being able to mow the lawn, paint the fence, extend it. I know I'm renting right now. I did buy in 2017 in a distress sale where I think I bought about 30% below fair market value.

But set that aside. But owning is a radically different experience to renting. There's a lot of non-price gratification that you get from having control over that place that you're spending most of your life in. And I think that those non-economic benefits i mean you could quantify them but i guess i describe them as non-financial benefits um that are hard to quantify create a tremendous amount of non-price inertia in the decision-making process of owner-occupiers i mean i can't tell you how many owner-occupiers I've met who have said,

I don't care what, you know, I've paid down a lot of my debt. I don't care what is happening to the value of my house. I want to live in this street, in this location. I want to, you know, watch the sunset every night from this vantage, and I want to be close to all my mates who are located within a few hundred metres of me. So the indivisibility of the housing asset and the fusing of the consumption and investment characteristics of that asset

and the fact that housing is not purely a financial asset like a share or a bond makes, I think, the price discovery process much more complex. And then, of course, it depends on the marginal flows. So are the owner-occupiers dominating the flows? Or is it of the investors? And one of the unique features of the Aussie housing market is two things. Firstly, we have a pretty unusually high home ownership rate by global standards, around 70%. And the second thing is our rental stock is also owned by those same owner-occupiers.

So owner-occupiers actually own like 98% of all housing in Australia, which is much higher than any other country in the world that I know of. And that means they're funding the debt. So that kind of elevates the household debt-to-income ratio vis-a-vis peers overseas. But it also means you have retail investors and owner-occupiers who are making decisions about investment properties. And they're likely to behave very differently to an institution. I know about 70% of the money I run is for instos and 30% is for retail. And, you know, I was actually on a call with a humongous, like multi-hundred billion dollar hedge fund style operation

in New York this morning, right? Bridgewater. Huh? And I was saying to them I didn't really want them as an investor because, you know, institutions tend to be fickle. They tend to try and tie markets. They can be too smart by half. I'm lucky that I have wonderful Insto investors who tend to be the more eccentric members

of their community. My Insto investors, with all due respect, tend to be more idiosyncratic and heterodox. But your kind of stereotypical Insto, I think, is too smart by half and is trying to rationalize their existence by moving your money around constantly and not necessarily adding value. And I think if you had that rental stock controlled by Instos, you can just see them. They're going to get beaten up by their researchers and consultants and analysts who are saying,

why are you holding on to Aussie housing when it's going to fall 20%, 30%? You should be investing in cash or long-duration bonds or US property. And so they could be whipping around that money left, right and centre if they control the Aussie rental stock, which they don't. So they have a sort of activity bias. Yeah. Absolutely.

I mean, I see it in my flows. The instos are much more yippee. I think in general, retail money is much stickier and there's much more inertia associated with retail money. I think that probably benefits the Aussie investment stock. Now, one of my other hypotheses, like over the last 10 years, has been the introduction of the Chinese bid to Aussie housing, I think is not a good thing in terms of that stability

because we trade against Chinese banks and they tend to be highly mercenary, highly transactional, highly zero-sum, and they can be hyperbolic. And so one of my fears has been if you assume away the possibility that the Chinese have been buying Aussie property as a hedge against internal political risk, and so they've been trying to diversify that away, in which case they're likely to be relatively static holders of the asset.

If they're just doing it as a trade, I mean, that Asian participation could actually only increase market volatility because they're the first that are likely to cut their losses. When that expectational shift materializes, a counter-argument to my argument is the point I just made about repatriation and diversifying political risk yeah it does seem a lot of these guys want to have a lump of money held outside of beijing and shanghai also the aussie dollars depreciated dramatically against the u.s dollar so from their perspective it probably probably looks like better value than what we um see

and uh so it's an open question i don't know whether i haven't got a firm view one way or another whether the the pronounced chinese participation is going to increase vol but it I'm forever blowing bubbles. Thanks so much for listening. I hope you enjoyed that as much as I did. Before you go, I have a quick favor to ask. If you liked this episode, please rate and review the podcast on iTunes. I know everyone asks, but it really makes a difference. I make these podcasts for free.

They are bloody time consuming, but they're important and I couldn't do it without you. Finally, for show notes and links to everything discussed in that conversation, you can find them on my website, josephnoelwalker.com. That's my full name, J-O-S-E-P-H-N-O-E-L-W-A-L-K-E-R.com. You can also get in touch with me there or on Twitter. My Twitter handle is at josephnwalker. Thanks again for listening. Talk to you soon. Ciao.