November 26, 2005

By Laura du Preez

There a number of parallels between the property bubble that burst in the United States in 1969/1970 and the situation today, and you should be aware of how the collapse of the US housing market will affect investment markets worldwide, Prieur du Plessis, the managing director of Plexus Asset Management, says.

It is difficult to predict whether what has been dubbed "the biggest bubble in history" in the United States housing market will burst, and if does, when, Prieur du Plessis, the managing director of Plexus Asset Management, says.

However, the same factors that preceded the bursting of a house price bubble in 1969 have emerged this time, Du Plessis says.

US house prices have risen sharply, and American consumers have been remortgaging their home loans to convert the gains they have made on their homes into cash to embark on spending sprees.

According to Michael Power, a strategist at Investec, in 2004, Americans took US$700 billion (R4 620 billion) out of their home loans to spend on goods and services.

However, a decline in house prices, rising interest rates and the fact that a number of home loans have been given to buyers who are likely to battle to meet their repayments if conditions worsen for them, could affect not only consumer spending, but the US and global markets.

Du Plessis says the seriousness of the situation is evident only when you consider the macro-economic consequences of the bursting of the house-price bubble, and therefore also the investment implications.

The most recent comparable period of exceptional house price increases was 38 years ago, when house prices increased by about nine percent a year from the end of 1966 to mid-1969, he says. "Yes, 1969 - for those who can remember, it was the year of the great collapse in equity prices, similar to the technology-inspired collapse of 2000," he says.

After reaching a high in 1969, the average house price in the US dropped by about 10 percent the following year, Du Plessis says. It took four years before the 1969 levels could again be reached in real terms.

However, the sharp decline in house prices did not occur in isolation, he says.

The US Federal Reserve Board (the Fed) hiked interest rates aggressively from the last quarter of 1968 to the end of 1969 in order to curb a sharply rising inflation rate and dampen the rapidly growing economy.

Long-term interest rates rose sharply as higher inflation rates were built into market expectations, and it therefore became expensive to finance houses, Du Plessis says. Furthermore, the broad share price indices in the US fell sharply in January 1969, on expectations of lower corporate earnings growth.

The macro-economic consequences of the 1969/1970 decline in house prices and share prices were enormous, Du Plessis says. US retail sales fell sharply over the following year, while the sales of new vehicles decreas-ed by 40 percent.

The economy, as measured in terms of industrial production, contracted by more than seven percent. Commodity prices, and specifically those of metals such as copper, declined by nearly 20 percent.

Contemporary parallels
The current situation is very similar to that of 1968/69, Du Plessis says. The US inflation rate is rising sharply. The Fed is aggressively increasing short-term interest rates.

In spite of the higher lending rates, the US economy is still showing momentum, he says, and there has already been a sharp rise in long-term interest rates.

And don't think the problems are unique to the US. Du Plessis says the rest of the world is also facing rising inflation rates, high house prices and rising long-term interest rates, and should the US house-price bubble burst, it would impact on economies and investment markets worldwide.

"A sharp drop in share and house prices would undoubtedly hit the pocket of the American consumer (who accounts for 71 percent of the US economy) and considerably curtail consumer demand for and the affordability of consumer products," Du Plessis says.
As the US is the largest single economy, a decrease in demand will have a knock-on effect on the rest of the world, he says. Even China, which is currently one of the driving forces in the global economy, will not be able to escape the lower demand.

Emerging economies
Commodity prices, and especially those of base metals, could come under severe downward pressure.

"This will be detrimental to the emerging economies, such as South Africa, which are largely dependent on commodity exports. It will be reflected in particular in the negative effect on these countries' trade balances and balance of payments.

"The increased economic risks will also result in their currencies (including the rand) coming under pressure. Lending rates will have to be raised in order to dampen domestic demand and counter the inflationary effect of the lower currencies."

However, this does not necessarily mean that economic growth in the emerging economies in local currency terms will decline sharply, Du Plessis says.

The composition of economic growth will have to change, as exports are supported in times of a weaker currency, while the growth in domestic consumer spending decreases.

The share prices of listed com-panies, especially those of local economically sensitive companies, could come under sharp downward pressure as a result of expected lower earnings growth, while those of primary exporters could benefit from the weaker currencies in spite of lower commodity prices, he says. Long-term interest rates in the emerging economies could also rise sharply.

Du Plessis says although it is difficult to predict whether or not the US property bubble will burst, what is clear, is that the time of cheap money is over for now. As a result, the risks in asset classes that have benefited from the time of cheap money have increased substantially.

This includes all investments that are sensitive to the local economy.

Du Plessis concludes that perhaps it is time to re-evaluate your investment portfolio as a whole. "Prevention is better than cure."