Finance Finance News Don’t be caught out by gearing when the ‘Trump rally’ ends

Don’t be caught out by gearing when the ‘Trump rally’ ends

trump rally markets
President Trump has enjoyed a long honeymoon in financial markets. Photo: AAP
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When Donald Trump gave his victory speech last November, stock-markets realised the worst elements of his campaign rhetoric had been taken too literally, and so rather than crashing as predicted, markets started to rally.

There have been a few bumps along the way, but the ‘Trump rally’ has essentially continued since then.

That now seems to be changing, with influential billionaire investor Ray Dalio selling off risk assets, and Reuters reporting that “the Trump-fed stock rally appears to be faltering as investors worry about geo-political risk and some weaker earnings reports”.

When these kinds of tremors are felt, the people who should be most concerned are those who have borrowed money to invest in the stock market.

‘Gearing up’ got many mum-and-dad investors into trouble during the global financial crisis, because they had not given enough consideration to how gearing works in a falling market.

It amplifies losses even more quickly that gains, because besides the fall in the capital value of shares the investor has to keep paying interest on the money borrowed to buy them.

There are other ways to gear up, but the common story in 2009 was of investors with ‘margin loans’ being asked to tip in more capital, or to sell off shares at bottom of the market.

So as the Trump tremors begin, the lessons of the GFC should not be forgotten: don’t gear up if you don’t know what you’re doing.

And, if you’re nervous about geared investments you’ve already made, get some proper financial advice – ASIC’s website provides a good starting point.

Australia in top gear

Shares are not the only asset class where gearing is used, of course.

In Australia we’ve had nearly two decades of ever-higher borrowing by mum-and-dad investors to invest in residential property.

peter costello property prices
Former Treasurer Peter Costello warns a ‘credit bubble’ could mean tough times ahead.

That, along with super-low interest rates, has created such a credit bubble that even former Treasurer Peter Costello is worried there may be a “big problem” ahead.

That build up in debt began in 1999 when the returns available from the negative gearing of investment properties were suddenly amplified by a huge cut to the capital gains tax – something that all governments since that time have failed to fix.

Labor finally released a policy last year intended to rein in the tax lurks that have driven the credit bubble – good economics, but difficult to sell to a nation addicted to geared profits.

One of the headwinds that policy faces is the misconception that negatively gearing a dwelling is just like doing the same with a portfolio of shares – actually, the economic effects are very different.

Labor may need to rethink the way its policy affects share investors because often they are funding real growth in a company – actually creating more jobs – rather than just inflating an asset bubble.

For example, the capital supplied by long-term investors is what made the US softward giant Microsoft a success. It famously did not pay any dividends to shareholders for many years, instead reinvesting its profits to help it establish market dominance.

In situations like that a sophisticated investor who borrows to invest is making a ‘loss’ year to year, in the hope of a large payout in years to come. If there is any justification for negative gearing, that is it.

Things are very different, however, in Australia’s property market.

The price of residential properties, and the ‘profit’ generated by those properties through rent, have been diverging for many years. ABS figures show that since 2003, rents across Australia have risen by 62 per cent, while house prices have risen 108 per cent.

Yet the ‘value’ delivered to renters by each dwelling is pretty much the same.

Unlike a Microsoft, which turned financial capital into more vastly more valuable intellectual capital, houses in Australia have increased in price but providing exactly the same utility to renters – three bedrooms, two bathrooms or whatever.

And there is almost no chance of houses paying higher ‘dividends’ in the near future.

Research firm Core Logic notes that: “The rental market is currently seeing historic low rates of rental growth and with the amount of rental accommodation ramping up it is easy to see why.”

So while a bout of Trump tremors is a good time to think about geared investments in the share market, it’s not a bad time to review our other gearing obsession – the ‘housing rally’ that increasingly looks to be on borrowed time.

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