This blog has been meaning to post on the relatively recent Goldman Sachs report on Australian housing by economists Tim Toohey, David Colosimo and Andrew Boak.
It is a very long report and there is little point in going through it blow-by-blow. But, contrary to the way it has been reported, the research is frighteningly bearish.
The most significant part of the report begins:
On whether Australian house prices constitute a speculative bubble: No
• We think that the behaviour of house prices over the past year, and indeed the past decade does not resemble a speculative bubble. Our rationale is that: i) Refinancing of established homes is at a 9-year low. ii) The turnover of home sales that needed some form of financing as a share of the existing housing stock is low compared to the past 20 years. iii) The loan to valuation ratio of established dwellings remains well below the level seen at the start of the decade. iv) The loan to valuation ratio of new dwellings has remained broadly unchanged over the past decade. Indeed, even with the large lift in first home buyer incentives, LVRs remained largely unchanged.
• There is a very big difference between a speculative bubble and a period of overvaluation. BIS analysis suggests that there is less than a 40% probability of a house price boom ending in a bust based on a study of 16 house price boom and busts since 1970. Periods of overvaluation can extend for long periods of time and if they are supported by fundamentals, need not enter a period of dramatic price reversal.
Obviously, this blog disagrees with this analysis. Ten years ago there was no commodities boom and there was still tear away growth in house prices. That a commodities boom came along and bailed out a housing bubble is an important historic and conceptual point. It also finds the quote from BIS ridiculous. A 40% chance of a bust is fantastically high coming from the permabulls at BIS.
But that is a by-the-by for this post. What matters is that despite different terminology, Goldman has identified a major overvaluation of Australian housing and they go on to estimate in the 24-35% range. Next comes the kicker.
On a template house prices deflation: The terms of trade and China excess returns
• The 1880-1900 period serves as an interesting historical parallel. i) House prices to income per head are currently as high as at any other time other than 1890. ii) Business investment as a share of GDP in 2011 will likely reach levels not seen for over 120 years. iii) Residential investment as a share of GDP finished 2009 well below the 2004 peak, yet it remains surprisingly historically high. If we are right in our forecast that residential investment will cycle up strongly in 2013, Australia's residential investment as a share of GDP will approach levels seen in 3 historically high investment periods: the mid-2000s,
the mid-1970s and the mid-1880s. iv) Australia's export mix has again returned to a dominance in primary commodities with its economic fortunes increasingly tied to its largest export market. In 1890 it was Britain. In 2010 it is China. v) The withdrawal of foreign capital was a primary catalyst of the 1890s recession. The main risk in the modern era remains Australia's reliance on foreigners to fund Australia's investment savings gap which requires ongoing foreign appetite for Australian bank bonds.
• In many ways the 1880's provides a rudimentary template for the economic conditions that could prompt the deflation of the Australian housing market. The prospect of an abrupt and sustained decline in Australia's terms of trade, most likely associated with the combination of deteriorating excess returns in China and substantially stronger resource supply, would be the key catalyst for a shift in Australia's house price dynamics. Absent a severe recession in China in the interim, the most likely period when such an event could occur is when bulk commodities enter a period of global excess supply. Our best guess is that iron ore and coal markets could well face this prospect in 2013-14.
In other words, whilst Goldman refuses to use the word ‘bubble’, it is nonetheless predicting a convergence of inflated prices, increased housing supply and falling national income in 2013. And it isn’t done. The final blow is below:
On the economic costs of a bust in housing: Could test Australia's policy capacity
• We study 6 house price booms and busts from the US, UK, the Nordic countries and the Netherlands. We conclude that: i) The experience of Australia during the boom phase is remarkably consistent with the other boom economies in terms of house price growth, credit growth, GDP growth, consumption growth, the decline in the unemployment rate and even the extent of interest rate rises. ii) The only real difference is that Australia
thought it fiscally wise to spend over 4% of GDP during the boom phase! iii) House price bubbles that are augmented by reversals in the terms of trade can be far more painful events than an independent house price bust pricked via monetary policy. iv) A house price bust consuming somewhere between 5% and 10% of GDP in fiscal resources of other countries would quickly exhaust Australia's fiscal capacity and the patience of foreign and domestic investors if replicated in Australia. v) In the event of a combined terms of trade and house price decline, the magnitude of interest rate reductions in Australia would quickly breach historical lows.
According to Goldman then, there's no housing bubble, but there is an Australia bubble; where overspending is based on the psychological extrapolation of past and current commodity prices and economic growth to the future. The unstated but inescapable conclusion is that when the terms of trade correction happens, we’ll face a balance-sheet recession (or depression) as assets deflate.
As the title of this blog suggests, unless we change direction, it agrees there is a significant risk of Goldman's scenario playing out.