Tuesday, September 28, 2010

Goldman warns of an Australian depression

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.


Anonymous said...

Hmm Just like 1890, There is a great paper on the RBA wesbsite, I think its called Australia Two Depressions one financial crisis. The financial crisis was 1890.
When I read it had to draw breath when the author said words to the effect " The boom was fuelled by cheap credit and the entrance of new 'Non Bank Lenders' (Land Banks).
The more things change the more they stay the same.

I do have one question for you David, I am a Stockbroker and I am thinking about moving all my clients money to Ten Year CGS when the time is right the only problem I have is that when the bust comes I dont think the ten year will be yielding 2.5% like U.S Treasuries I have a feeling they will be 12% ?





David Llewellyn-Smith said...

Hi Steve,

Thanks for the tip on the RBA paper. You're right, yes. If the Goldman scenario comes to pass, CGS rates will climb, and therefore, lose face value. Though we don't have a retail bond market so you might want to check the second part.

RBA will of course cut like mad and presents a possible complication in that it may decide to quantitatively ease in an effort to control bond rates and devalue the currency. Some offshore hedge might therefore also be worth consideration.

You should look out for a book by Peter Jonson (Henry Thornton) early next year. It has a lot of detail on the 1890s. And yes, the parallels are quite unsettling... David

Anonymous said...

Thanks for that David. Yeah I was wondering about RBA QE. I just feel that the aussie govt would not allow it, the rest of the world would not tolerate it either from US.
Lets face it QE is the last move by a bankrupt banana republic, its one thing for the Super Powers like the U.S Japan, UK, and even Switzeralnd to do it. But when middle powers like Aus try it I think it will result in a total collapse.
Bets move into greenabcks I think



David Llewellyn-Smith said...


Yes, that is probably right. Either way, currency is going to get hammered so offshore is still the best hedge.

I guess the ultimate nightmare is actually that capital flight is so extreme that the RBA has to raise rates in the midst of the crisis...

Elson Cade said...

Dave and Elsie Ryn pose in front of their home, which saw its assessed value increase by 45 percent over the past two years, on May 21 in Windsor.(Photo: Morgan Spiehs/The Coloradoan)
When Elsie Ryn saw the 45 percent increase in what Larimer County figured to be the value of her Windsor home, her thoughts were pretty simple.
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