How Goldman Sachs views the Australian economy
Our small caps team recently met with strategists from Goldman Sachs and Macquarie Bank. We were keen to hear how these two investment banks view near-term trends for asset classes, and the Australian and U.S. economies. In this blog, we summarise the views of Goldman Sachs. A forthcoming blog will summarise those of Macquarie Bank.
According to Goldman Sachs, the challenge for Australian policy makers will be to bring inflation down without breaking the housing market or causing a recession. To achieve its inflation ambitions, the Reserve Bank of Australia will need to move rates to the restrictive side and Goldman Sachs believe rates will be raised to four per cent (from 3.10 per cent currently) by mid next year.
Below-trend growth will be required to keep inflation down
Importantly, Goldman Sachs also believes below-trend growth will be required to keep inflation down. According to the firm, growth needs to slow a lot and they see growth halving to 1.75 per cent in 2023, thanks to tighter monetary policy and rising living costs. A few years of below trend growth will bring inflation towards a sustainable level.
As an aside, Goldman’s view sits uncomfortably with history. History tells us it can take far longer for inflation to return to normal levels than many would like. For example, when Federal Reserve Bank Chairman Paul Volker presided over rampant inflation in 1979, he first sent the Fed Funds rate to 20 per cent. This was five per cent above the peak inflation rate. Doing the same today would mean a Fed Funds rate in the double digits! It then took another two years for inflation to halve to seven per cent and more than six years for inflation to decline to two per cent.
According to Research Affiliates LLC, “in a meta-analysis of 67 published studies on global inflation and monetary policy, Havranek and Ruskan (2013) found that across 198 instances of policy rate hikes of 1 per cent or more, in developed economies the average lag until a 1 per cent decrease in inflation was achieved was between roughly two and four years.”
Helpfully, Research Affiliates also note, “If inflation is cresting, inflation levels of 4 or 6 per cent revert by half in about a year. If inflation is accelerating, 6 per cent inflation reverts to 3 per cent in a median of about seven years, threatening an extended period of high inflation.”
How long will inflation continue?
Returning to Goldman Sachs insights, they see private consumption slowing the most – so households will do the work. But with Australia’s greater economic momentum heading into Christmas – with a higher savings rate and strong wages growth – Australia’s growth momentum means inflation will continue into the new year.
Specifically, Goldman Sachs notes Australian inflation is hot – annualizing at seven per cent. That is four per cent above the RBA target band. So Australia’s inflation problem is at least as big as peers.
Weaker commodity prices from softer global demand however will help to see inflation peak. Inflation however remains a long way from the RBA’s upper band of three per cent.
Goldman Sachs notes some inflation components are still rising – like utilities and rents. Meanwhile, wage growth is the most challenging component, and wage growth tends to have momentum in it – once it gets going, it’s hard to stop.
Australian private sector wage growth is annualizing at 4-5 per cent which is similar to the U.S. Goldman Sachs also notes the minimum wage is up 5.2 per cent, and this impacts a fifth to a quarter of the workforce. Their view of the outlook for wages growth in Australia is that it is at least as strong as global peers, so Goldman Sachs thinks accelerating growth in wages and rents will keep inflation uncomfortably high.
Strong wages growth reflects the super tight labour market – unemployment is as low as 1974 and vacancy rate high. That implies further rate rises next year, which is precisely what the RBA Governor has warned.
Indeed, Goldman Sachs says the RBA has more work to do because the most recent rate rise to 3.1 per cent puts the overnight cash rate into neutral territory rather than restrictive.
With respect to house prices, Goldman Sachs expects a 15-20 per cent peak-to-trough decline and notes Australia is about half way through that adjustment now.
The sharp rise in associated debt servicing means the recession risk has increased but that is not the Goldman Sachs base-case because the starting point in house prices is far from normal. A 20 per cent decline still puts house prices above pre-COVID levels. But the seven per cent increase in debt servicing ratio is a big deal – and will slow growth a lot but it may not lead to recession, according to Goldman Sachs.
Noting only a third of Australians have a mortgage, Goldman Sachs doesn’t think a doomsday scenario for Australian housing market should be the base case.
In summary, Goldman Sachs believes Australian inflation is high, rates have risen quick but are not yet restrictive, and therefore further tightening is necessary. A recession may be avoided with the decline in the housing market a key.