There is little dissent among economists with the view that a housing sector recession has begun. There is a consensus that residential construction will decline for the next several quarters, with the steepest decline in the third quarter of 2006. However, there is a much more substantial debate about the magnitude of the spillover effect of the sectoral recession in housing on the rest of the economy. The pessimists place heavy weight on the role of housing collateral in generating spendable cash and strong credit growth among households during the housing boom. Measures of "mortgage equity withdrawals" or MEW should decelerate sharply now that the housing downturn is underway. The pessimists believe that consumption will therefore weaken dramatically, potentially leading to a full-scale recession.
The proponents of a less pessimistic view agree with the forecast of declining residential construction but believe that the spillover effect on the rest of the economy should be more muted, permitting a soft landing rather than a recession. They argue that it is total net worth (including equities) and not housing net worth alone that is crucial to consumer spending. They tend to argue that consumer spending responds over a period of time to changes in net worth, so that the lagged benefit of past rises in net worth may mitigate for some period of time the negative impact of a slower current growth rate of net worth.
We take a middle-of-the-road position on this. Following the sharp drop in residential construction likely to be reported for the third quarter, we expect prolonged weakness in the housing market in the aftermath of substantial erosion in affordability. Because interest rates only rose to normal levels rather than to extremely high levels, the potential for a large drop in mortgage rates is much more muted than in past cycles. Thus a quick return to a strong housing market seems quite unlikely. At the same time, worst-case scenarios also seem unlikely. We believe that the "mortgage equity withdrawal" analysis somewhat overstates the likely magnitude of the impact on the overall economy from the housing recession in a context where oil price declines will aid real income growth, corporate liquidity is ample and most interest rates are at normal levels.
Builders have already cut back their new housing starts, but inventories have risen due in part to the lagged completion of homes started earlier. There are early indications that inventories have stopped rising. We believe that “housing inventory liquidation" is now starting. Price discounts are likely to be required in the coming months to get surplus houses and condos sold. The greatest weakness should occur where there was intense speculative activity or dubious credit standards. We believe that the odds of a slightly negative 12-month rate of change in house prices at some point in 2007 are reasonably good. Over the coming quarters, a portion of the reduced demand for housing should be absorbed by a reduction in new supply as a decline in housing completions follows the recent decline in housing starts. This drop in the flow supply of new houses can help mitigate the intensity of the downward pressure on nominal nationwide housing prices once inventories drop to normal levels.
In summary, (1) a housing recession has begun, (2) the housing markets are likely to remain weak for an extended period of time, (3) the overall economy should be able to avoid a full-scale recession but below-trend economic growth is likely to persist through late 2007 and (4) the Federal Reserve is likely to ease in the spring or summer of 2007.
Editor's note: ETFs that track the U.S. housing market include PowerShares Dynamic Building & Construction (NYSEARCA:PKB), SPDR Homebuilders (NYSEARCA:XHB) and iShares Dow Jones U.S. Home Construction (NYSEARCA:ITB).
Written by Richard Hoey