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Robbie Morrison
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Investment analyst concentrating on (and working in) non-U.S. markets. Favors bottom-up fundamental analysis but recognizes the necessity to apply a robust macro-overlay given linkages of markets, myriad crises and dynamic global economic environment. Sector concentration has been on those... More
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  • U.S. Housing: Heading In The Right Direction 0 comments
    Jul 8, 2013 2:35 PM

    Not since last autumn have these pages directly addressed the condition of the U.S. housing market. At that time data were mixed at best, with optimists predicting….well praying….that the sector's inevitable recovery would provide a needed boost to overall economic growth. Those with a more cautious nature fretted over the number of properties underwater, tight credit conditions, and the difficult-to-pin-down, but nefarious sounding, shadow inventory looming over the market. Members of the bullish camp saw the formation of a floor in home prices as well as a bounce in new home construction as signs that housing, as it had done prior to the crisis, would boost consumer wealth (and confidence) and that the sector again would provide a multiplier effect across other industries. Home sales tend to share the love with furniture and appliance purveyors along with service providers such as cable-TV operators and the local lawn boy. Less directly, rising prices of one's largest asset should lead to general consumer giddiness, which translates into looser purse strings.

    While theoretically all valid points, absent from that logic was the reality of supply and demand. During the crisis aftermath, there was too much supply, and demand…given tepid jobs growth and restrictive credit standards ….was nowhere near sufficient to sop up the excess inventory. In recent U.S. recessions…those caused by inflation-inducing, overheated growth forcing the Fed to raise interest rates….the subsequent lowering of borrowing costs would boost activity in credit-dependent segments of the economy like housing. Not so this time around. America's attempt to create a perpetual motion machine by having housing become a primary driver of growth, led to absurdly high building activity and once the crisis hit, the stratospheric level of inventory had to be rationalized.

    (click to enlarge)

    Home building on this frenetic scale inevitably outstrips a country's needs. We cannot export houses like we can automobiles or farm equipment. Back in 2007 one prescient economist stated that in housing-based recessions, first equities turn around, then the economy enters recovery and lastly housing finds a bottom as the inventory overhang is worked through and shell-shocked (and overleveraged) consumers regain the confidence to make big-ticket purchases. Sadly this process could take over a half-decade. The good news is that we are more than that far along since the crisis's onset and, as evidenced by the following data, housing has apparently turned the corner.

    If You Build It, They Will Come…..And Did They Ever.

    The country's ill-fated push into creating an equity society was met with enthusiasm by the building industry. In the 20 years beginning in 1980, U.S. home starts have averaged just over 1.4 million per year. At the housing bubble's zenith it reached over 2 million. In a particularly nasty example of mean reversion, starts plummeted in the wake of the crisis, averaging 687 thousand (half the long-term trend) over the past five years. The silver lining is that 2012's number of 781 thousand was a 28% jump over the prior year's activity. The good news has continued into 2013 with March's monthly data cresting over 1 million on an annualized basis. May's figure of 914 thousand represents a 29% gain over the May 2012 figure. True much of the gain has come from multi-family units, the domain of renters, rather than the single family space, which has a more positive knock-off effect across the economy. But this development could be considered beneficial as it rebalances the market away from marginal (i.e. risky) owners and allows the rental space to play catch up.

    The overhang in housing inventory can be seen in the chart below. At the end of 2006 there were nearly 540 thousand new homes on the market. As fate would have it, this peak occurred just about the time the easy credit spigot got turned off. Over the ensuing six years, this glut had to get worked off before the industry could once again ramp up its core operations.

    (click to enlarge)

    Sales of new homes followed a similarly depressing trajectory. Monthly sales on an annualized basis peaked at nearly 1.4 million in July 2005. Sales plummeted to 270 thousand by early 2011, nearly one-quarter of its pre-crisis average. Time has healed this wound as well, given that monthly sales have risen 76% since the bottom to 476 thousand (annualized) this past May. Even when ignoring the distorted figures of the bubble years, if demand for new homes continues to climb towards its pre-crisis average, the increased building activity should provide a tailwind for the broader economy.

    (click to enlarge)

    Although a painful process, this culling of inventory was necessary to meet the toned-down demand from homebuyers. The same dynamics have played out with existing homes, which represents 85% of the housing market. May's inventory of existing homes for sale is 10% below figure from 12 months prior. Existing home sales ticked up nearly 13% over the same period. While this segment does not prime the overall economic pump as new home activity, it is evidence of a market finding a new equilibrium. The combination of rising sales and lower inventory has pushed the widely followed figure of market supply at the existing sales pace to 5.1 months, below the accepted equilibrium of six months. The market for new homes has proven even tighter with the inventory to sales figure at 4.1 months.

    A Wealth Effect That the "Rest" Of the Country Can Appreciate

    Normalization of supply and demand has led to a welcome bump in home prices. The S&P Case-Shiller Home Price Index for 20 major cities has posted positive year-on-year gains for the past 11 months. April's 12.1% gain represents the largest advance in the post-crisis era. Still home prices remain 26% below the market's peak. A consequence of that is a large amount of homes still underwater, hindering the owner's ability to enter the market for an upgrade or borrow against the home's equity for some good old-fashioned personal consumption.

    (click to enlarge)

    The fact that prices remain so far below the market peak partly explains why existing homes inventory is at such a low level. Owners….well those not already tossed onto the street….may be willing to wait for prices to rebound rather than take the immediate hit by putting a house on the market. As prices rise, potential sellers…and there are lots of them…may be drawn into the market, which could act to keep a lid on any rapid price gains over the near term. This is especially true as buyers would likely be unable to stomach higher prices given that other factors impacting the home-buying process…job security and access to credit….remain flighty at best.

    (click to enlarge)

    A Remaining Hurdle: Lending Standards Still Tight

    A consistent theme during the post-crisis environment is the lack of access to credit for much of the public. In order to atone for past stupidity, the majority of banks, as seen in the chart below, have steadily tightened lending standards. Only within the past four quarters have a net number of banks surveyed by the Fed begun easing credit standards for prime borrowers. If one has less than stellar credit, then forget it. The draconian conditions imposed in the wake of the crisis have yet to ease. Welcome (back) to the world of renting.

    (click to enlarge)

    For the blessed few that qualify, then rates are deliciously low thanks to the Fed's intervention into the Treasury and Mortgage Backed Security (MBS) market. Yet rates eventually will go up. And when they do, it will add another headwind to the housing market. According to Bankrate.com, the rate on a 30-Year fixed mortgage has risen nearly 100 bps since December to 4.3%. That said, that is still over 2% below the 2000-2013 average. And while higher rates add to the cost of ownership, the slightly juicier returns for banks may entice them to loosen lending standards. One unforeseen consequence of the Fed's strategy is that with rates so low, it is simply not worth it for banks to take on the risk of originating long-term loans. Instead they have kept these funds stashed in ultra-safe and ultra-low yielding short-term instruments.

    (click to enlarge)

    While Not the Pilot in GDP Growth, Housing At Least Contributing

    An easing of lending standards while interest rates remain near historic lows could provide a needed boost to housing demand to complement the aforementioned rationalization of supply. Such a development could ensure that home building ceases to be a drag on economic growth. Over the past 20-plus years, residential construction has averaged a 4.7% slice of GDP. During the housing boom, the sector accounted for as much as 6.1%. While a relatively small piece of the economic pie, given its multiplier effect, having housing continue its climb back to the long-term average will be a necessary step if economic growth is to escape from its current funk.

    (click to enlarge)

    Already this is occurring. In 10 of the past 12 quarters, residential construction has been a positive contributor to overall GDP growth, with the past six quarters being especially strong. This contribution is welcome given that overall GDP growth has averaged a forgettable 2.1% over that period. For full-year 2012, 0.27 percentage points of the overall 2.2% rise in GDP was attributable to home building. That was after a six year run of the sector being a net drag on economic growth.

    (click to enlarge)

    Despite Turnaround, Further Housing Gains Need Support From Broad-Based Growth

    While it has indeed been a long, tough road, the U.S. housing sector appears to have turned the corner. Hopefully the country won't once again put the cart before the horse. As has been previously argued on these pages, a robust housing sector should be the consequence of a strong economy, not the source of it. Economies built for the long haul would be better suited to rely upon manufacturing, professional services and other productive sectors as growth engines. For housing to reach the next stage of recovery, an improvement in the jobs market will be necessary. Recent employment gains have largely come in the temporary, retail and food-service segments; a pool of borrowers that despite higher interest rates, likely won't get banks off the sidelines.

    Still the overall news is good. Higher home prices could also aid economic growth by serving as collateral for entrepreneurs who often rely upon personal assets to fund new ventures. Higher property prices will also stop the bleed on tax-starved municipalities across the country. One could argue that the prime beneficiary of the Fed's extraordinary policy initiatives has been Wall Street rather than ordinary Americans. While financial market participants may indeed feel wealthier, at least ephemerally, it is difficult for Joe Consumer to thump his chest when his primary asset is still at 2004 levels…and possibly underwater. In a twisted irony, in the absence of retail buyers, major asset managers with cash to burn and access to cheap credit have scooped up homes as investment vehicles, and in the process have become some of the largest homeowners/landlords in the country. And we wonder why current Fed policy has produced its fair share of cynics.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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