Rising House Prices: A Sign of Weakness?

Includes: ITB, IYR, REZ, RWR, RWX, XHB
by: Firat Ünlü

Around the peak of a bubble there’s always not just one but many signs that asset prices have seriously decoupled from reality. The astronomical increase in the price of jade should make even the most bullish investor pause for a second and reflect on the fundamentals.

In the old days rising house prices were associated with a growing economy. In those days rising asset prices reflected a sound and solid economic foundation. Higher income supported higher mortgage payments or rents. This still holds true in some economies but over the last couple of decades an increase in housing prices has often been a sign of economic weakness and imbalance.

The typical response of central banks after a downturn is to open the monetary spigot and lower rates. The US housing bubble was in no small part down to actions of the Fed. Similarly the Japanese central bank opened the way for an astonishing rise in asset-prices; one sign of the madness was that the palace grounds of the Imperial Palace were higher than the value of all the real estate in the state of California.

In the US consumers were supposed to benefit from the ‘wealth effect’ and keep the economy going through spending which itself was supposed to be justified as their asset rose in value.

The reason why many economists did not foresee the crash was that it increasingly becomes unclear whether it is higher asset-prices that drive the economy as they lead to jobs in specific sectors such as real-estate and construction and spending is kept higher through borrowing. Or whether the economy fundamentally does support higher asset-prices; there’s all low unemployment and all those high-paying jobs after all. The causality becomes difficult to entangle.

The Chinese case is a bit different as leverage only plays a small role but, just like the US (lower income for the middle class) and Japan (supposed to increase domestic consumption) rising house prices may be a sign of fundamental economic weakness.

In the past those with capital were able to use if profitably in areas such as light manufacturing. They did benefit from cheap and diligent labour. Now that pressure for higher wages swells profit margins go down. Insecurity over the future value of the RMB only adds to it. The housing sector was highly regulated and it wasn’t until a couple of years ago that real reform kicked in and it became a target for substantial investment and speculation.

As has been pointed out by other authors China does not offer a wide range of option for savers, never mind deep and liquid ones, which causes them to look for investment opportunities. Income distribution in China is heavily skewed towards the rich. The Chinese Gini-coefficient is higher than the American one; i.e. there is more inequality in China than in America. And here a Chinese paradox comes into play.

As wages increase the capability of citizens to afford higher priced house units augments but at the same time as wages increase and profits fall, the incentive to use one’s savings elsewhere in the economy becomes apparent. Some of those that became rich earlier e.g. through in the export sector, moved into the real-estate sector in time to benefit from the recent boom. Case in point: the infamous Wenzhou speculators . Having amassed vast fortunes in the export sector they have switched to real-estate and are blamed by many ordinary Chinese for sky-rocketing house-prices.

Now is Chinese real-estate overpriced? It’s hard to tell on a general basis and for as long as wages rise significantly, as they do, they are backed by sound economic fundamentals. But as seen above it is difficult to entangle the exact causality.

The irony behind all this is that investors did benefit twice from the transformation of a Communist economy, one time because of low wages and as wages increased through higher asset-prices.

Disclosure: No positions

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