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August Residential Construction Spending: Yet More Evidence Of A Turn In Housing

by: New Deal Democrat

Residential construction spending's -0.7% decline was foretold by the recent decline in housing permits.

This, in turn, is more evidence of a likely economic slowdown by next summer.

It is also foreshadowing a Q3 decline in the major long-leading indicator of private fixed residential investment as a share of GDP.

The August decline in residential construction spending was foretold by the recent decline in permits

While, as reported yesterday, construction spending as a whole rose by +0.1% in August, the long-leading part of the report is residential construction spending, and that declined -0.7%. In fact, since its high in April, it has declined -2.6%, as shown in the graph below:

This is noteworthy for a variety of reasons.

Let me start by restating that while residential construction spending historically lags housing permits and starts by several months, it has the advantage of being the least noisy metric of all of the housing series. Here it is, YoY (in blue), compared with the second least volatile series, single-family housing permits (red):

Since single-family permits reached their most recent peak in February and have declined over -6% since then, it is really no surprise that residential construction spending has followed.

But even though construction spending isn't as leading as permits and starts, it is a good leading indicator, as shown, for example, in the below graph in which it is compared with GDP (beige):

Certainly not a 1:1 relationship, but a leading indicator nonetheless. In the past, when private construction spending has slowed down by this much (see 1996, 2002, and 2011), industrial production growth has decelerated sharply in the following year. So, at the very least, this adds to the evidence that a slowdown is likely sometime around summer of next year.

The Q3 decline in residential private construction, in turn, is foreshadowing a decline in residential investment as a share of GDP - a major long-leading indicator

There's an even more specific, and significant, relationship: residential construction spending correlates very closely with private residential fixed investment in the GDP report. Here it is, averaged quarterly and measured YoY (blue) compared with the GDP metric (red):

You can easily see how closely the two compare.

The above graph only runs through Q2. But here's what the monthly readings of residential construction spending look like m/m:

The average of the first two months of Q3 is -0.3%. This is a good working estimate of what the Q3 reading of private fixed residential investment is likely to be in the GDP report, which will be released near the end of this month. Here's what their historical correlation has been:

With the exception of a -0.1% reading in Q2 of last year, there have been no negative quarters of private fixed residential investment in GDP reports since 2011.

Why is this important? Because nominal private fixed residential investment as a percentage of nominal GDP is the pre-eminent long-leading indicator identified by Prof. Edward Leamer in his paper "Housing IS the Business Cycle," in which he pointed out that this metric tends to turn five quarters before the onset of a recession. (This is also, by the way, one of the three favorite metrics of Bill McBride, a/k/a Calculated Risk.) Here's what the long-term relationship looks like:

This measure has the virtue of being fairly non-noisy, but to distill recession signal from noise, a decline of at least 5% from its high. (Note, this is a percent of a percent. Thus, for example, a 5% decline from a reading of 3% of GDP is 2.85%.)

If residential construction spending us is telling us that there is a good chance of a significant decline in private residential fixed investment in Q3, coupled with an increase of 3% or so in overall GDP, then we are likely to see a significant decline in Leamer's pre-eminent long-leading indicator, although probably not out of the "noise" variance at this point.


The bottom line is that yesterday's residential construction spending report is more cogent evidence that the economically important housing sector has been stalling and may be rolling over, particularly if interest rates and house prices continue to rise.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.