Arguably, interest sensitive homebuilding stocks bore the outsized brunt of last year’s market downturn. D.R. Horton's (NYSE:DHI) (orange bars) market slide came off of a strong market performance in 2017 where income before taxes rose almost 29% at the end of the company’s fiscal year in September. The company’s fortunes by the end of the 1st quarter turned decidedly south, giving up 33% of its market value by year's end. The market slide came despite a tax windfall that reduced the company’s effective tax rate from 35% in 2017 to 29% through the end of its fiscal year.
The three months ending in December saw the company’s effective tax rate fall even further to 24%. DHI’s first fiscal quarter saw income before taxes actually fall 4% before tax savings boosted net income almost 52% in one of the worst December markets since the Great Depression.
The pivotal cost of sales rose 16% through September 2017 YOY, moderating somewhat in 2018 to gains of just over 12%. In the three months through December, the cost of sales shot up just under 7%, a pace that if maintained for the rest of the year would put the annualized growth of the category in the neighborhood of 25%. While DHI’s market performance outpaced that of the Philadelphia Housing Index (purple line) which finished the year down just under 38%, DHI’s market fall was steady and largely unrelenting (red shaded area), despite a month’s growth respite in the early weeks of the 4th quarter. By way of comparison, the S&P 500 (black dotted line) was down just short of 7% over the same period - the benchmark’s second down year since the Great Recession of 2007 (see Figure 1 below).
Figure 1: D.R. Horton, the Philadelphia Housing Index and the S&P 500, 2018
On the supply side, lumber futures (orange bars) peaked in May of last year at a high of $636/1,000 board foot by mid-May (see Figure 2 below). By the end of the year, lumber futures closed for the year at $332.5, down just under 92% over the course of an 8-month period (red shaded area). By year’s end, lumber would scratch out one of its worst years since the Great Recession of 2007.
With little surprise, housing starts (black dotted line) began the year at what turned out to be its peak for the year at 1.334 million units annualized, see-sawing to its second highest level of the year in May at 1.329 million units before plummeting to its June low of 1.18 million units. Recovering to an August level of 1.280 million units, housing starts plunged again to an October reading of 1.217 million units annualized before settling at 1.256 million units through the end of November.
The month’s total was down 8% on the year and down 3.6% from November 2017. The trend appears to be to the upside in December, the report for which was originally scheduled for release on the 17th of January and has yet to be published due to January’s partial federal shutdown.
On the demand side, the federal funds rate (purple dotted line) created a steady headwind for those would-be home buyers in both the existing and new home markets that entered the capital markets to finance their purchase. The federal funds rate notched four consecutive 25-basis point increases to a range of 225 to 250 b/p by December’s Federal Open Markets Committee meeting. With an effective federal funds rate already at the high end of the current range at 2.40% through the end of January, the implied risk premium on the 10-year Treasury at 2.65% at Thursday’s market close (14 Feb) stands at 15 b/p - strikingly out of place this late in the current bull cycle.
Figure 2: Lumber Futures
Treasury yields are even more at odds with this year’s equity gains as the S&P 500 (cyan dotted line), leaving the benchmark about 6% shy of completely clawing back its 4th quarter losses that found the benchmark in a 20% pre-Christmas hole. Yet with the bottom-line bonanza from the Trump corporate tax cuts fast washing out of YOY earnings calculations, analysts are busy downsizing their forecasts on corporate profits in the months ahead.
The downsizing is hardly unusual given the strength of the underlying US economy throughout 2018 coupled with the one-off windfall from corporate tax rates falling to 21%. Continuing fears of further interest rate increases and headwinds coming from the slowing of global trade justify a more bearish stance. The Baltic Dry Index, a leading indicator of global trade, is still down more than 50% YTD. While corporate earnings are hardly an end-all commentary on the health of the overall economy, the direction of corporate health is very much a driver of market sentiment.
Earnings remain under pressure from myriad domestic and global cross-currents already identified by the Fed - just as the Trump fiscal stimulus grinds to a halt. Meanwhile, the fixed 30-year rate has beaten a steady path to the downside after peaking for the year at 4.94% for the week ending 15 November to finish off the year at 4.55%. The 30-year benchmark has fallen further through the first week of February to 4.41%. Interestingly, mortgage originations for the past year were at their lowest level since 2014.
The toxic mix of a 20% US tariff on imported Canadian softwood that came on line in late 2017, devastating wildfires in British Columbia, the infestation of wood-boring beetles—all wreaked havoc on lumber supplies during the course of the year. Time delays due to logistical transport bottlenecks added further costs to the equation which all added up to unprecedented increases in lumber prices for the period. Severe weather conditions in the Southeast and an unusually wet building season in Texas further dampened building activity across large swaths of the south and southeast, areas that comprise about 63% of DHI’s total revenue.
Contract cancellations from these areas made up about 65% of total contract cancellations through the three months ending in December. The tariff regime on Canadian softwood imports quickly bid up prices on the US side of the border. Shares of US lumber producers Weyerhaeuser (WY) and PotlatchDeltic (PCH) were both up 25% from Trump’s April 2017 announcement through the end of the year. At the same time, Canadian listed West Fraser Timber and Canfor, two the North America’s biggest sawmills, were reducing production in response to tariff pummeled low prices for British Columbian soft timber, reflective of the downward plunge in lumber futures.
Nationally, the median selling price of a new home in 2017 came to $323,100 while the average price for the year tipped the scales at $384,900 with building activity for the year, skewing decidedly toward the high end of the market. By December 2017, the median new home price had increased to $343,300 while the average new home price topped $402,900. The median home price growth came to 6.25% - more than doubling the 2.74% annualized wage growth in the greater economy.
By November 2018, the median selling price had moderated considerably to $302,400 while the average selling price had fallen to $362,400. Even with the improvement in wage growth to 3.34% through the end of 2018 paired with an almost a 12% decrease in the median price of a new home, the market remained largely out of reach for all but the upper crust of US hourly wage earners. For DHI, the average selling price across its markets came to $298,800 through the end of the company’s fiscal year in September. Three months through December, that average price had fallen to $292,100.
In the wake of the Fed’s dovish turn, investor appetite for risk assets has improved dramatically both here and abroad. MSCI’s emerging markets stock index is up just under 8% YTD. Since the beginning of the year, the EM space has been the overall market’s most crowded trade. Inflation remains largely subdued across large swaths of the EM space from Brazil to Poland and from the Philippines to Indonesia, slowing monetary tightening.
Even in Turkey where interest rates recently hit 24%, rates now appear headed to the downside with a level of about 15% being likely by year’s end. The S&P 500 is up just over 9% through Thursday’s market close (14 Feb). At this pace, the yield on the 10-year US Treasury could be close to 3% by year's end. The CBOE VIX index has fallen just under 34% YTD. D.R. Horton is up just over 15% YTD. The Philadelphia Housing index is up just under 17% through Thursday’s market close (14 Feb).
Still, a strong dollar, up just over 7% since last February, runs counter to investor expectations as growth in Germany, France and Italy continues to sag, sending the euro down almost 8% against the dollar over the past year. The impact of a strong dollar in international currency markets has applied downward earnings pressure on US multinationals in the 4th quarter. A strong dollar also makes global commodity prices more expensive in local currency terms.
More US oil is widely projected to reach international markets toward the end of the year as pipelines connecting the Permian Basin with export terminals in Houston and along the Gulf Coast go online. The added supply to world markets will likely moderate upward price pressure while likely dampening local price inflation, keeping October’s $84/barrel - last year’s peak - a distant memory. The current $10 spread between WTI, the US benchmark, and Brent, the global benchmark is more than enough to cover shipping costs from the Gulf Coast to Asian markets. That spread will decrease as more discounted US oil hits world markets. Still, the outsized yield spread between US assets and those of its major trading partners will likely remain for the foreseeable future.
DHI is still in correction territory, down almost 13% from its peak August peak. Ditto for the Philadelphia Housing index, down almost 15%. Lumber futures are slowly regaining at least some of last year’s tariff infused losses with March deliveries settling at $401/1,000 board feet, down almost 37% from May’s peak. While logging one of its fastest starts of recent years, the S&P 500 remains down just under 6% from its end of September peak.
The yield on the 10-year Treasury note remains down just under 18% from November peak of 3.24%, its highest yield since April 2011 amid mounting concerns that economic growth both in the US and across the globe could slow. And the price of Brent crude at $66/barrel through Friday’s market close, remains about 22% shy of its October peak.
The dovish turn of the Federal Reserve has clearly boosted both market sentiment and market demand for risk assets both here in the US and abroad. Headwinds remain strong. In the first week of March, we will learn whether the US and China forge some kind of trade agreement, extend their current truce or if the current tariff regime on $200 billion of Chinese goods bumps up from 10% to 25% - inflicting further pain on an already slowing Chinese economy.
Chinese and US markets have both staged double-digit gains of late in hopes that trade tensions are indeed on the wane. Below the immediate surface, however, the ideological chasm between the US and China extend well beyond the mere flow of goods across each country’s respective borders. The flow of traditional goods across international borders has been relatively flat for years. It’s the flow of data across international borders where forward growth resides. The rules governing such data flows remain largely unwritten.
Complicating the equation, the Trump administration’s trade priorities remain mercantilist relics of bygone eras long past. These divergences will last for decades into the future with some form of accommodation rather than a hard-and-fast resolution being the most likely end result.
On the other side of the world, March will also deliver a verdict on whether Britain ignominiously falls out of the EU on a no-deal Brexit. The British Parliament is hopelessly paralyzed on a way forward which makes the default position of the Article 50 process - a no-deal Brexit - frighteningly more likely. To complement the ongoing US tariff regime on steel, aluminum and lumber, the Commerce Department is scheduled to submit its report this week on whether the importation of foreign cars and auto parts constitute a threat to national security under Section 232 of the Trade Expansion Act (1962).
Such a determination could seriously increase the cost of foreign autos and parts, barring exemptions, from Japan, South Korea and Germany for US consumers. Trade tensions have already contributed mightily to the economic slowdown in Germany, Japan as well as China. Italy fell into a technical recession - the country’s third in a decade - with the latest quarterly data from Eurostat, exacerbated by its notoriously weak banks, political uncertainty and a looming credit crisis.
This puts Italy’s recent budget agreement with Brussels at risk. Here in the US, December’s sharp 1.2% MOM drop in consumer spending, a 0.6% decline in industrial production with a precipitous drop in manufacturing production of 0.9% in January, measures that all ran contrary to analysts’ projections—underscoring a heightened level of data noise for the period. January’s PMI survey of US manufacturers logged fairly solid gains in both overall production and new orders. Job creation remained strong. Estimates of 4th quarter GDP growth have fallen from 2.7% to 1.5% on the basis of the new data.
Differences in tabulation and methodology aside, the sheer number of unpredictable economic and dubious political variables, from government shutdowns to trade wars to pseudo-national emergency declarations and resulting political paralysis, are now showing up in the underlying data, pressuring growth and sentiment to the downside. Ravaged supply chains, distorted markets and rising costs to end users are increasingly the end result of these headwinds.
Without the final removal of current tariff regimes on global goods, it is only a matter of time before the FOMC will be forced to push through another uptick in the federal funds rate - if for no other reason than to keep ahead of the ongoing flight of capital to US safe harbor vehicles that global economic uncertainty sets into motion. Without a solution to the current global trade tensions, derivative markets’ verdict on the cessation of rate hikes for the balance of the year now at a 98.7% probability amounts to little more than wishful thinking.
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