Home Truths

The US economy is driven as never before by the housing market. This would be fine if it was a reliable and sustainable source of growth. Unfortunately, it is a highly cyclical sector and most valuation measures have now been pushed to the limits if not beyond. If that was not enough then Alan Greenspan’s Jackson Hole statements suggest that if the housing market does not subside by itself, then the Federal Reserve will increase interest rates until it does. Additionally, insiders at homebuilding stocks have now begun selling their own stock in amounts that suggest that they now believe that the housing cycle is very mature.

So it is clearly a very important time to analyze the extent to which the economy has become driven by the housing market and the influence it will have if housing activity suddenly goes quiet.

The Real Estate Economy

The chart below shows just one example of the dramatic economic transformation, over recent years, away from manufacturing and towards real estate. As manufacturing employment has collapsed, one of the greatest offsets has been real estate employment.

In the short term this switch has helped support job growth but longer term housing is just masking the underlying weakness of the US economy. Over time Real Estate employment is stable as a proportion of the working population. How many realtors and mortgage specialists do we really need? At the moment we have more than usual, simply because we are in a housing boom. However, it is likely the plunge in manufacturing employment is to a large extent structural as jobs continue to be transferred overseas due to the dramatic improvement in the competitiveness of developing countries.

Indeed, the housing market is currently boosting the economy to a remarkable extent. According to Freddie Mac, the amount of cash-out mortgage refinancing soared to $59 billion in Q2, up from $43 billion in Q1. So refinancing alone is running at a $200 billion annual rate in 2005, up from $126 billion in 2004, $139 billion in 2003, and $96 billion in 2002. If anything this trend has been accelerating and so far this cash flow boost has added 2% to GDP and has dwarfed the drain from higher gasoline costs – roughly $22 billion annualized in Q2.

Sometimes economists and politicians tell us that the economy is remarkably resilient in the face of higher energy costs and other constraints, so it must be that it is demonstrating underlying strength. This is upside down analysis. They seem to be totally unaware that the incredible level of debt creation dwarfs any and all other constraints, at least for the time being. Debt that is just a cyclical boost generated from the strongest house price boom we have experienced in our lives.

  Furthermore, the impact of the housing market on the US economy does not stop at just refinancing. Merrill Lynch have estimated that making additional allowance for the impact of the wealth effect, realized capital gains, home equity loans and residential investment, that housing is now contributing fully half of the growth in the economy in 2005. These calculations are shown in the table below.

 

Housing market constraints

With the economy dependant on housing as never before any downturn could have a dramatic impact on growth. The downturn may not be too far away as now the odds are heavily stacked against the housing market. With higher short term rates and relentlessly higher prices, the housing market has become a significant challenge for first time buyers in particular. The charts below show that affordability is now at its lowest level since the end of the 1980s, and that the Homeprice-To-Income Ratio is stretching new buyers as never before.

 

Furthermore, existing owners have been reducing the amount of equity they own in their own houses, even while house prices have been rising dramatically. So Americans have been increasing their borrowing at a phenomenal rate, through refinancing, even to the point of reducing their store of wealth in real estate.

This at a time when the savings rate has gone to zero! Americans, in general, have truly become borrowing and spending addicts. This is the main source of growth in US today. Massive debt expansion generated from the housing market and remarkably lenient lending criteria.

What comes next?

If the housing market is extended, homebuilder insiders are selling and the Federal Reserve has indicated that it will raise rates as far as in necessary to control the house price boom, it is time to consider what will happen next. Clearly the housing market will soon no longer support the economy and just as important debt expansion will suddenly subside. With the consumer up to their eye-balls in debt, with a zero savings rate it is not so far fetched to expect that consumers will have to retrench, perhaps dramatically so.

Then we need to consider whether the oil price explosion will finally begin to tell. The chart below shows that for the last 30 years a dramatic rise in oil prices, just like our recent experience, has lead to or coincided with a recession.

Summary

It is now highly likely that we are near the end of the house price boom. House prices are extended on most measures, homebuilder insiders are selling their shares, and the Federal Reserve is clearly out to stop further house price escalation.

If the house price boom is finally near an end, it is highly likely that a recession can not be far behind. The housing market has been boosting growth substantially and slower activity will have a substantial impact.  Beyond housing, related consumer debt creation has also been extraordinary in recent years and the savings rate is now zero. The remarkable borrowing and spending binge must also surely come to an end or at least a substantial moderation with a slower housing market.

Very few economists ever forecast a recession but if we are right about the end of the house price boom, American consumers will no longer be able to maintain their borrowing and spending addiction, and it is likely that energy price increases will finally have their impact and induce a recession, or something close, sometime in 2006. No doubt the Federal Reserve will then quickly revert to providing another interest rate fix in time for a 2007/08 election boom. Funny how it all ends up fitting nicely into the election timetable.

 

 

 

 

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