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With or Without You: Can the Economy Still Hum if Housing Falters?

With or Without You: Can the Economy Still Hum if Housing Falters?

Key Points
  • Deteriorating homebuilder sentiment, weak single-family housing starts, a plunge in building permits and deteriorating affordability elevate concerns that housing may be sending a negative economic signal.

  • But trends in household formations and residential investment as a share of GDP suggest there may be more room to run.

  • In a rare occurrence, equities have now crossed real estate in terms of contribution to household net worth.

It’s been a while since I devoted these pages to housing; but given the rash of data out last week and concerns which are elevated, it’s time to have a look at the latest trends. This will be a chart-heavier, word-lighter report, so feast your eyes.

Builders’ concerns growing

Let’s start with the well-followed NAHB/Wells Fargo Housing Market Index (HMI), which is a survey of homebuilders. Although the latest reading of 67 for August was better than expected, it remains well below this cycle’s peak of 74 last December and tied for the worst reading in a year.

Homebuilders’ Confidence Faltering

NAHB Housing Market Index

Source: Charles Schwab, FactSet, National Association of Homebuilders (NAHB), as of August 31, 2018. 

Within the HMI, current sales and future sales expectations did pick up; but prospective buyer traffic remains at 49, which is below the threshold of 50—meaning more survey respondents describe conditions as poor vs. good. Builders remain concerned about rising overall material costs—exacerbated by tariffs—as well as limited construction labor supply and lack of buildable lots.

Starts up, permits down

A deteriorating HMI historically has been associated with weaker housing starts and building permits. And that is exactly what we are beginning to see. Housing starts did rebound in August by the most since January; however, the increase was nearly all due to a more than 27% surge in multi-family starts, with single-family starts up less than 2%.

Housing Starts Topping?

Housing Starts

Source: Charles Schwab, Census Bureau, FactSet, as of August 31, 2018.

Building permits were more disappointing last month and dropped the most since February 2017; with weakness in both multi- and single-family. The decline suggests there is less construction in the pipeline, which tends to lead housing starts. It’s also worth pointing out that building permits is one of the 10 sub-components of the Conference Board’s Leading Economic Index (LEI).

Building Permits Rolling Over

Building Permits

Source: Charles Schwab, Census Bureau, FactSet, as of August 31, 2018.

Inventories lower, prices higher

Given that both housing starts and building permits remain well below their historical averages prior to the housing bust, it’s contributed to the inventory problem—especially for smaller and less-expensive homes—which in turn has kept upward pressure on prices. Historically, housing starts have peaked a median 22 months before a recession. As such, to the extent we get a sense that the recent peak was indeed the peak of this cycle, the countdown may begin.

Also of note as we look ahead, nearly 8% of housing starts were in the path of Hurricane Florence, so the data will likely be skewed and whipsawed over the next few months.

Stronger sales now due to weaker sales then

There is another “skew” of sorts with regard to housing data, and it relates to the severity of the prior downturn. According to Ned Davis Research (NDR) data, the pace of sales ran below average for the first six years after the bottom in 2010. The recovery was slow and subpar, due to the excesses created in the prior expansion, and the depth of the Great Recession. The pace of homes sales is now stronger than average only because it was weaker before. This catching-up phase partly explains why the current housing cycle—as well as the overall economic expansion—are already longer than average.

Speaking of sales, existing single-family home sales were flat at a 4.75 million unit rate in August, which followed four consecutive prior declines. Although the data is volatile, the trend has turned negative. In addition, new home sales have faded from their recent March peak, confirming what the aforementioned HMI suggests. 

New Home Sales’ Trends Besting Existing

Existing and New Home Sales

Source: Charles Schwab, Census Bureau, FactSet, National Association of Realtors (NAR). Existing homes as of August 31, 2018. New homes as of July 31, 2018.

In turn, home prices continue to post year-over-year increases, albeit at a slower pace—certainly relative to the late-2013 peak. But prices are still rising at about double the rate of consumer price inflation. This is a negative from an affordability perspective, but a positive in terms of household net worth and the wealth effect—both of which support consumer spending.

Home Prices Still Rising, But Well Off Highs

Existing and New Homes Median Price

Source: Charles Schwab, Census Bureau, FactSet, National Association of Realtors (NAR). Existing homes as of August 31, 2018. New homes as of July 31, 2018.

Affordability takes a hit

Given still-rising price increases, higher mortgage rates and persistent supply shortages, housing affordability has deteriorated and sits at the lowest level in more than a decade. Mortgage rates have rebounded by about 120 basis points since their low two years ago, and are currently more than 4.7%

Sinking Affordability

NAR Housing Affordability

Source: Charles Schwab, FactSet, National Association of Realtors (NAR), as of July 31, 2018.

Another way to measure affordability is by comparing home prices to median family income. New homes are now less affordable relative to income than they were at the 2005 peak of the housing bubble; although existing home affordability is faring a bit better. The rub as it relates to new homes is that builders have been disincentivized to build smaller and less expensive homes due to the aforementioned supply shortages and material cost pressures.

Home Prices Elevated Relative to Incomes

Median New Home Price divided by Family Income

Source: Charles Schwab, Census Bureau, FactSet, National Association of Realtors (NAR), Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2018(c) Ned Davis Research, Inc. All rights reserved.), as of July 31, 2018.  Based on 12-month moving averages. 

Over the past couple of decades, builders have been focusing on larger homes. In 2017, 78% of new homes completed were more than 1800 square feet (48% were between 1,800 and 2,999 square feet, and 30% were more than 3,000 square feet).

Supply shortage

I mentioned supply shortages, which have generally deteriorated, especially for existing homes. The months’ available supply—for both new and existing homes—has mostly stayed below the 6.0 month mark consistently for six years. The low of 3.1 months for existing single-family homes hit last year was an all-time record low.

Low Housing Inventories

Existing and New Homes Months Supply

Source: Charles Schwab, Census Bureau, FactSet, National Association of Realtors (NAR). Existing homes as of August 31, 2018. New homes as of July 31, 2018.

The deterioration in construction activity recently suggests that the inventory problem will not ameliorate. According to NDR, as of mid-2018, there is a housing shortage of about 1.2 million units relative to longer-term trends. This shortage has existed since about 2013, and the tepid level of construction has failed to make a dent in it.

It’s not all bad

Mortgage applications for house purchases remain at multi-year highs for this time of year. In addition, wage growth is finally kicking into higher gear courtesy of the extremely tight labor market; which should support ongoing housing demand. Finally, although Millennials were tagged as the generation of perpetual renters, they are now moving into the stage of their lives where they possess the financial means and work stability to become homeowners, hence the stabilization in household formations.

Household Formations Stabilizing

Household Formations

Source: Charles Schwab, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2018(c) Ned Davis Research, Inc. All rights reserved.), as of June 30, 2018.  

Looking bigger picture

In the post-WWII era, real estate has nearly always represented a larger share of household net worth than equities. There have been only three periods when the opposite was the case—a couple of times in the late-1960s, in 2000, and again today (for the second time in the past few years). 

As a share of household net worth, real estate has been in a sideways channel for the past several years and sits at about 23%. However, given the strength of the bull market, equities now represent a larger 25%; similar to the cross that occurred in 2000. In and of itself, this is not a recession warning sign; however, these crosses in the past have preceded recessions.

Residential construction spending is currently running at 6.7% year-over-year, which is close to its slowest pace since April 2012 according to NDR. Since 1965, residential construction spending has turned negative on a year-over-year basis a median of five months ahead of recessions.

As a share of gross domestic product (GDP), residential investment spending is nearing 4%, up from a record trough of 2.4% in 2010; but clearly well off the bubble high before the financial crisis. The historical average is 4.6%, which suggests this cycle has legs; however, this cycle’s peak is likely to be (much?) lower than past peaks.

Housing Crawling Higher as Share of GDP

Residential Investment

Source: Charles Schwab, Bureau of Economic Analysis, FactSet, as of June 30, 2018.

The economic expansion still has legs and the runway between now and the next recession remains long in our view. We also think the housing cycle likely has more room to run as well, with supports from a strong labor market and higher wages. But higher mortgage rates will continue to dent affordability. Given that housing market activity has led inflection points in the economy, we will be keeping a close eye on starts and permits to judge whether the recent slowing represents a secular shift, or just a cyclical blip.

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