Economic Insights - October 22 - 26, 2018
- A housing market stumble: With higher mortgage rates, housing data have disappointed since the start of the year. However, there are still some supports to the sector.
- Weekly highlights: Key Purchasing Manager Indexes (PMIs) for Europe broadly disappointed. The third-quarter GDP report for the United States printed strong consumer spending but surprisingly weak investment.
- Investment implications: What’s the connection between the housing market slowdown and the broader stock market? Higher interest rates.
A housing market stumble
Housing is a key leading indicator for the US economy. In fact, according to Edward Leamer’s 2007 National Bureau of Economic Research Paper Housing is the Business Cycle, weak housing and consumer durables sectors have preceded eight recessions since World War II. Recently, housing data have turned down. Should we be concerned about recession, or worse, a collapse in the housing market like the period that preceded the financial crisis?
Residential investment detracted from GDP growth the first three quarters of this year. Existing-home sales have declined for the last six months. New-home sales are down 13.2% over the last year. Building permits, which lead housing starts, have been declining since the start of the year.
Higher mortgage rates likely explain some of the weakness. According to Bankrate.com, the 30-year mortgage rate is up 90 basis points since the start of the year. Higher mortgage rates are eroding housing affordability. The National Association of Realtors housing affordability composite index has declined sharply.
However, there are still some tailwinds to housing. Homebuilder confidence remains buoyant albeit down from its cycle high. Home prices have started to modestly decelerate potentially boosting affordability. Inventories, which had been a constraint on sales, are picking up. New-home inventories are at the highest level since 2011 and existing-home inventories, while still very low, have moved up over the last year. Stronger wage growth could also bolster demand.
The strongest support to the housing market is probably demographics. Household formation is trending up. The homeownership rate is finally picking up too. In fact, after bottoming in 2016, 2017 was the first year since 2004 that the homeownership rate increased. And, it was up for the under-35 age group.
Millennials, who according to Bloomberg are the largest home buying generation since the baby boomers, are finally moving out of their parent’s basements. That pent-up demand could support the housing market even as mortgage rates rise. Indeed, according to Smead Capital at Seeking Alpha, demographics supported the housing market during the 1970s and 1980s, a period when mortgage rates were at record highs.
Comparing this soft patch to the housing crisis is way overblown. Residential spending makes up about 3.9% of GDP versus 6.7% in 2005. So even if housing continues to slow, it’s impact on overall growth will be much smaller. In fact, even as housing detracted from growth in the third quarter, GDP was still up 3.5%. There also isn’t a lot of imbalance in the housing market. Housing starts are far below their mid-2005 peak. The housing vacancy rate is low as well.
Housing has stumbled into a soft patch. If mortgage rates continue to rise, that could be further near-term drag on housing. But, there are plenty of supports to the housing market as well, demographics being the biggest.
Eurozone PMIs disappointed. The headline manufacturing PMI dropped from 53.2 to 52.1. Germany’s composite PMI dropped to 52.7, the lowest level since 2016. This unexpected weakness suggests downside risks to growth, which has slowed from the end of last year. The European Central Bank (ECB) has been undeterred by the soft patch. At last week’s meeting, Draghi continued to emphasize that risks were broadly balanced, although he acknowledged that data had weakened. The bar is extraordinarily high for the ECB to not end its asset purchase program at the end of this year.
Decent headline GDP print:
For the third quarter, GDP grew at a 3.5% pace. But below the surface, the report was somewhat mixed. On the positive side, consumer spending soared 4.0%, the fastest gain since 2014. Inventories added two percentage points to GDP growth. Government spending stoutly accelerated, up 3.3%. However, on the negative side, investment spending disappointed, with nonresidential investment spending barely increasing. And with core capital goods orders down the last two months, there is tepid momentum for investment going into the fourth quarter. With the strength in consumer and government spending, real final sales to domestic purchasers accelerated 3.1%. Net exports detracted about 1.78 points from growth, the largest drag in 33 years.
We don’t expect housing to derail the US economy, consumer spending should keep growth well supported. But, higher interest rates, which caused problems in the housing market also created trouble for the stock market. The move up to nearly 3.25% on the US Treasury rate created considerable market volatility. We expect market volatility to continue as the market adjusts to higher rates. We’d consider staying cautious and being defensively positioned.