Economics & Growth | Equities | US
Is This a Housing Recession or a Mid-Course Correction?
- By John Tierney
- 4 min read
Summary
- Housing activity is going through an abrupt slowdown as rising rates crimp affordability, leading many to declare that housing is in a recession.
- Housing will get worse – but there is little chance that it turns into a 2008-09 bust.
- A key reason is that housing inventory is remarkably low. It may take only a modest adjustment in home prices to bring the market back into balance.
- If affordability remains an issue for many people, we expect homebuilders will transition to building more multifamily structures for the rental market.
Market Implications
- We are underweight homebuilders XHB ETF due to headline risk and the likelihood we see another leg of the bear equity market in coming months.
- This is a tactical position, and we expect to move to market- or over-weight due to strong underlying fundamentals, as the housing sector stabilizes.
- One risk is that shelter costs – a key component of inflation – are slow to stabilize and reverse, pushing the Fed to raise rates more than many expect to tame inflation, and making a full-blown recession more likely.
Housing Will Slow Further
The ominous words are popping up everywhere: Housing is in recession. Here’s the bad news. It is going to get a bit worse. But there’s good news too – barring some economic disaster we are not going to end up with a 2008-09 housing bust either.
Since the beginning of 2022, US mortgage rates have risen from about 3% to 5.2% recently, causing monthly mortgage payments to jump 30%. As of June, new and existing home sales are down 29% and 25% respectively from January highs (Chart 1). Housing starts are down 18%. In fairness, these peak levels reflect a sudden unsustainable spurt before rates started rising; relative to the 12M moving average, new and existing home sales are down 9% and 5%, respectively, and housing starts are actually up 2%.
The more important takeaway from Chart 1 is that during recessions housing activity usually falls considerably more than what we have seen so far. Leaving aside the post-2008 crash, existing home sales typically fall well below a four million annual rate and new homes can fall below 0.5 million rate annualized. Housing starts fall to the one million level, versus 1.5 million currently.
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Falling Affordability Drives Cancelations
We expect to test these levels at least temporarily during 2H. Indeed, new home sales for July came in at 511,000, far below the consensus forecast of 575,000. Two key reasons are affordability and inventory.
The National Association of Realtors publishes a monthly index of housing affordability where a value of 100 means the median income household has 100% of the required income to buy the median priced house.
Over the past 30 years, this index has been comfortably above 100; the only time it fell below 100 was during the 1980s when mortgage rates were well into the teens (Chart 2). Over the past few years, it has been above 150, thanks to record-low mortgage rates.
Suddenly, in a matter of months, it collapsed to less than 100 due to sharply higher mortgage rates, and still climbing housing prices. The Case-Shiller Index of home prices jumped 40% during the past 2½ years of the pandemic (or an annualized rate of 15%). Late last year it was rising 22% per annum, as of June 2022 it had slowed but only to a still-sizzling 18%.
One consequence has been a surge in cancelations of new home orders, resulting in more than nine months’ supply of new homes at current selling rates (Chart 3). Particularly noticeable is the supply of completed new homes, from less than three months to six months. Even during the worst of the 2008-09 crash completed homes only reached 4.5 months’ supply.
Homebuilders will almost surely slow the pace of housing starts during 2H until this inventory is worked off. And new and existing home sales will likely slow further until either mortgage rates fall significantly, probably to below 4%, or home prices actually decline or at least stabilize. Mortgage rates are unlikely to fall much, and home prices will likely be sticky for some time before sellers finally start capitulating.
Housing Supply is Still Tight
The prognosis for housing appears grim, but there are several reasons why we are not likely to relive the 2008-09 housing market, and indeed why this housing recession may prove to be shallow.
First, while new home inventories have spiked, existing home inventories remain near record lows (Chart 3). This will likely rise in coming months, but anecdotal evidence suggests that many homeowners are taking their properties off the market or deciding not to list at this time.
That means would-be homebuyers will find little existing home inventory to choose from. They will have to turn to new homes, and they may find homebuilders are willing to deal to get inventories under control.
Housing Supply is Closely Linked to Household Growth
The second reason is that the overall inventory of housing stock is remarkably low.
Over time the housing stock has risen roughly in line with the rise in population and households. During the housing boom of the 2000s the housing stock inventory grew much faster than households, pushing the number of units per household from about 1.13 in the late 1990s to 1.17 by 2008. In round numbers, that amounted to some 4.5 million excess housing units, or about three years of production based on 1.5 million housing starts per year.
It took the next 15 years to work off that excess supply. Now, there are about 1.12 housing units per household. If we assume that 1.13 units is a balanced market, the housing stock is now short about 1.3 million units, or nearly a year of normal production. In other words, homebuilders must build nearly a year’s worth of housing units to balance the market – on top of the 1.5 million they are already producing just to keep up with population and household growth.
Vacancy Rate is Near Record Low
But that is only part of the picture. The Census Bureau data on housing stock distinguishes between occupied and vacant housing units. Within the vacant cohort, it further subdivides units that are vacant but off the market (e.g., second homes, estate properties, uninhabitable properties) and units available for occupancy (Chart 5). The total vacancy rate is about 10.5%, well below 12% in the early 1990s (and 14% in 2009) but also well above 8% in the 1970s. But the active vacancy rate is a scant 2.4%, similar to the 1970s when baby boomers were coming of age and forming households more rapidly than homebuilders could match.
Another potent indicator of the tight housing market is rents. The Census Bureau publishes an index of median rents and the percent of rental properties that are vacant (Chart 6). Rents have jumped some 30% since yearend 2019 as the rental vacancy rate fell below 6%. A similar index published by Zillow is up 26%. For all the angst about inflation, the Consumer Price Index is up only 14% over the same period.
Clearly, there is strong underlying demand for housing – although homeownership has become less attractive for now at current prices and mortgage rates.
Housing Recession May Be Shallow
Our expectation is that the worst of the housing recession will play out during the 2H. Housing starts will continue to fall as homebuilders slow pace of single-family housing construction until inventories fall. Home prices will level off or decline modestly.
Homebuilders will transition to building more multifamily housing for the rental market, especially if affordability continues to be challenging for many households. That may tighten the supply of single-family housing, placing a floor on how much home prices fall.
Indeed, the surprise for many may be how shallow this ‘housing recession’ proves to be.
The risk is that the Fed, whether by design or circumstance, engineers a deeper recession that drives unemployment up and pushes housing into a deeper recession. But barring outright economic collapse it is unlikely that housing market will go off the rails.
What About Homebuilders?
Homebuilders face a fair amount of headline risk in coming months. But all things considered it is difficult to be negative on homebuilders over the medium term.
Since the market bottom in 2009, homebuilders (as represented by the XHB ETF) have mostly outperformed the S&P 500 (SPX, Chart 7). It soared following the 2020 election, then came back to Earth during the growth -to-value equity rotation of 2022. Then, despite the growing accumulation of negative housing, headlines XHB outperformed the SPX by 9.5% during the recent summer rally. Apparently, many investors agree with our thesis that homebuilders can operate profitably even in a slow housing market.
That said, we have a tactical underweight on homebuilders. The next six months or so will be a transitional period for many homebuilders as they adapt to a world of high and rising interest rates, and earnings will likely be weak. We also expect many companies in the broader SPX index will struggle to meet earnings forecasts due to high inflation and a sluggish economy, fueling another downward leg in the bear market.
As new home inventories and home prices stabilize or adjust downward, we expect to upgrade XHB to market- or over-weight.
Housing Impact on the Economy Will Be Mixed
Housing enters the broader economy in two ways – through GDP, and through inflation.
GDP – Housing contributes about 15-18% of GDP, through two channels – building new residential structures and upgrading existing ones; and housing services, including rent payments, owners’ imputed rent, utilities and related services. Construction related activity accounts for 3%-5% of GDP; housing services about 12-13%.
Any slowdown in housing construction will have a modest downward impact on GDP, but certainly not enough to drive the economy into recession. And this effect may well be more than offset by rising rents due to the tight rental market.
Inflation – Housing accounts for about one-third of the Consumer Price Index and other inflation measures via the cost of shelter. Rents and home prices (and imputed owner’s rent) rising much more rapidly than broader inflation housing, has been a key contributor to higher inflation over the past year. As long as rents and home prices keep rising, housing will keep upward pressure on inflation.
To the extent that we are correct in our view that both rents and home prices will take time to contain, the Fed may raise rates more aggressively than many investors seem to expect if it is serious about bringing inflation down to near its 2% target.
If that scenario starts to play out that is when we can start worrying about a more serious housing recession and economy-wide recession. But again, it will take a major economic collapse to bring on another 2008-09 housing implosion.
Closing Remarks
We would characterize the ongoing housing slowdown as more of a mid-course correction rather than a recession, as homebuilders and consumers adjust to higher mortgage rates. Whether it turns into a recession depends (as does the broader economy) on many moving parts, including Fed policy, employment, and ongoing geopolitical developments.