Financial markets were hit with an onslaught of weak economic news across the housing sector recently. One of the most notable metrics was the plunge in the National Association of Home Builders (NAHB) Market Index from November levels. Although a four-point move in the Index may not be significant per se, what made the slide so noteworthy was the trend it signified. The recent weakness shadowed an even deeper drop of eight points just one month earlier, making the move over the last two months the largest drop in the Index since October 2001. Given the importance of the housing sector to the U.S. economy, the unexpected free fall in the Index sent investors scurrying for a safe haven. The sharp reaction across markets begs some fundamental questions; what’s driving the bout of current weakness? Are we finally experiencing a turn in tide in the U.S. economy?
Possible drivers of current weakness
The report showed all three subcomponents within the NAHB Housing Market Index; present sales, future sales outlook and prospective buyer traffic, falling to their lowest levels for the year. Further insight into the report points to an even deeper and more challenging shift in dynamics within the sector. Confidence amongst home builders plunged more than 31 percent to the lowest levels for the year as they faced rising input costs from tariffs and tightening labor markets. This forced home builders to reduce home prices, squeezing profit margins. Hikes in interest rates from the Federal Reserve’s commitment to policy normalization have further served to stymie the mortgage slowdown, given the sector’s sensitivity to interest rate movements.
Looking at history, there is empirical evidence to suggest a direct relationship between increases in mortgage rates and home sales. Following policy changes in 2013, a 100 bps move in mortgage rates led to almost a 10 percent drop in home sales. Equally, following a selloff in treasuries prior to the last presidential election, a 67 bps rise in mortgage rates saw home sales decrease by close to 5 percent. Since late spring, mortgage rates have spiked almost 100 bps with a resulting 8 percent drop in home sales. This anecdotal evidence is quite compelling, leading us to infer that reduced affordability from higher mortgage rates may have quite a bit to do with the recent cooling in demand.
Adding fuel to the fire, leading indicators within the sector suggest that the current bout of weakness has further room to run. This may force home builders to cut prices even deeper in an attempt to spur demand. With new and existing home sales expected to fall to five million units per month over the first half of the year, an earnings surprise to the downside may be lurking in the shadows. If the trend of massive outflows from housing sector ETFs continues, a negative feedback cycle will once again project itself into financial markets.
Not all news is bad news!
Amidst the deafening negative reports on the sector there are, however, a number of notable bright spots. To the relief of many, the current bout of weakness exhibits very different dynamics to the last housing crisis. For one, sales levels are currently much lower than prior to 2008. Further, the quality and abundance of credit heading into the previous housing crisis appeared to have a much looser association with housing affordability. Moreover, the jobs market is still very strong lending support for increases in wage growth.
Although the unaffordability of homes is frequently cited in surveys, given the challenging environment, a deceleration in prices is expected. Coupled with the average hourly earnings, this should bolster affordability and drive demand from potential home buyers on the sidelines. As mortgage rates have somewhat stabilized following the 10-year U.S. treasury retrenchment below 3 percent, new home construction and work permits climbed to a seven-month high, sending positive sentiments back into the sector.
Outlook for 2019
Given the tripartite crosswinds impacting the housing sector, what can we expect in 2019? Market consensus is for a softening in demand at least for the first half of 2019. Whilst history suggests housing woes are a precursor to broader economic downturn, this cycle appears synthetically driven to starve the economy off years of easy money policy. In an economy heavily dependent on domestic demand, the answer to the current weakness may lie in the delicate balance between changes in mortgage rates and strength of the labor market. Any growth in household income above the average home price increase is sure to boost affordability and steer the housing sector from the brink of an abyss.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
Statistics and Data Source: Bloomberg LP., NAHB Market Index, Evercore ISI, Bloomberg Intelligence, The Federal Reserve Bank of San Francisco, BCA Research