Focus
November 08, 2019 | 14:02
U.S. Economy: Is Housing Back Home?
U.S. Economy: Is Housing Back Home? |
Real residential investment increased at a 5.1% annual rate in 2019Q3, marking the first increase after six consecutive quarterly declines (Chart 1). The housing sector had not displayed such persistent weakness since the Great Recession, although the 5.4% cumulative decline paled in comparison to what occurred back then. From the peak in investment (2005Q3) to the trough (2010Q3), real housing activity plummeted 58.8%. This contraction created an annualized GDP growth headwind averaging 75 bps in each of the 20 quarters. Again, although the recent downturn doesn't compare with a 14-bp average headwind, the economy’s prospective sub-2% pace can still ill afford it. Does Q3’s increase indicate that the lengthy slide has halted and housing will again become a GDP growth contributor, i.e., is housing back home? The answer is yes, as the key factors that triggered the downturn have either reversed course or faded, which should allow the underpinning positive fundamentals to have fuller effect. Affordability improves after deteriorating In November 2018, the NAR Housing Affordability Index (HAI) hit its lowest level—meaning housing had become its least affordable—in more than a decade (Chart 2). Mortgage rates were hitting multiyear highs at the time. For example, 30-year fixed rate borrowing costs peaked just below 5%, higher than during 2013’s “taper tantrum” (which also cooled housing activity) and the highest since the spring of 2011 (Chart 3). Meanwhile, home price inflation had been creeping up for years and crested early 2018 in the 6½%-to-7½% range, importantly, faster than income growth. Subsequently, the bond market rally, first triggered by plummeting stock prices, was propelled further by the Fed’s policy pivot. The FOMC went from hiking rates in December 2018 (which capped six consecutive quarterly actions), to being “patient” in January 2019 and prepared to “act as appropriate” in June, and finally to cutting rates in each of July, September and October. In turn, 30-year mortgages rates tumbled about 140 bps by September to around 3.60%, although they have since backed up to just below 4%. Meanwhile, as the housing market cooled, home price inflation slowed to the 3.0%-to-4.5% range, now slightly slower than income growth. These developments caused affordability to rapidly improve. By August, the HAI’s nine-month advance was the largest in the 48-year history of the index, apart from the time of the Great Recession. Getting used to new rules The Tax Cuts and Jobs Act of 2017 (TCJA), which became effective January 2018, contained several provisions that negatively impacted the housing market. For example, it limited the mortgage interest deduction to interest paid on an underlying loan amount of no more than $750,000, down from $1 million before, and capped the property tax deduction at $10,000, where there was no cap before. These changes increased the after-tax cost of homeownership, particularly for higher-priced homes and properties in higher-taxed states and local areas. However, the TCJA also reduced the tax attractiveness of having any amount of housing-related itemized deductions by nearly doubling the standard deduction and lowering marginal tax rates. |
Other things equal, these tax changes were expected to dampen the demand for owner-occupied homes and housing activity broadly. The shift to a new lower level of activity than would otherwise be the case wasn’t going to happen instantaneously, thus creating a persistent housing headwind until the adjustment was complete. Monetary policy changes can take one-to-two years to work their way fully through the economy, so it seems reasonable to assume that it could take one-to-two years for tax changes to work their way fully through the housing sector. We reckon the adjustment is now complete. Solid foundation As easily as affordability improved after deteriorating, there is a risk that it could deteriorate again. However, we judge 30-year mortgage rates are unlikely to soon return to levels that proved to be onerous for the housing market both in 2018 and 2013… about 4¾% and above. On October 30, Fed Chair Powell said the FOMC “would need to see a really significant move up in inflation that’s persistent before we even consider raising rates.” And, with cyclical inflation pressures continuing to be mostly countered by the secular forces of disinflation such as an aging population and technology-enabled disruption (e.g., automation, digitalization, AI), we suspect the FOMC won’t be seeing anything “really significant” and “persistent” anytime soon. As such, the trifecta of (1) unchanged Fed policy rates influencing the root of the yield curve, (2) continued relatively low actual core inflation that keeps curve-embedded inflation expectations in check, and (3) a sub-2% real GDP growth trend that helps keep real yields constrained, should restrain nominal longer-run bond yields and, thus, mortgage rates from revisiting previous peaks. This is good news for continued housing sector gains, particularly given the other positive fundaments. |
For example, household balance sheets are in a relatively healthy state despite record debt levels (Chart 4). As a share of disposable personal income (DPI), household debt continues to drift down. The ratio sat at 84.6% in 2019Q2, down more than 30 percentage points from the housing bubble peak and hovering around its lowest level since 2002. Household net worth stood at 6.92 times DPI, just shy of the record high, while the debt service ratio ran at 9.69%, matching the record low. Elsewhere, although slowing, payroll job growth remains sturdy (12-month average of 174k in October) and is supportive of expansion in DPI. Even if job growth slows further, this should be partly compensated by (modestly) faster wage growth against a background of persistent historically low unemployment rates. These income and balance sheet trends indicate capacity to take on additional mortgage debt. And, still-elevated levels of consumer confidence suggest a potential willingness to do so. On the other side, banks moved to very slightly tighten mortgage lending standards in 2019Q4 (Chart 5). However, this followed a 19-quarter run of easing standards, so we suspect the level of willingness to make loans remains constructive for continued expansion in mortgage credit and residential investment. While we expect housing might contribute more than its fair share to real GDP growth going forward (like in 2019Q3 at an annualized 18 bps), there are other issues preventing robust activity. For example, at 10½ years into the economic expansion, pent-up demand has probably been exhausted. Also, millennials aren’t engaging in homeownership to the same degree this age cohort did in previous cycles. High levels of student debt may be a factor here. Finally, it appears that people are now staying in their homes longer than they did before, either not trading up into larger ones or not trading down into smaller ones, which reins-in overall activity. On balance, while we expect housing’s share of the economy to creep higher in the period ahead, we suspect it will remain below the long-run average… albeit less so than where it is now (Chart 6). |