Monday, May 19, 2008

You know better than to trust a strange statistic!

Stock futures got a little bump, and bond prices took a dive, immediately after Friday's better-than-expected housing start number. Things reversed themselves later in the day, but still, the initial reaction was that number was good news. I don't get it. The housing start statistic really tells us nothing about how close we are to the end of the housing slide.

Let's think about the progression of a housing recovery. We know prices can't start climbing again until there is more demand than there is inventory at a given price point. Right now its is clear that supply and demand are not balanced and therefore prices must keep falling. Normally we might assume that either supply or demand could change in order to resolve the imbalance. But given the exceptionally tight lending standards in the residential mortgage market, demand will be capped for some time to come. So the solution has to come from supply.

Marginal supply is coming from two primary places. First is foreclosures. Second is new home construction. We know that foreclosures are increasing, and anecdotal evidence suggests that servicers are so busy that they aren't able to keep pace with foreclosures they "should be" doing. So foreclosures aren't about to bottom. Government intervention could have a huge impact on foreclosures, and I don't want to get into a debate on the wisdom of intervention. Suffice to say that the impact of any intervention may be many months away.

So in order to see a decline in housing supply we need new home construction to slow to a crawl. So to me, higher housing starts numbers are disappointing. The news that much of today's jump in starts is related to multi-family projects is more encouraging. Yes, I know that will be a drag on GDP growth, but the sooner we clear out the excess housing supply, the sooner we can get to a more normal housing market. That's sure worth a couple ticks on GDP.

The question now is, where are we in the inventory reduction process? The Census Bureau reports that new home inventory has fallen from 570,000 units at its peak to 460,000 units now. FTN economist Chris Low estimates that inventories have to get to 305,000 before we bottom out. The less building, the faster we get there, but still to drop another 155,000 units from inventories will take at least a year. Probably more like two.

We might be near a bottom in terms of the direct drag on GDP from residential construction. Residential investment's share of GDP peaked at 6.3% and has fallen to 3.8% in Q1. The all time low in this figure was 3.2% in 1982. We certainly could set a new bottom in this cycle, but it won't go to zero. So we probably only have 1% or so of a continued drag from residential construction left. That's all well and good, but I think we'd all agree that's a small part of the story. The bigger story is about the indirect effects on consumer spending. But this direct effect is the only element of the bust that housing starts is any indicator. Pay housing starts no mind.


Anonymous said...

Thanks again for the interesting post. What is actually in those inventory numbers? I'm just trying to reconcile how the US can have 100-150K households but still have 3-5x that of inventory.

Moreover, I'm trying to figure out why 300K is the steady-state inventory figure at which we bottom.


Anonymous said...

Sorry, misinterpreted the decimal place by a power of 1000. Still the question is why is 300k the equilibrium point? Is that the historical average?

Accrued Interest said...

No its just one economist's view of where the stat will bottom.

Christopher Wheeler said...

This is a great post, AI.

I think the variable that no one can truly estimate is future foreclosures. Housing prices are a function of inventory and supply and demand.

But housing prices are also a function of income. Right now, prices are still way, way above historic levels, when measured as a multiple of household income. Check out the Case-Schiller index chart.

As more and more homeowners have their mortgages reset, or just give up paying 60+% of their income on the mortgage because they are underwater, the number of foreclosures could continue to grow.

If demand remains steady (IE the absorbtion rate stays the same), but supply starts growing faster again through more foreclosures, inventory will increase and prices will fall faster.

That said, there will always be some new construction going on, if only because the population is mobile and the houses are not. For example, Michigan is losing population, and Florida is still gaining.