By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company
During the Dutch Golden Age, lavish dollhouses stood in homes as a reminder of the families’ assets and the meaning of their homes.1 Like the popular tulip bulbs, these miniature houses were also investments. In the U.S. we had our own version of Dutch dollhouses, only we received ours through a flat screen television: Extreme Makeover: Home Edition. Millions of Americans tuned in to see a display of what a house should mean to us emotionally – not just shelter, but an entitlement of luxury. Is it any coincidence that the show’s popularity peaked along with home prices from 2005-2006? (Fig. 1)
Between 2000 and 2006, the U.S. experienced a pronounced housing bubble. In some areas of the country, particularly California, Florida, Nevada and Arizona, prices rose between 120 to 160 percent. Bidding wars broke out as consumers feared that housing prices would continue to increase so rapidly that they would be permanently locked out of the market. Mortgage underwriting, appraisals, lending products and other parts of the home buying process grew increasingly loose as price appreciation outpaced the ability of consumers to afford housing. Fueled by record low interest rates in the wake of the 9/11 attacks, prices continued to rise, feeding more speculation.
As bubbles are wont to do, this one ended in 2006 when the housing market reached a peak. The bursting of that bubble, along with the Global Financial Crisis and the resulting Great Recession, has had a profound impact on the U.S. economy. For nearly seven years, the housing market has constrained the economy. After two years of fits and starts, when it seemed like the housing market was recovering, only to fall back, it now seems like housing has turned a genuine corner and is again at a position of becoming a net contributor to economic growth.
There are many positive signs in the housing market indicative of a long-term, positive uptrend: housing formation levels are rising after years of decline and new home starts are also increasing. While the foreclosure crisis is far from over, a falling supply of foreclosed homes is putting upward pressure on housing prices as consumers and investors who snapped up foreclosures at the lower end of the market are now having to move to non-foreclosed homes or more expensive foreclosed homes. Many U.S. metro areas are seeing increasing or at least stabilizing home values, and more homeowners are regaining positive equity with that rise or stabilization in prices. All of this is good news for the U.S. economy.
In this month’s commentary, we'll look at the factors behind the positive trends in the housing market, the impact of the housing market on the overall economy and the employment market, and what all this means for the markets and investors.
During the past few months, a number of housing market trends have been flashing positive. A major positive for a durable housing rebound is the sustained increase in household formation (Fig. 2). During the Great Recession and the lingering slow economy that followed, household formation fell or stagnated, as adult children who were unable to find jobs moved in with their parents and single people put off marriage. In September, the U.S. Census Bureau reported that the U.S. added 1.15 million households in the previous 12 months, a significant increase from an average of 650,000 over the past four years. Although household formation still lags the levels that occurred during the housing boom years – where household formation averaged 1.25 million a year – the recent data is a very positive sign for the housing market and the overall economy. In addition, quarterly trends show that trend accelerating with additional growth in the third quarter over the first and second quarters.
Household formation is key to housing market growth. When consumers feel confident enough to form households, many are interested in buying rather than renting homes because they’ve had to delay household formation for so long. The cyclical trend in household formation is driving upturns in new home sales and housing starts just as the demographic trend of echo baby boomers is reaching the point at which they enter their prime household formation years. The echo boom generation – born between the early 1980s and early 2000s – is roughly similar in size to the baby boom generation. Many echo boomers have been forced to live with their parents or remain in apartments with roommates; the pent up demand and increasingly confident economic expectations of that generation could drive household formation levels higher than normal in the next year or two.
Following this trend, September housing starts and permits were higher; at the highest level of the year and the best since July 2008. Single-family housing starts were also at their highest level since August 2008, increasing 12.7 percent; this data was particularly strong in the Midwest, rising 23.1 percent. In mid-November, the National Association of Realtors (NAR) reported that the nation’s inventory of unsold homes on the market has declined to its lowest level since March 2006. U.S. for sale inventory fell 17 percent compared to November 2011.
A sign of future activity, total construction permits rose 11.6 percent from August to September. Builder sentiment, as measured by the National Association of Home Builders/Wells Fargo Housing Market Index (Fig. 3), is at its strongest since June 2006, at the height of the bubble. The index has increased six months in a row.
The Federal Reserve Board’s low interest rate policies, fueled by quantitative easing, round three and Operation Twist, are another factor as low interest rates further encourage consumers to purchase homes. A decline in the inventory of foreclosures and existing homes is encouraging builders to build more new home stock; analysts expect that housing starts will continue to rise at a brisk pace through 2013.
The S&P/Case-Shiller index of property values in 20 large cities showed gains in 19 of those markets, with housing prices increasing on average .9 percent in August 2012 over July 2011. This increase marks the largest increase in prices seen in this index in the past two years. Another positive indicator was seen with the Trulia Price Monitor, which reported that home prices rose 2.9 percent in October 2012 over the previous year with rents soaring 5.1 percent from year-before levels. In line with these trends, the National Association of Realtors said that median home prices are 11.3 percent higher than a year ago.
Rising home prices are having a ripple effect across various aspects of the economy. Home prices, which have been rising in many areas during the past year, have translated into more than 1.3 million homeowners gaining positive home equity during 2012. One factor that is playing into rising home prices is the falling number of foreclosed homes available and the fact that the discount between foreclosed homes and non-foreclosed homes is decreasing. Currently that “foreclosure discount” stands at 7.7 percent according to Zillow.com, compared to 9 percent in 2011 and 24 percent in 2009.
Consumer confidence, which has been fragile in regard to the housing market given the fits and starts of the past couple of years, is gaining traction as well. In early November, Fannie Mae reported that its monthly national housing survey revealed that Americans expect home prices to rise an average of 1.7 percent during the next year. The share of those polled who believe housing prices will drop fell to 10 percent, the lowest since the survey began in June 2010. Nearly three-quarters of those polled believe it is a good time to buy a house, while 18 percent think it’s a good time to sell.
In line with those trends, more analysts and experts are jumping on the bandwagon of a positive outlook for the housing market. Lawrence Yun, the chief economist for the National Association of Realtors, sees home prices climbing 15 percent during the next three years. The NAR and Yun are known for their optimistic forecasts. He did express concern about home affordability, noting that supply remains constrained as builders ramp up construction of new homes, which probably won’t get close to pre-recession levels until 2014. Jaime Dimon, CEO of JPMorgan Chase, believes the housing market has turned positive and has the potential to create many more jobs.
If new home construction surges as many analysts expect – driven by a falling stock of existing homes, low interest rates and rising demand – housing is likely to continue contributing significantly to economic growth next year. For the second quarter 2012, residential investment contributed 33 percent of the total two percent GDP. The average residential contribution over the past four quarters is now positive (Fig. 4).
As housing starts increase, overall real residential investment rises, which could benefit the economy as much as a .8 percent increase in gross domestic product (GDP) growth. With third quarter U.S. GDP at 2 percent, such an increase from the housing sector is very positive.
The housing bust led the economy into the Great Recession in 2007, and the lingering aftereffects have held the economy back ever since. Housing tends to be a major indicator of underlying domestic demand and confidence; as housing metrics gain strength, so should the overall economy, especially with the uncertainty around the election resolved.
The positive story around housing isn’t just confined to the residential real estate market. The multi-family housing and apartment markets are extremely strong, with very low vacancy rates – hovering around 5 percent – and more institutional money coming into the space, which means more construction and more jobs, adding to overall economic growth.
The Federal Bureau of Labor Statistics estimated that between 1.2 million and 1.7 million construction jobs were attributed to bubble-related demand. Many of those jobs and more disappeared when the bubble burst. In the absence of housing demand, those workers have had to take lesser-paying jobs elsewhere or have remained unemployed. As housing recovers, more of those unemployed or underemployed workers will be rehired, as will new entrants to this employment market. The construction industry is traditionally a decent paying field for those without much education, and significant rehiring in this industry has the potential to boost employment and the overall economy.
With other economic trends turning positive, including unemployment, the stage is set for a positive feedback loop, where good news builds on itself, increasing consumer confidence. When consumers are more confident, they are more likely to buy homes and spend money. This is vital for an economy where two-thirds of gross domestic product is typically attributed to consumer spending. In early November, the Conference Board Consumer Confidence Index reported that confidence increased in October and stands at its highest level of the year. In line with that survey, the Thomson Reuters University of Michigan Surveys of Consumers, released in mid-October, saw record gains in confidence, which stood at a five-year high.
On average, housing contributes 17 percent to 18 percent of GDP, according to an analysis by the National Association of Home Builders via private residential investment and consumption spending on housing services. When the housing market is positive, it contributes to GDP growth; in an uptrend such as the one that the country could experience in 2013 and 2014 as growth in housing stock makes up for lags in the past six years, the potential to accrete positively to GDP is enhanced. Conversely, when the housing market is expanding, the possibility of recession dims.
Although most signs are flashing positive for the housing market, there are some downside risks. Foreclosure activity has slowed, but there is still a huge potential shadow market inventory as banks continue to foreclose on homeowners who can’t make their mortgage payments (Fig. 5). Banks also have slowed processing of foreclosures and placing them on the market following scandals in this area over the past several years.
In addition, though millions are escaping from the underwater or negative home equity plight, millions more remain stuck there for the foreseeable future. Those homeowners aren’t able to move to potentially take better jobs or seek opportunities elsewhere and can’t save or spend as much as they otherwise could if they had positive equity. These owners of underwater homes also aren’t able to sell their homes and remain at higher risk for foreclosure. Even those who have climbed out of the underwater hole are still just marginally positive and have years to go before they can claim significant equity.
And while mortgage interest rates are at historic lows and have the potential to fall further, underwriting is still too tight. Many homeowners who would like to purchase new homes or refinance are unable to do so because they can’t meet tougher underwriting standards. While standards were way too loose during the housing bubble, they have overcompensated and are now too tight, which could constrain the recovery.
In terms of the macro economy, the resolution of the fiscal cliff at the end of the year and in 2013 is paramount. If this is resolved successfully, business and consumer confidence and the economy will continue to grow. If not, there is a possibility that even with continued strong performance in the housing market the economy could dip back into a recession.
As far as housing statistics go, housing starts and housing inventory are key metrics to assess the health of the market today; for future growth, total construction permits and builder confidence are strong indicators.
Our investment philosophy is to continue to maintain a prudent level of risk for individual risk profiles. For investors, timing trends is impossible, but those with a longer term view should be keeping diversified risk assets as an important part of their portfolio - consistent with their own risk preferences.
The Dutch stopped building dollhouses when the Golden Age ended, and when the housing market collapsed, we took the “extreme” out of makeovers. The show has been canceled, and we can now turn our attention toward more practical matters. Well, until the next great makeover emerges…
1“How Dutch Dollhouse Mania Explains the U.S. Housing Bust,” Michelle Chihara, Bloomberg.com, May 22, 2012.
Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.
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The National Association of Realtors (NAR) is a real estate trade association involved in all aspects of the residential and commercial real estate industries. NAR also functions as a self-regulatory organization for real estate brokerage.
The National Association of Home Builders (NAHB) is a trade association that helps promote the policies that make housing a national priority. The NAHB services its members, the housing industry and the public at large.
The NAHB-Wells Fargo Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse of the single-family housing market. The survey asks respondents to rate market conditions for the sale of new homes at the present time and in the next six months as well as the traffic of prospective buyers of new homes.
The S&P/Case-Shiller Home Price Indices are designed to be a reliable and consistent benchmark of housing prices in the United States. Their purpose is to measure the average change in home prices in a particular geographic market. They are calculated monthly and cover 20 major metropolitan areas.
The Federal National Mortgage Association, doing business as Fannie Mae, buys and holds mortgages, and issues and sells guaranteed mortgage-backed securities to facilitate housing ownership for low to middle-income Americans. The Company was chartered by the U.S. Congress but went public in 1970.
The Trulia Price Monitor is an early indicator of trends in home prices and rents. Based on for-sale homes and rentals, it takes into account changes in the mix of listed homes, reflecting trends in prices and rents for similar homes in similar neighborhoods.
The Bureau of Labor Statistics of the U.S. Department of Labor is the principal Federal agency responsible for measuring labor market activity, working conditions, and price changes in the economy.
The Conference Board Consumer Confidence Index is a survey that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.
Thomson Reuters University of Michigan Surveys of Consumers gauge how consumers feel the economic environment will change. The survey’s Index of Consumer Expectations is an official component of the U.S. Index of Leading Economic Indicators.