Is housing signaling where the economy is headed?

A perspective from E*TRADE Securities1

11/16/18

Housing has long held a special place in the American psyche. Buying a home is one of the biggest investments any of us will make, and homeownership is at the core of the American dream.

Housing can also be an economic catalyst. Case in point: The 2008 financial crisis was precipitated in no small part by subprime mortgages that went south after being collateralized and rubber-stamped as investment-grade debt. When the housing market finally recovered after a long, painful recession, so did the US economy. That shouldn’t come as a big surprise, given that housing makes up about one-sixth of gross domestic product.1

But after a remarkable run, housing is beginning to show cracks that could weaken the foundation of the decade-long US economic recovery.

Housing starts as a leading indicator

Earlier this year, we discussed leading indicators and their role in signaling where we are in the business cycle. To refresh: Leading indicators typically go up or down before the economy as a whole does. Think of them as a string of locomotives pulling freight cars that make up gross domestic product. When the lead engines turn, it may take a while for the train to follow suit, but eventually it will.

As you might’ve guessed from this creosote-tinged metaphor, one of the US economy’s leading indicators is housing—specifically, housing starts. And in this case, the locomotive appears to be descending a 5% grade.

Key housing metrics are showing weakness

•  Housing starts: Housing starts for new, privately owned units fell by 5.3% from August to September, to a seasonally adjusted annual rate of 1.2 million, and are off 10% from the start of the year.2 A bright spot: Housing starts are up 3.7% on a year-over-year basis.2

•  Building permits: Building permits offer a similar glimpse into construction activity. Seasonally adjusted building permits for privately owned housing units fell a modest 0.6% in September but are down nearly 10% from their high-water mark in March.2

• New home sales: Seasonally adjusted sales of new single-family homes fell 5.5% in September and are off 13.2% from the previous year.3

New home sales, 9/2015 - 9/2018

Source: U.S. Census Bureau


• Median new home sales prices: The median price of new homes sold in the US in September was up modestly from August but fell by 3.6% over the past year.4

Bear in mind that these figures represent aggregate data and vary widely by location. Notably, housing starts in the Midwest have lagged other parts of the country, including the Northeast, where starts surged by nearly 30% in September.2 Also, some of the hottest real estate markets are still grappling with housing shortages, and home affordability has reached crisis levels in parts of California and the Pacific Northwest.

Rising interest rates creating headwinds

Interest rates have played a key role in housing’s recent weakness. The average rate on a 30-year fixed-rate mortgage is in the neighborhood of 5%—the highest level in more than seven years.5 With the Federal Reserve all but assured of hiking short-term rates in December and into next year, housing fundamentals could continue to soften as mortgage rates climb.

30-year fixed rate mortgage average

Source: Federal Reserve Bank of St. Louis


Takeaways for investors

Trends in housing can have implications for individual stocks. Consider:

• Building-related stocks: The housing market is supported by firms closely tied to the real estate sector. Most obvious are home builders and home improvement stores, whose shares can trade up or down based on the outlook for housing. But housing trends can also affect the companies that produce gypsum wallboard, tool makers, durable goods firms that manufacture home appliances, and a host of other industry players. Many of these firms are in the consumer discretionary sector, which has gained ground year-to-date but could be due for a correction.

• Real estate can still act as a portfolio diversifier: Although housing weakness could undercut economic gains, real estate still has diversification potential relative to broad-based equities. In particular, real estate investment trusts (REITs)—which also include commercial real estate—have shown relatively low correlations with traditional equities over time, and since 2009 correlations have fallen even further.6 (The less correlated assets are to each other, the greater their diversification potential.)

Where the housing market finally lands is anyone’s guess, but the signals being sent could prove useful in determining the direction of the US economy. How these signals are interpreted is ultimately up to investors to decide.

1. National Association of Home Builders, “Housing’s Contribution to Gross Domestic Product (GDP),” November 2018, https://www.nahb.org/en/research/housing-economics/housings-economic-impact/housings-contribution-to-gross-domestic-product-gdp.aspx

2. U.S. Census Bureau, “Monthly New Residential Construction, September 2018,” October 17, 2018, www.census.gov/construction/nrc/pdf/newresconst.pdf

3. U.S. Census Bureau, “Monthly New Residential Sales, September 2018,” October 24, 2018, www.census.gov/construction/nrs/pdf/newressales.pdf

4. U.S. Census Bureau, “Median and Average Sales Prices of New Homes Sold in United States,” October 24, 2018, www.census.gov/construction/nrs/pdf/uspricemon.pdf

5. Federal Reserve Bank of St. Louis, “30-Year Fixed Rate Mortgage Average in the United States,” November 14, 2018, fred.stlouisfed.org

6. Nareit, “REIT Correlations in 2017,” January 24, 2017, https://www.reit.com/news/blog/market-commentary/reit-correlations-2017