October 30, 2006
The Economy's Housing Problem
Weak third-quarter GDP numbers came courtesy of the housing slump. Is a real estate-led recession far behind?Anyone trying to judge the state of the housing sector could be excused for feeling a bit…befuddled. On Oct. 20, Goldman Sachs (GS) issued a report suggesting the worst of the housing downturn could be over, and former Federal Reserve Chairman Alan Greenspan reiterated remarks of his own to a similar effect on Oct. 26 (see BusinessWeek.com, 10/23/06, "Is Housing Out of the Woods?"). Encouraging words, to say the least.
But while analysts and economic eminences see a trough, data reports point to more gloom ahead. In the third quarter, the biggest drop in homebuilding investment since 1991 slowed economic growth to its worst pace in more than three years, an Oct. 27 report showed. New home sales rose in September, but the median price of a new home fell by nearly 10% in the biggest one-year drop since 1970, according to the Census Bureau on Oct. 26 (see BusinessWeek.com, 10/27/06, "The Housing Fire Sale"). And on Oct. 25, the release of September existing home sales slightly missed Wall Street expectations.
It's enough to leave homeowners across the country understandably perplexed (see BusinessWeek, 11/6/06, "Boom! Bust! Boom?"). Should they believe the ex-Fed "Maestro," or the numbers? While the housing slowdown may not wind up crippling the economy the way some pundits feared, many analysts say its effects aren't finished just yet.
How Long a Slump?"The velocity of the slowdown [in housing] is going to moderate," says Jeff Kleintop, chief investment strategist at PNC Wealth Management (PNC). "But we are still a number of quarters away from a true bottom."
The cooling housing market has already taken a slice out of the economy. Gross domestic product (GDP) expanded at a pace of 1.6% in the third quarter, down from a 2.6% pace in the second quarter, according to the Commerce Dept.'s advance report. Residential investment tumbled at a 17.4% one-year pace from a year earlier, trimming 1.1% from GDP growth. Fed Chairman Ben Bernanke has predicted softening housing would probably subtract 1% from economic expansion in the second half of 2006, and possibly 2007.
Experts are divided over how long the housing weakness will continue and what its effect will be on the overall economy. Troubled homebuilder stocks like D.R. Horton (DHI), Lennar (LEN), Pulte Homes (PHM), and KB Home (KBH) have perked up since their midsummer lows. As for the decline in new home sale prices, "it remains to be seen" what this development implies for consumer spending, according to Thomas Stolper, global markets economist at Goldman Sachs. "The market for now seems to be giving greater attention to the boost to real disposable income from falling gas prices," Stolper says in an Oct. 27 note to clients.
Impact Could Be WideSome analysts expect economic growth to start increasing again, until the Fed is forced to raise interest rates yet again sometime next year to rein in inflation. "After the housing construction adjustment has worked through, we look for growth to rise back above potential," says John Ryding, chief U.S. economist at Bear Stearns, in an Oct. 27 dispatch.
On the downside, a drop in mortgage applications for new home purchases may illustrate the depth of the housing decline. Mortgage applications were down 16% from the start of the year through the week ended Oct. 20, observes David Rosenberg, North American economist at Merrill Lynch (MER). "In stock market parlance, if the Dow were down that much, it would barely be above the 9,000 mark right now," Rosenberg says in an Oct. 25 research report. The Fed and the Street will likely have to lower their estimates for fourth-quarter GDP growth, he adds in an Oct. 27 note.
Real-estate softness could have potentially wide-ranging effects on the economy. "A seemingly minor dislocation originating in the housing sector, such as a higher rate of foreclosures, might cascade through the rest of the economy in unforeseen ways—for example, in a collapse in bank earnings or a hiccup in the huge market for securities that back residential mortgages," observes Jeffrey Knight, chief investment officer of global asset allocation at Putnam Investments (MMC), in his most recent market outlook.
Enduring SlowdownStill, outside of housing, other economic factors are looking up, most analysts say. A drop in oil prices and the stock market's rally to all-time highs have boosted consumer confidence, suggesting stronger retail sales in the fourth quarter than in the third quarter, according to Peter Morici, a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission.
The housing drop-off could signal investing opportunities elsewhere. Shares of drugmakers like Johnson & Johnson (JNJ) or Pfizer (PFE) might be among the downturn's unwitting beneficiaries, historical patterns suggest. The relative return of pharmaceutical stocks is "extremely negative correlated to housing activity," notes Jack Ablin, chief investment officer at Harris Bank.
In any event, homebuilder stocks skidded in afternoon trading on Oct. 27, and the broader stock market retreated following four consecutive record finishes for the Dow Jones industrial average. The housing slowdown might not derail equity investors' gains, but it's probably still too early to declare the downturn defeated.