• U.S. housing is important for two reasons.
• First, it is the cause of U.S. economic woes and the credit crunch due to excessive sub-prime lending in recent years.
• Second, it is the most leading of leading indicators for the U.S. economy, and thus serves as an important bellwether for both the bond market and the economy.
• The U.S. housing market is in a dismal state, and should remain a drag for several more months.
• It is important to note that residential construction is less than 5% of GDP, and so this by itself does not spell doom for GDP.
• The weakness in housing is driven by higher mortgage rates, poor affordability, high debt-service ratios and tightening lending standards.
• Even more fundamentally, some Americans were able to purchase homes without the obvious means to afford the homes if house prices ever ceased to rise at a robust pace, and are now facing foreclosure.
• The largest set of sub-prime mortgages were issued over the past few years, constituting roughly 20-25% of all mortgages (Source: Mortgage Statistical Annual and Inside Mortgage Finance). Many mortgages offered an initial teaser rate followed by a sharp increase in rates. These higher rates will hit quite hard over the next year.
• For the U.S. housing market (and economy) to improve, one needs to see improvements in affordability which will in turn boost home sales (market estimates a further 15% drop in home prices), Only then inventories will begin to fall. Finally, construction activity will pick up again.
• However, there is a hurdle. Buyers are unlikely to purchase new homes as long as home prices are falling. There is no easy solution to this.
• In the meantime, although the direct economic impact of the housing slowdown is clear – less construction activity, diminished furniture sales, a slowdown in the realtor sector – there is also an equally important potential indirect impact. This is via a reduced wealth effect and mortgage equity withdrawal that affects consumers.
• The U.S. housing market is still suffering from a significant supply/demand imbalance. In the half decade to 2006, there was a significant housing construction boom (adding to supply) that was not matched by sufficient population growth (limiting the demand side of the equation).
• Although short & medium-term issues such as interest rates and even the sub-prime market influence the U.S. housing landscape for now, demographics can ultimately also play a role.
• The influence of this factor has waned somewhat in recent years in the U.S. as housing excesses have muddied the water, but the historical record is clear that demographics must ultimately determine the amount of housing stock in the U.S. market.
• The pace of U.S. population growth right now is on the low end of normal, and thus one might expect that the sustainable pace of housing starts in the U.S. – once the recent hub-bub is done – will be closer to 1M units per year than to 2M units per year.
• But given that population growth is still, nonetheless, close to 1% per annum (an increase of approximately 3 million people per annum), the excess supply of housing should slowly but surely start to unwind.
• In fact, the weaker the number of new housing starts are in the months ahead, the faster the house price recovery will emerge.
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