Chart of the Week : Housing IS the business cycle

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The American economist Edward E. Leamer wrote an interesting paper at the eve of the Global Financial crisis in September 2007 : Housing IS the business cycle. While we don’t agree with all the conclusions, the main take fully makes sense. Over the past decades, the housing market has systematically played a key role in the U.S. business cycle. This is also the case in the current cycle. Economists but also investors certainly did not pay enough attention to the housing market over the last two years, especially early in the pandemic when massive stimulus had fueled demand and had increased price bubbles all across the United States (at national level, housing prices are up almost 40 % on average since the outbreak).

The housing market is now in a vulnerable position. With high inflation across the board pushing consumer confidence downward and mortgage rates surging above 6 % following the U.S. Federal Reserve’s tightening cycle, the risks of hard landing are tilted on the upside. Over the past few weeks, several large real estate firms such as Redfin Corporation or homebuilders such as Lennar (the second largest player in the United States) have warned against the risk of slowdown. Some of them have already introduced lower prices and incentives in certain areas to sustain demand. But it is too early to know whether this will be successful. At the moment, all the data confirm a material slowdown. The market is very unbalanced. In May, existing homes sales fell 3.4 % to 5.4 million units. This is a new post-pandemic low. They are down 17 % from January. The biggest and most worrying drops are in the Midwest, the West and the South. At the same time, median prices continue to jump (+15 % at $408 000 – this is a new all-time high). Inventory is very low at only 2.6 mo. Housing permits and housing starts are down in May too. Housing starts feel 14.4 %. This marks the third monthly decline in five months. Housing permits dropped by 7 % the same month. The market is a unique situation. The last time housing affordability was so low, it was in 2007 – see below chart. Expect it will get worse in the short- and medium-term. The surge in mortgage rates, which is only starting, is a major constraint for new home buyers. Adding to that the ‘rate lock’ at very low rates (this means the interest rate won't change between the offer and closing), expect also less housing mobility. This will have ripple effects on the whole economy, starting from the housing construction activity, with varying lags depending on backlogs.

Upcoming data from the housing market will help us assess whether there is a material risk of recession or not. The latest survey of professional forecasters shows a 20 % recession probability. When we hit these levels, the economy is usually already in recession. Economists have a poor track-record to accurately forecast recession. There are only two exceptions : in the early 1980s when the Fed chair Paul Volcker jacked up rates to kill inflation (but it was so obvious that even economists saw it coming) and in 1995 when it ended up in a soft landing. We are currently not forecasting an upcoming recession in the United States. The probability it happens this year or next year will highly depend on the evolution of the housing market. But there is no debate we are going to be in much lower growth, especially in 2023 than many had expected, technical R or no R. The material growth slowdown is visible across all the data.