The U.S. economy clearly has fallen into recession and the contraction is deepening considerably during the fourth quarter of the year. Furthermore, Japan and the euro zone now are in recession and a contraction in global GDP is underway.
The much-anticipated G-20 summit meeting held in Washington in mid-November reportedly produced a number of important agreements among member countries. However, there was no announcement of concrete measures to deal with the evolving global recession and the financial markets failed to rally in the wake of the historic meeting.
In the U.S., virtually every component of domestic spending is weakening, led by downdrafts in consumer spending and residential fixed investment and followed by downshifts in nonresidential business investment. Furthermore, support from the export market is fading fast as the economies of our major trading partners are giving way.
We’re now looking for the most serious U.S. economic recession since the early 1980s, even assuming considerable doses of monetary and fiscal policy stimulus that will extend into 2009 and 2010. Not only will real GDP contract sharply in the fourth quarter of this year but further setbacks also are in our forecast for the first half of 2009. The contraction could be even deeper than in our current forecast, and it could take even longer before the economy starts to climb out of the hole, if the economic policy response is weaker than expected.
The labor market is weakening badly as economic output (real GDP) slides downhill. The contraction in payroll employment has accelerated in recent months and the unemployment rate has moved up substantially in the process. Claims for unemployment compensation just hit a 16-year high and serious deterioration of labor market conditions is likely to run through most of 2009, lagging the projected GDP pattern to some degree.
Credit markets remain under considerable stress, both nationally and globally. While some key money-market spreads have narrowed substantially and interbank markets are functioning better, longer-term credit spreads remain extremely wide and bank lending standards have been tightening considerably for virtually all types of loans to businesses and consumers. Furthermore, the cost of protecting corporate bonds from default has been soaring recently, shown by another surge in the cost of credit default swaps.
Commodity markets are about the only bright spots in the U.S. economic outlook. Prices of crude oil and gasoline are down dramatically from their mid-2008 highs, delivering key support to the economy over the balance of this year and in 2009; indeed, crude oil recently slipped below $50 a barrel, compared with the $147 peak in early July. Prices of key agricultural products and industrial metals also are well off their highs, providing additional benefits for consumers and businesses. Of course, support from commodity markets can provide only partial offset to the major downward pressures that are weighing on the U.S. economy and, by their nature, falling commodity prices have adverse effects on commodity-producing areas.
Inflation rates in the U.S. are slowing dramatically, reflecting falling global commodity prices, the weakening global economy and growing slack in labor markets; indeed, the core Consumer Price Index fell in absolute terms in October, the first decline in 26 years. As potentially damaging deflation has jumped onto the radar screen, central banks around the world naturally have been shelving long-standing inflation concerns as this situation has evolved so quickly. Even the European Central Bank has gotten into the game.
The Federal Reserve is poised to enact another half-point cut to the federal funds rate target and the discount rate at (or before) the next FOMC meeting on December 16; indeed, the Fed has been keeping the effective funds rate below the current 1% target for some time. With respect to further stimulus, 0.5% is not necessarily the lower bound for the funds rate, and the Fed can pursue “quantitative easing” when the funds rate hits bottom. We also expect key foreign central banks (including the Bank of England and the European Central Bank) to enact further cuts in their policy rates in the near term, continuing the recent process of international cooperation for at least a while longer.
Indicators of the demand for single-family homes continue to deteriorate badly. NAHB’s proprietary survey of 30 large builders showed stunning declines in gross and net sales of new homes in October (seasonally adjusted), sales of existing single-family homes and condo units fell back in October despite rising sales of foreclosed homes, and our broad-based monthly single-family Housing Market Index moved down sharply in November--easily posting a new record low.
Respondents to our November HMI survey revealed plans to cut back single-family housing production further during the first half of 2009, about in line with our forecast of single-family starts for the first half of next year. Survey respondents generally cited mounting consumer concern about the economy and tightening mortgage credit conditions. We also found that about two-thirds of single-family builders are attempting to diversify into other lines of business, primarily residential remodeling.
Data for the third quarter reveal maintenance of near-record levels of both homeowner and rental vacancy rates in the U.S. housing stock, despite massive cutbacks in production of new housing units since early 2006 and sizeable declines during the past year in the inventory of new homes for sale; of course, the Commerce Department inventory data for the new-home market exclude units handed back to builders via cancellations! Sharply rising foreclosures continue to pour more units onto glutted markets through the back door, compounding problems for home builders.
The stubborn imbalance between weak housing demand and heavy supply on the market ensures that the contraction in housing starts will extend well into 2009. We expect total and single-family starts to bottom out around the middle of the year at a lower trough than projected earlier, and the multifamily sector probably won’t stabilize before early 2010. The housing production component of GDP (residential fixed investment) figures to exert a sizeable drag on overall economic growth through mid-2009 before swinging back into the positive zone. That development is absolutely essential to the beginnings of our projected recovery in the overall economy in the second half of 2009.
Stabilization of house prices is an essential part of the stabilization of the housing market during 2009. Price-to-income and price-to-rent ratios have come down toward earlier norms in many places and standard measures of housing affordability (including NAHB’s quarterly Housing Opportunity Index) have improved quite a bit in recent times. However, these measures do not take tighter mortgage lending standards into account, and an overshoot of prices on the downside certainly is possible--worsening mortgage credit quality even further and provoking even tighter mortgage lending standards in 2009. That’s the diabolical feedback loop that must be broken by public policy before the housing sector can truly stabilize and move ahead.
Recession Realities
The as-yet unofficial economic recession is here and it’s deepening considerably as we roll through the fourth quarter. Downward economic momentum undoubtedly will extend through the early part of 2009 before the economy stabilizes. It now appears that the current recession will be the most serious since the 1982 episode (the second part of the disastrous double-dip experience in the early 1980s) and this one could turn out to be even worse if policymakers fail to react effectively.
Real GDP contracted at a 0.3% rate in the third quarter, according to the Commerce Department’s “advance” estimate, a smaller decline than we had projected. However, key monthly data released since then point toward a significant downward revision to the advance estimate, and it’s clear that economic activity was weakening progressively during the third quarter--setting up weak “initial conditions” for the fourth quarter of the year.
Virtually all components of domestic spending have been weakening recently. Consumer spending has been contracting rapidly, led by a virtual collapse in auto sales. Residential fixed investment continues to cascade downward, and investment by nonresidential businesses has turned down as well. Support from the foreign sector (exports) also is giving way as the stunning U.S. economic contraction is taking a heavy toll on the economies of our trading partners.
We now expect real GDP to contract by 3.8% in the fourth quarter, followed by further contraction during the first two quarters of 2009, and the cumulative decline (from the second quarter of 2008 to the second quarter of 2009 comes to 1.54%. We currently expect modest economic growth to emerge during the second half of 2009, aided by further declines in commodity prices (including oil), lagged effects of massive monetary stimulus from the Federal Reserve and foreign central banks, and substantial fiscal stimulus from Congress and the new administration early next year. (see below) Assuming this pattern materializes, some modestly above-trend GDP growth is in store for 2010.
Labor Markets
The job market has been losing ground since late last year, and the retreat has accelerated recently. Nonfarm payroll employment fell by 240 thousand in October and the numbers for the two previous months were revised down substantially. The cumulative decline so far this year amounts to nearly 1.2 million jobs and the experience since mid-year definitely is in classic recession territory. An extended and deep contraction in residential construction employment (builders and specialty trade contractors) has been a major part of the evolving deterioration of the national labor market.
The unemployment rate naturally has been rising as payroll employment has fallen. The civilian unemployment rate jumped from 6.1% in September to 6.5% in October, and this rate now is more than two percentage points above the low of last year. Broader measures of slack in labor markets, including discouraged workers and those working only part time for economic reasons, have made even more dramatic moves. (Figure 3)
As if things weren’t bad enough, initial claims for unemployment compensation recently climbed to a 16-year high.
Further deterioration of labor market conditions is inevitable during the period ahead. The average pace of job loss experienced in recent months is likely to be exceeded during the rest of this year and the early part of 2009, and we do not expect positive payroll job growth to emerge until late next year.
We now expect the cumulative decline in payroll employment (from the fourth quarter of 2007 through the third quarter of 2009) to reach 2.7 million. We also expect the unemployment rate to top out at 7.9% in the fourth quarter of 2009, higher than the peaks reached in the 1990-1991 and 2001 recessions but still short of the peak in the early 1980s. Above-trend GDP growth should begin to shepherd the unemployment rate downward during 2010.
Financial Markets Stress
There are signs that the functioning of short-term credit markets has improved to some degree from the virtual lock-up experienced in the first half of October, and central banks at home and abroad can take a lot of credit for that. Their liquidity-enhancing and market-making efforts have been impressive, and a new Fed purchase facility now is propping up the commercial paper market.
Credit market improvements have shown up largely in the so-called TED spread (3-month dollar Libor less 3-month Treasury yield), a key measure of risk aversion, and in the spread between the 3-month dollar Libor and the federal funds rate target expected to prevail over the next three months--a measure of cash scarcity among banks. But despite recent improvements, these spreads remain wide and conditions are much more serious in longer-term private credit markets—marked by huge quality spreads and rising costs of credit default swaps. To make matters worse, equity markets have descended drastically, with no clear bottom in sight.
The weakening economy, expectations of additional Fed easing and extreme risk aversion in credit markets have been putting extremely strong downward pressure on short-term Treasury yields, driving the 1-month and 3-month rates to incredibly low levels. At the same time, expectations of soaring Treasury issues--to finance the recently enacted $700 billion “Troubled Asset Relief Program” as well as a large prospective fiscal stimulus package early next year--have put strong upward pressure on longer-term Treasury rates. This combination of forces has produced a Treasury yield curve with an extremely steep upward slope, a structure that does not bode well for longer-term borrowing by the private sector. Of course, substantial risk permia are being piled on top of Treasury yields across the curve, particularly for longer-term credits.
G-20 Summit
The historic meeting of leaders from the Group of 20 countries (plus the Netherlands and Spain), convened in Washington on November 15-16, held out hope for a quick resolution to the global financial crisis and the rapidly evolving global recession. After all, not only were all the major developed countries represented, but also China, India and Brazil--advanced developing countries with the resources and capability to contribute to resolution of the global down-cycle.
Perhaps the financial markets expected too-much too-soon. The G-20 summit actually covered a lot of ground, and major areas of common agreement were revealed:
an agreement to pursue stimulative monetary and fiscal policies, where appropriate, to combat the global recession.
a consensus to do what is necessary to stabilize the global financial system by providing sufficient liquidity, bolstering capital positions and unfreezing the credit markets.
an agreement to expand the role of the IMF and other multilateral agencies to support emerging economies that have been affected by the crisis.
an agreement on common principles for financial reform as well as immediate action on specific issues such as integrity in credit-rating processes and disclosure standards for off-balance-sheet activity.
More concrete recommendations on financial reform are due to be presented at the next G-20 summit, planned for April 2009. In the meantime, let’s hope the window of opportunity that has been opened wide will encourage recalcitrant central banks to press harder on the monetary policy accelerator and break free from present meeting schedules. Such action by the ECB would be particularly fulfilling.
Monetary Stimulus
Central banks here and abroad fortunately have a lot of leeway to adjust monetary policies without prior political approval, and we’ve been witnessing impressive rounds of monetary easing by the Federal Reserve and key foreign central banks during the past year. But monetary policy stimulus can prove to have little immediate kick when depository institutions are afraid to lend (even to each other) and private sector participants (consumers and businesses) don’t want to borrow and spend. Unfortunately, that seems to characterize the current situation in the U.S. and many other parts of the world at this time.
But monetary stimulus normally works with a rather long lag and central banks are not about to give up the fight; indeed, Chairman Bernanke has said several times that the Fed will not “stand down” until financial markets are functioning normally. In that regard, we’re looking for further reductions in key policy rates at home and abroad. In the U.S., we expect the Fed to drop the target federal funds rate from 1% to 0.5% at the December 16 meeting of the Federal Open Market Committee, and the discount rate should be cut by the same amount. We now expect the Fed to hold this highly stimulative monetary policy stance throughout 2009 and the Fed might hold the effective rate below the announced target for some time.
In any case, the lagged effects of monetary stimulus are bound to gain traction during 2009, helping to limit the depth and duration of the recession.
Fiscal Policy
Recent conduct of fiscal policy has caused a good bit of confusion in financial markets and some angst on Capitol Hill. The major issue has been management of the huge $700 billion Troubled Asset Relief Program (TARP) that was sold aggressively by the White House, the Treasury and the Fed and that was approved in late September by the Congress. Half the TARP funds were made available to the Treasury at that time, with the other half available on request from the Congress.
The TARP originally was characterized as a mechanism to get deteriorating mortgage assets off the balance sheets of U.S. financial institutions, at a relatively small net cost to the Treasury, and the Treasury was expected to work aggressively to prevent foreclosures on troubled mortgage loans that had come into its possession. But shortly after the TARP was created, the Treasury (in consultation with the Fed) decided that the first $250 billion should go toward capital injections for depository institutions ($125 billion to 9 selected big banks). On November 12, Treasury Secretary Paulson announced that TARP funds would not be used to purchase illiquid mortgage related assets. At the same time, the consumer finance sector was given high priority, as an “important market for securitizing credit outside the banking system.” At this point, it’s not clear whether or not the Secretary will request the second half of the TARP funds during the remainder of the Bush presidency or how requested funds would be used to buoy financial markets.
Whatever the fate of the TARP funding, there’s little doubt that aggressive fiscal stimulus will be applied to the economy in the early days of the Obama Administration. The need for stimulus obviously is extreme and Democratic majorities in both houses of Congress will give the new president a good bit of political leverage.
Legislation extending unemployment benefits has just been signed into law, although further extensions may be enacted under the new president. Infrastructure spending obviously is high on the list of Obama’s stimulus measures, along with increases in food stamp benefits and aid to the states. We may also get a payroll tax holiday, more temporary cuts in personal income taxes and some investment tax credits. Obama’s campaign pledge to reshape the personal income tax system hopefully will be deferred at least until the economy is clearly out of the woods!
A truly effective fiscal stimulus package must include strong measures to boost housing demand and stop the destructive downward spiral in house prices. The housing market sorely needs a new set of tax credits for home buyers (not repayable to the Treasury) as well as sizeable buydowns of mortgage interest rates--similar to the stimulus measures used to fight the 1974-1975 recession and the housing slump at that time.
Whatever the composition of the upcoming fiscal stimulus package, the package is likely to be huge--perhaps exceeding $500 billion.
Mortgage Finance
Fixed-rate home mortgages are essentially the only game in town, since hardly any lender wants to make adjustable-rate mortgages in the current environment. Unfortunately, the stubbornly high 10-year Treasury rate, combined with a very wide spread of mortgage rates over Treasuries, has kept even the prime conventional conforming mortgage rate (salable to Fannie Mae and Freddie Mac) above 6%. Required yields on jumbo home mortgages are hanging above 7%, reflecting investor aversion to any credit instrument without clear government backing.
The FHA/VA market, backed up by the gilt-edged Ginnie Mae securities program, has been gaining a lot of market share in this environment. That market, together with a GSE market that’s functioning reasonably well under federal conservatorship, heavily dominates home mortgage lending at this time. The private-label mortgage-backed securities market has effectively disappeared, and depository institutions clearly are not inclined to hold a lot of home mortgages in portfolio.
We’re expecting long-term Treasury rates to recede in coming quarters, as the economy weakens further and inflation recedes, and we expect the mortgage-Treasury spread to gradually narrow over time--dropping the prime fixed-rate mortgage to about 5.6% by the middle part of 2009. We also expect the prime 1-year Treasury-indexed ARM rate to move down to some degree in 2009.
These projections of mortgage rates are hardly a slam-dunk, in view of daunting uncertainties about the course of the real economy, the questionable condition of financial markets going forward and market uncertainty about the actual amount of federal backing behind Fannie and Freddie.
Even if prime conventional and FHA/VA mortgage interest rates behave reasonably well, prospective home buyers will continue to face stringent mortgage lending conditions in the foreseeable future. The Fed’s October survey of senior loan officers at commercial banks showed that large majorities of banks had tightened their lending standards on all types of home mortgages during the previous three months, including “prime” loans that can be sold to Fannie Mae and Freddie Mac. This round of tightening came on top of the systematic tightening process that began in earnest around the end of 2006, and the cumulative tightening in mortgage lending standards now is the most serious on record.
Housing Demand
Available indicators of housing demand displayed considerable weakness in October, and early signals for November are hardly encouraging.
NAHB’s October survey of 30 large single-family builders was weak in all respects. Gross sales (new orders) fell sharply on a seasonally adjusted basis, the number of sales cancellations ticked up after an extended downswing, and net sales registered a very large decline for the month.
Seasonally adjusted cancellation rates calculated from our big builder survey moved up in October, whether measured relative to current gross sales or to the backlog of signed sales contracts.
These increases wiped out much of the improvement that had occurred in earlier months of the year.
In the existing-home market, sales of both single-family homes (including townhomes) and condo/co-ops fell back in October, and sales prices were down considerably in both components of the market (year-over-year basis). Ironically, sales volume has been rattling essentially sideways since late last year, reflecting a rising number of foreclosure-related sales at deeply discounted prices--hardly a sign of market vitality!
NAHB’s monthly single-family Housing Market Index (HMI) hit a record low (9) early in November.
Furthermore, all three components of the HMI (current sales, buyer traffic and sales expectations) hit record lows, as did all four major regions of the country. The decline in the HMI has been particularly striking in the West region, falling from a cyclical high of 91 in October 2005 to 6 in November of this year.
Messages from the Field
In November, NAHB surveyed about 420 single-family builders about their plans for the first half of 2009, their assessments of the key problems facing the housing market, and their efforts to diversify into other lines of business.
With respect to building plans, 16% of respondents actually said they plan to build more homes in the first half of 2009 than during the second half of this year, and 35% said they plan to build about the same amount in those two periods. However, half of all respondents said they plan to build fewer homes during next year’s first half, some by whopping amounts. Taken together, the survey results imply a downshift of roughly 17% in single-family starts from the second half of 2008 to the first half of 2009, close to the rate of contraction shown in NAHB’s current forecast (14%).
When asked about key problems/issues currently facing the housing industry, 98% of respondents to our November survey cited consumer concern about the economy, nearly double the frequency found early this year, and the November response rate was similar across both size of builder and regions of the country. Nine-tenths of builders also cited the inability of prospective buyers to sell their existing homes, and an equal proportion cited negative media reports about housing. Three-fourths of respondents cited tight mortgage lending standards in November, up from only one-fourth recorded in similar surveys conducted during the first quarter of this year. There’s no question that tightening mortgage standards have become a big negative swing factor as the year has progressed--documented by surveys of both builders (NAHB) and lenders (the Fed).
The depth and duration of the contraction in the new-home market has encouraged some single-family builders to diversify their operations into other lines of business. In our November survey, 35% of respondents said they had not diversified in 2007-2008 and would not be diversifying their operation in 2009; this response was most common among larger builders (starting more than 100 units pre year). Twenty percent of all respondents said they had not yet diversified but plan to in 2009. The remaining 45% said they had diversified during the 2007-2008 period, and the frequency of this response was greatest for small builders (starting less than 25 units per year) and for builders in the Midwest region.
For those that had diversified in 2007-2008, and for those who plan to diversify in 2009, the most common route is residential remodeling--cited by 40% of respondents. Light commercial construction came in second (21%), followed closely by commercial remodeling (19%). Only small proportions of single-family builders pursuing diversification were getting into new multifamily construction or land development. Those sectors, of course face their own stiff challenges in financing markets.
It’s ironic that so many single-family builders are flocking to the remodeling market, since that market is losing a good bit of volume on its own, particularly for large improvements to owner-occupied homes. Our quarterly Remodeling Market Index has weakened considerably through the third quarter, and many professional remodelers actually are complaining about the intrusion of traditional single-family builders onto their turf. Translation: the shift can go only so far!
Housing Recovery Delayed
The recent downward momentum in housing markets is bound to extend well into 2009. This pattern is part-and-parcel of a weakening national economy, relatively stringent financial market conditions and extremely weak consumer confidence/sentiment. We’re assuming strong actions from the Fed and foreign central banks, as well as considerable fiscal policy support from the new Administration and Congress (including some direct support to the housing market). We view that support as limiting, but not eliminating, further retrenchment in housing market activity.
In addition to weak demand, there still is a daunting overhang of vacant year-round housing units on the market. At the end of the third quarter of the year, this overhang amounted to nearly 5% of the housing stock.
Furthermore, vacancies were historically heavy on both for-sale and for-rent components of the market.
We’ve revised single-family housing starts downward to some degree, making the peak-to-trough decline 62%, and the upswing doesn’t commence until the third quarter of next year.
The upswing is rather tepid, compared with earlier rebounds, since we expect credit conditions in construction and land development markets to be quite challenging for some time.
The multifamily market has not gone into a major retrenchment mode yet, owing largely to long lead times in planning and financing before start, but our contacts in the field are expecting sharp falloffs in starts of both rental and condo projects before long. Thus, we’ve weakened the pattern considerably next year, and the tepid recovery projected for 2010 is subject to some downside risk.
Our projections for manufactured home shipments and residential remodeling have not been altered significantly this month. They both show serious weakness in 2009, followed by small and tentative improvements in 2010.
Putting all components of housing production together (including commissions on home sales), the real value of residential fixed investment displays a steep decline from the end of 2005 through the second quarter of 2009, followed by a steady recovery over the balance of 2009 and in 2010.
That switch in direction is absolutely essential to the beginnings of economic recovery that we’re expecting in the second half of next year.
Once the ball starts rolling in the right direction, of course, the housing sector will enjoy a lot of growth room based on our expectations for demographic trends and other fundamental components of demand, including replacement needs and the second home market. We won’t get back up to trend for several more years (beyond 2010), but the potential is out there for builders to work toward in coming years.
For more information about this item, please contact Bernard Markstein at 800-368-5242 x8237 or via e-mail at bmarkstein@nahb.org.
