August 8, 2018— Recent data have raised concerns about a slowdown in the housing market. After a solid 2017, in which both existing and new home sales posted their strongest readings since 2006 and 2007, respectively, 2018 has been a lackluster year in comparison. Sales of existing homes in the housing market, which account for close to 90% of all home sales, have been negative on a year-over-year basis for most of 2018. Sales of newly constructed homes have been edging lower in 2018 as well. Sales of newly constructed homes are a much smaller component of total home sales, but are still important because new construction is a boost to the investment portion of gross domestic product (GDP). In addition, other leading indicators of future housing market activity, such as the number of building permits issued for new homes, the number of new housing units started, and pending home sales (existing homes sales that are under contract for sale but have not yet closed), have all turned negative on a year-over-year basis in June as well.
Is it time to worry about the housing market? Not yet, in our view. While recent housing-related data have been softer, the deceleration has been moderate so far. Rising house prices, along with climbing interest rates, may keep growth in the housing market tame in the near term. However, a healthy labor market and longer-term trends suggest underlying demand should remain in place. Despite this backdrop in housing, we still look for GDP growth 2.75%–3.00% in 2018, with consumer spending and business capital expenditures (capex) as the main drivers of growth in the broader economy for the remainder of the year.
Current housing market slowdown in context
How should we read this recent flurry of soft data in the wake of the housing market-induced Great Recession? Figure 1 shows that total home sales activity (newly constructed single family home sales plus existing single, co-op, and condo home sales) has dipped into negative territory only a few times during the course of this recovery. The first major dip was in 2010–2011, as housing activity pulled back after being boosted artificially in the years prior by the Housing and Economic Recovery Act of 2008, which established a tax credit for first-time home buyers in 2008 (and was extended through 2010). The second major dip was in reaction to a sharp rise in interest rates in 2013 known as the “taper tantrum,” when markets were surprised by the Federal Reserve’s announcement that it was contemplating paring back, or tapering, its balance sheet purchases for the first time after the Great Recession. The 30-year mortgage rate jumped by nearly 100 basis points, or bps (1.00%), between May and September of 2013, and home sales declined sharply in response.
Figure 1: Total home sales activity dipping its toes into negative territory
Data as of June 2018.
Sources: National Association of Realtors, Census Bureau, Bloomberg.
2018: A story of rising house prices and interest rates weighing on affordability
This year’s cooling in housing activity has been moderate relative to past post-recession dips, and unlike the previous two episodes appears to be more organic in nature. Demand for housing was strong in 2017, supported by robust labor markets and low interest rates, as well as a temporary boost due to post-hurricane rebuilding. While labor market strength has continued to support demand for housing going into 2018, interest rates have crept higher, and tax reform has weighed on demand, particularly at the upper end of the market, given changes to the tax code related to the housing market.[i]
On the supply side, both home builders and realtors have noted consistent constraints on the construction of new homes. Tight labor markets have made it challenging for builders to find construction labor and have driven up wages in the industry while rising construction material costs due to recent tariffs (lumber, steel, aluminum), have had an additional upward impact on prices. This has made it more difficult and expensive for builders to construct houses, resulting in low inventory levels. The supply of existing home for sale has been low relative to demand as well.
The combination of strong demand for housing and low supply has pushed house prices higher. In recent months, various measures of house prices indicate growth 6%–8% y/y, though the pace of growth has moderated slightly. Interest rates remain low in level terms, but they have been grinding higher since the start of 2018, with the 30-year mortgage up by about 50bps since the start of the year (Figure 2). Higher home prices and interest rates have taken a toll on the affordability of housing, which in turn may dampen consumer demand going forward (Figure 3).
Figure 2: House prices and mortgage rates are rising
Data as of May 2018.
Sources: Freddie Mac, S&P Dow Jones Indices LLC.
Figure 3: Rising house prices and interest rates are weighing on housing affordability*
*Measures affordability of housing based on median income, median house prices, and interest rates.
Data as of May 2018.
Sources: National Association of Realtors, Bloomberg.
Will housing hold up?
Despite these near-term headwinds for the housing market, longer-term trends are supportive of underlying housing demand. The homeownership rate has been recovering since 2016, after hitting its lowest level since 1967 two years ago (Figure 4). Household formation has been on an uptrend in recent years as the labor market has improved, enabling more individuals to afford living on their own (rather than with parents or roommates). The share of 18–34 year olds living with parents has stabilized at just above 30% after edging up in the post-recession years. Millennials are also aging and, as a result, are beginning to build families and purchase homes in greater numbers.
Figure 4: Home ownership rate starting to recover
Data as of June 2018.
Sources: Census Bureau, Bloomberg.
In addition, the impact of a slowing housing market on GDP should be fairly contained. Housing’s impact on GDP can be measured through business spending in the sector (also known as residential investment) and consumer spending on housing services. As share of GDP, residential investment is the more cyclical of the two components, and has been recovering since the recession, now at 3.9%, close to its historical average (4.5%), but still well below its pre-recession high of 6.7%. This suggests the housing market is not overextended relative to history.
In the short term, rising house prices, along with climbing interest rates, may cool housing market activity. However, longer-term trends and demographics, along with a strong labor market, still suggest underlying housing demand should hold up. Residential investment as share of GDP remains below historical averages, suggesting the housing market is not overstretched. We would expect the housing market to continue to grow at a more moderate pace compared to 2017, but we continue to look for GDP growth of 2.75%–3.0% in 2018 and expect the Fed to continue on its gradual path of rate hikes.
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[i] The Tax Cut and Jobs Act of 2018 introduced measures that lower the amount of mortgage debt that is tax deductible, down to $750,000 from $1,000,000 previously. In addition, whereas previously property taxes had no limit on tax deductibility against federal income tax, now there is a limit of $10,000 total for the combined deduction of property, and state and local taxes. The standard deduction was also doubled, which may reduce the number of taxpayers itemizing deductions (and therefore using the mortgage interest deduction).