Last night on K&C, Larry asked me about the improvement — after 5 down months — in New Home Starts. My answer was a single data point does not make a trend. Besides, rates are still historically cheap compared to the 1990s, when mortgages were primarily above 8%. (I also failed to mention in the allotted time that this is a notoriously noisy data series, with very inconsistent reporting standards; see this for more on that subject).
The way Real Estate’s growth rate has cooled is very consistent with our expectation for a "slow motion slow down" in the economy. But I did not have time for the specifics as to why I believe a decelleration, and then outright reversal, in Real Estate will matter so much to the economy. Let’s flesh this out a bit more:
Its long been a tenet of our economic outlook that the prime driver of the 2002-05 recovery has been the Fed. They slashed interest rates to 46 year lows, bringing the Fed Funds rate down to 1%, while cranking up the printing presses. Then, they kept rates low for a long time. Cheap money sent all sorts of hard assets — oil, gold, real estate, other commodities — soaring. This stimulus — and not tax cuts, as Rich Lowry incorrectly claims — was the key driver of the economy. Hey, I like tax cuts as much as the next guy, and personally benefitted ALOT from the dividend tax rate of 15% (before the AMT got me). But I calls ’em as I sees ’em, and it was historically ULTRA-low interest rates, and not the marginal change in top rates, that have been the prime domestic engine. (China was a close second, with the weak dollar right behind it).
Where was I? Oh, yes, Real Estate. When we first started prosletyzing this perspective of RE as the key, the skepticism was thick and the pushback was fierce. Now, this viewpoint has become fairly well established. Even the mechanism of MEW — Mortgage Equity Withdrawal — has gotten recognition as it put trillions of dollars into the hands of consumers, where it has been transmogrified into SUVs, new Kitchens, and HDTV plasma screens.
The mechanism for how this plays out is less well understood by Wall Street and the general public, and is slowly becoming accepted. It has begun to infiltrate the collective consciousness of investors. How the prime mechanism of the growth engine plays out, where its trending, and how it is likely to shift
over time will be the key to if we ultimately end up with an economic soft landing, a hard landing, or an outright crash.
To get a sense of how important MEW is, look at what GDP would be like without it. (Pretty scary, huh?). The usage patterns of consumers is the key to understanding where this can go.
Here’s where it gets tricky: Despite the rise in interest rates and the cooling of real estate, US Mortgage Equity withdrawal has remained robust. According to an article in Economy.com by Zoltan Pozsar, in Q1 2006, gross equity extraction slipped sequentially from $1.033 trillion to $996.8 billion (annual run rate). This is still "way up in the stratosphere" to quote Joanie. MEW represented 8.4% of personal income in Q1, and is a very meaningful source of spending cash with incomes flat and real incomes negative.
The Penebscott Princess puts it this way:
"How does John Q. get his hands on some MEW? 1. sale of home. 2. refis 3. HELOCs. (In that order, btw.) Okay, since the sale of a home is the largest factor, what is truly bad news then, is a deceleration in the pace of home sales and of course, any evidence that prices are softening as well.
And we know that both are in the works. So yesterday’s HMI release, a real dog, was unwelcome news, while acknowledging that it reflects new home sales only. Because face it. If they ain’t linin’ up to buy new ones, fat chance the used ones are flyin’ off the shelves either.
Bottomline, the increase in interest rates is depressing sales and prices in the housing industry. In turn, this should eventually become evident in John Q.’s spending habits as the well runs dry. But for the moment, we now have one mystery solved as to where he’s gettin’ his funding: he’s either sellin’ or hockin’ the ranch."
So how does all this fit in with our concept of a "slow motion slow down?" Spending patterns following mortgage equity withdrawals. The extra MEW green in consumers pocket is typically spent over 2 to 3 quarters. That implies the $249B or so extracted in Q1 will be spent from then to Q3. If Q2 slows even more, that gets spent from then thru Q4, and so on.
Even as MEW slows, it will still be stimulative, albeit at a decreasing rate, for the foreseeable future. This will continue until something stops the spending — most likely, a sentiment panic that freezes consumers from spending, with a religous epiphany involving saving money (hard to even imagine tho that may be).
I suspect that will occur slowly — much later this year or early 2007. The market’s action in May could even be the beginning of discounting that consumer slow down.
Mortgage Equity Extraction, components
Bottom line: Without something else to take the place of MEW, the consumer cannot drive the US economy at these levels for very much longer. Unless business spending ramps up dramatically, there is nothing else on the horizon to take the spending baton.
That spells trouble for GDP.
UPDATE: June 21, 2006 9:54am
The request goes up for the MEW GDP chart, and courtesy of Calculated Risk, here it is:
click for larger chart
UPDATE June 21, 2006 2pm
The WSJ picks this up in Market Beat: Mew Mix
Estimates of Home Mortgage Originations, Repayments, and Debt On One-to-Four-Family Residences
Alan Greenspan and James Kennedy
Federal Reserve Board, Staff working papers in the Finance and Economics Discussion Series (FEDS)
US Mortgage Equity Withdrawal Remains Strong
Zoltan Pozsar in West Chester
Economy.com, June 16, 2006
Softer Housing Sector Is Seen,But Data Don’t Point to Collapse
CHRISTOPHER CONKEY and MICHAEL CORKERY
WSJ, June 21, 2006; Page A2