The Economy in the Plastic Bubble
We’re going to leave behind the topic of Cyprus for a day. It does seem as if events are coming to a head, but with banks there closed until Tuesday (and the ECB lifeline in place until Monday), there will be lots of news over the next few days but most of it will be heat without light.
So, speaking of heat and light, let’s look at today’s data. Specifically, let’s look at Existing Home Sales.
While the total sales number fell just shy of the 5mm-unit level, the 4.98mm print still represented the highest number (aside from the home-buyer-tax-credit induced surge in 2009) since 2007 (see chart, source Bloomberg).
The inventory of homes available for sale bounced off of 14-year lows, but remains at levels lower than any we’ve seen in over a decade.
And, near and dear to my heart, the median price of existing homes accelerated from last month (although, due to historical revisions, last month’s y/y was revised down to 10.67%) and stands at 11.34%. The January Home Price Index from FHA also came out; the 6.46% year-on-year rate of increase in that index is also the highest post-2007.
There are long lags between both of these indices and the appearance of price pressures in the Consumer Price Index, but at the moment all indicators of housing point the same direction: Owner’s Equivalent Rent should be in the 2.75% neighborhood by year-end, and could be as high as 3%. This is a key part of our forecast that core CPI should reach 2.6%-3.0% by year-end, and accelerate further in 2014.
The amazing recent run in home prices – which I suspect is driven in part by institutional investor interest in real estate – has caused existing home prices as a multiple of household income to move above levels that prevailed for the last quarter-century of the 20th century. The housing industry likes to present charts of housing affordability, which takes into account the current level of interest rates, because currently those interest rates make even the relatively high home prices look more affordable.
Yes, I said “relatively high home prices.” The median sales price of existing homes averaged 3.36x median household income from 1975 to 2000, with a relatively small range of values around that average. Even including the bubble, when the multiples reached 4.8x, the average through 2011 only rose to 3.54. As of year-end 2012, the multiple was back to approximately 3.48 and if median prices rise “only” 8% this year (remember, the current pace is 11.3% and rising) the multiple will be around 3.6x by the end of the year (see chart, source U.S. Census Bureau, National Association of Realtors, Enduring Investments).
Notice that even at the depths of the crisis, home prices were only slightly cheap by pre-2000 standards. Similarly, equity prices at the lows only reached approximately fair value by pre-2000 standards. There are two interpretations of this fact set. It could mean that the pre-2000 era valuations were too low, and that modern financial markets and structures make higher valuation multiples permanently viable. Or it could mean that the Federal Reserve continues to artificially support markets at multiples that are not likely to be sustainable in the long run. I suspect the latter point is more accurate, although I am open-minded about whether the former point might have some validity.
This isn’t necessarily a bad strategy, if the idea is to let the market stair-step down to equilibrium rather than letting it crash there all at once. But I don’t see anything that suggests the Federal Reserve has the slightest idea how to value assets. I understand that they don’t want to substitute their own analysis for the market’s judgment (at least, that would be the counterargument), but that’s what they’re doing anyway – with no indication that they plan to back off anytime soon. The Fed is just more comfortable in the bubble, and afraid to leave it entirely. But don’t we have to, eventually?
The VIX returned to 14 today, which makes a bit more sense to me than the 12.7 level of yesterday. It still seems low to me, but at least there is a way for long-vol positions to actually lose.
Leave a Reply to Michael AshtonCancel reply
Hi Mike – Is it possible that with the big investor rush into rental property puts a damper on rents, so that they don’t follow prices up? It just seems like an unusual situation and I am wondering if the usual relationships apply…
It’s always dangerous to assume that they do not. But in this case, surveys of primary rents started moving up in 2011 and have been rising 4-5% since mid-2011. So I think we have some indication that both parts of the relationship are already moving.
In any case, if you take up the price of a good, what happens to the price of a substitute? People who may otherwise have bought houses may now bid for rentals. And in fact in some places in the country (e.g. Phoenix) there are already bubble-like conditions in rental markets. So while I think the point is worth considering, I think we have enough other indications to suggest it’s worth taking this seriously.
Great points, thanks!
I’m here for ya pal!
Michael, this is a very important post. Two questions for you:
1. You say that all indicators of housing point the same direction: Owner’s Equivalent Rent should be in the 2.75% neighborhood by year-end, and could be as high as 3%. This is a key part of our forecast that core CPI should reach 2.6%-3.0% by year-end, and accelerate further in 2014. Now, are you implying that this is now, in effect, GUARANTEED? Or guaranteed subject to … ?
2. Incomes (or real disposable incomes) just don’t seem to catch up yet to the pace of asset price growth. Therefore, (speaking of that ‘marketed’ affordability) there is a nominal interest rate on, let’s say 10 year treasuries, beyond which mortgages will no longer be serviceable for a lot of households should they choose to buy. Now, the other day I came across some hedge fund musings, suggesting that as soon as treasuries reach 3 per cent (nominal), house purchases will collapse. Do you have that estimate as well (in addition to your nice graph of EHP to MHI multiple)?
Let me just say that from what I hear, the Fed is ‘VERY AWARE’ of the underlying dynamics, and that, apparently, the only thing that could stop them from ‘GLADLY TIGHTENING’ this year(!) is the continueing inability of ‘fiscal authorities’ to solve deficits problem. Time is running out very fast before inflation expectations come on fire. Unless, of course, Europe (Japan, … you name it) blow up in our face…
Thanks for the post. Answering:
1. No, it’s not guaranteed, because the relationship may have changed. Rich T pointed out one way the relationship might have changed, although I don’t think so. And there could be other offsetting effects on OER, or other offsetting effects elsewhere in CPI (e.g., apparel and medical prices start to decline) so that we’re right on OER and wrong on core! This is why I give a range for our forecasts, rather than a point estimate (and there are still tails on both sides).
2. I don’t think that house purchases will collapse at 3%. Partly, that’s because I think the marginal purchaser here may not be a family but a fund. But more important is the fact that home buyers care about the expected return on the house relative to the cost of the loan…so, let’s assume that Treasuries are at 3% because expected inflation rises from 2.5% to 3.0% and real yields rise to zero from -0.6%. Now, if you expect home prices to rise at 5% and your mortgage is at 5%…then you’re getting the same return on investment as if you’d bought Treasury bonds, with the additional benefit of having a place to live. In fact, if rates began to rise because home prices were rising and pushing up inflation expectations, it might HELP sales as individuals rushed to buy before rates went up and ruined that arb.
In reality, home prices tend to rise roughly with CPI plus or minus 0.5%, and people still bought them. In the 1990s, people would take out 7% mortgages versus 3% real yields (so paying CPI+4%, say, for an asset that in the long run was merely CPI flat). So consumers seem to value the residence-value of the house at something like 3-5% in normal times.
Moreover, if the bubble mentality re-asserts, buyers may get the same sense that they did in the bubble, when they expected CPI+7% returns from housing. In that case, you’d pay, say, up to CPI+10% and be satisfied!
But most directly, one of the reasons that people are buying homes with rates at 2% is that it currently looks like a good deal with core inflation at 2%. Therefore, it isn’t clear to me that 3% would cause them to stop buying if inflation was also at 3%, ne c’est pas?
I’ve spoken to a number of Fed people, and it isn’t clear to me at all that they understand housing dynamics. They still think in nominal space, most of them. Although they clearly understand it BETTER than they did in 2007, as a result of lots of study, they also have lots of models now that fit historical data. That’s not the same as understanding. If they did understand it, they’d be raising rates now to prevent the bubble from re-forming, and to cool down the housing market!!
Great answer. Thank you
You’re welcome! Thanks for the great question!