Housing A Headwind, Not A Hurricane

You need look no further for evidence of a weakening U.S. economy than the housing market.

As a leading economic indicator for housing, we focus on housing permits – authorizations to build new homes. Permits typically move ahead of “shovels in the ground” metrics, such as housing starts, by several months. They often fall well ahead of recessions.

A precipitous drop in housing permits over the last three quarters, nearly 30% from their peak a year ago, risks driving the economy into recessionary territory.

Typically among the first dominoes to fall, the housing market is one of the most interest rate-sensitive areas of the economy; since most homeowners borrow to purchase homes, changes in mortgage rates usually have a meaningful impact on demand. Over the past several COVID-19 pandemic-influenced years, the U.S. housing market has taken a wild ride. Home prices rose by double-digit percentages in 2020 and 2021 before rolling over in mid-2022.

The U.S. Federal Reserve has raised its target rate 450 basis points over the last year to cool economic growth and tame inflation. These rate hikes helped push mortgage rates much higher from their late 2021 trough. Rising mortgage rates combined with increasing home prices have pushed affordability metrics down to multi-decade lows.

There is good news: the threat from higher interest rates is likely to be muted relative to history.

After the global financial crisis (GFC), borrowers shifted away from adjustable-rate mortgages (ARMs) and have largely stayed away. ARMs as a percentage of all mortgages (by dollar volume) have fallen to 13.5% after peaking last fall near 25%. Entering the GFC, about 50% of homebuyers used this variable financing. Borrower creditworthiness appears far healthier today.

Just over 80% of mortgages originated in the past five years went to super-prime borrowers (those with credit scores above 720), and the share of subprime borrowers (those with credit scores below 620) was in the low single digits. In the early days of the GFC, super-prime was under 60% and subprime over 10%.

Consumer balance sheets remain in great shape after a tough year for markets, with robust wage increases, rising home prices and accumulated savings supporting household net worth.

Demographics also matter. The millennial generation is hitting peak earning and child-bearing years, helping support longer-term housing demand. The trend toward “aging in place” means fewer retirees are moving into retirement homes, limiting housing supply during a period of increased demand. These factors should limit how far activity and prices fall in a downturn.

While housing prices have rolled over and transaction activity has stalled, construction activity has held up. Housing completions in the fall of 2022 were their highest since 2007, and 2023 is likely to see the highest number of new multifamily units come to market in several decades.

This activity supported strong gains in construction jobs, but as the backlog of building projects clears out this spring, the typical layoff cycle will likely commence. The pain in housing has yet to be felt, but decreasing permits and starts suggest it will become a headwind.

Of equal concern, the National Association of Home Builders (NAHB) survey historically has led changes in the unemployment rate by 12 months, and its massive 2022 drop suggests more pervasive layoffs may be likely in 2023.

The economy’s trajectory is relatively clear, although the timeframe and severity of a potential downturn is anything but. The economy and housing market are structurally in vastly different places compared to the outset of the GFC. That should limit the damage from a housing slump, creating more of a headwind than a hurricane.

Jeffrey Schulze, CFA, is a director and investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice. Past performance is no guarantee of future returns.