With the revision of fourth-quarter 2006 real Gross Domestic Product (GDP) growth down to 2.2% annualized from the Commerce Department??™s first estimate of 3.5%, this marks the third consecutive quarter in which growth was below the Federal Open Market Committee??™s (FOMC) perceived range for potential growth of 2-3/4% to 3%. To refresh your memory, second- and third-quarter annualized real GDP growth was 2.6% and 2.0%, respectively. Real GDP growth in the first quarter 2006 of 5.6% was biased upward due to the rebound from Katrina-depressed growth in the previous quarter. We are expecting annualized growth in this current quarter to come in at 2.5%, which would represent the fourth consecutive quarter of below-potential growth and would put the year-over-year change at just 2.3% - the lowest year-over-year growth since the second quarter of 2003, when the FOMC had cut the federal funds rate by 25 basis points to a level of 1.00%.
It really should come as no surprise to any financial professionals that economic growth would be moderating. After all, this is exactly what the Conference Board??™s index of Leading Economic Indicators (LEI) has been signaling. As shown in Chart 1, the year-over-year change in the quarterly average of the LEI peaked this cycle at 9.0% in the first quarter of 2004 and is essentially flat vs. year-ago in this current quarter, based on the January index reading. A year-over-year contraction in the LEI has yielded only one false recession signal since 1960. That false signal was in late 1966 ??“ early 1967, and was referred to at the time as a ???mini??? recession. By the way, the FOMC engineered a lower fed funds rate at that time, perhaps preventing an official recession. Some market economists refer derisively to the LEI as the index of Misleading Economic Indicators. Many of these are the same economists who are predicting the FOMC will raise the fed funds rate later this year. We would like to see their real GDP forecasting record vs. that of the LEI at cyclical inflection points ??“ when it really counts!
As everyone knows, the housing recession is the biggest drag on the pace of economic activity right now. But is the housing recession at its bottom? And more importantly, are there negative multiplier effects emanating from the housing recession? With regard to whether the housing recession has hit bottom; it is doubtful. In an average housing downturn, real residential investment expenditures decline by about 25% peak to trough. As Chart 2 shows, through the fourth quarter 2006, these expenditures have fallen by only about 13%, or slightly more than half of an average housing recession.
The current supply of single-family houses for sale ??“ both new and existing ??“ continues to outpace by a wide margin the current demand for them. Chart 3 shows that in January, single-family homes for sale were up 23.4% year over year while single-family homes sold were down 2.4%. The supply-demand situation probably is even more out of balance than these data show inasmuch as cancellations of new home sales are netted out of sales and are not added back into inventories for sale.
The deterioration in the subprime residential mortgage market has hit the front pages of many newspapers. At least two dozen subprime mortgage lenders have closed their shops (boiler rooms?) since December. Many survivors are tightening their underwriting standards. For some, that means instituting some standards other than just the detection of a pulse for the mortgage applicant. Commercial banks are tightening their underwriting standards for residential mortgages in general, as evidenced by the most recent Federal Reserve survey of bank lending terms. As shown in Chart 4, a net 15% of bank respondents reported they had tightened their lending standards for residential mortgages - the largest percentage since the second quarter 1991. There does not seem to be any definitive source on the size of the subprime mortgage market. Bank of America estimates that subprime mortgages account for about 14% of total outstanding mortgages and Alt-A mortgages account for about 27%. Alt-A mortgages lie between prime and subprime. Many Alt-A mortgages were issued to individuals with good credit ratings but who chose to borrow at somewhat higher interest rates than prime borrowers because they did not want to disclose their current incomes or intended to finance a house/condo for investment purposes. Delinquencies in the Alt-A sector also are starting to rise faster than expected.
The tightening of residential mortgage standards will increase the inventories of homes for sale and adversely affect the demand for them. The tightening standards will increase the inventory of homes for sale as foreclosures rise because some borrowers will not be able to afford their stepped-up monthly mortgage payments after the ???teaser??? interest rates have expired and will not qualify for a new mortgage with lower monthly payments. According to CreditSights, defaults/foreclosures in the subprime market alone will add an additional 500,000 housing units to the inventory of homes for sale. This is approximately equal to the current inventory of unsold new single-family homes. Demand will be adversely affected because fewer first-time and move-up buyers will qualify for mortgages as compared with recent years. According to Bear Stearns, the tightening of subprime lending standards could shut out approximately 1.1 million households from becoming homeowners, or at least renters with options to buy. In sum, it is doubtful the housing recession is over.
Now to the issue of whether what happens in housing stays in housing? Housing as a sector historically has led the rest of the economy. Chart 5 shows that the peaks and troughs in the year-over-year change in real private residential investment expenditures lead the peaks and troughs in the year-over-year change in real GDP excluding residential investment. The highest correlation between the two series is obtained when residential investment leads by two quarters. So, even if the current housing recession were at its bottom, its full impact still has not transferred to the rest of the economy.
Housing activity seems to have played an extraordinarily (oh, how we miss Greenspanish) large role in the current economic expansion. One way to gauge this is to calculate the dollar volume of single-family home sales as a percentage of nominal GDP. Chart 6 contains such calculations. In the current expansion, the dollar volume of single-family home sales rose rapidly relative to nominal GDP, hitting a record high of 16.3% in 2005. The median percentage from 1968 through 2006 is only 8.4. It strains credulity to think that such large relative activity in the housing sector in this expansion would not have a significant negative multiplier effect on the rest of the economy now that housing has entered a recession.
Housing starts lead housing completions, as shown in Chart 7. On a year-over-year change basis, starts lead completions by about two quarters. Thus, a sharp drop in housing completions should be expected in the coming quarters, given the sharp decline in housing starts. There is little value added in starting a house. The value added and employment rise throughout the ???gestation??? period of construction of the house.
With the expected sharp drop in completions, housing-related employment also can be expected to fall sharply, which will negatively impact total private-sector employment. Chart 8 shows that the year-over-year change in housing-related employment peaked in January 2006 at 6.0% and was contracting 1.8% by January 2007. Again as housing completions plummet in the months ahead, so too will housing-related employment as trades people are laid off, furniture and appliance manufacturing contracts and more mortgage brokers seek alternative employment. Year-over-year growth in private-sector employment excluding housing-related appears to have peaked in March 2006 at 2.2%, slipping to 2.0% in January 2007. Housing-related employment growth tends to lead private-sector employment growth excluding housing-related by about four months. Therefore, as housing-related employment begins to contract more significantly in the immediate months ahead, employment growth in the rest of the private sector will also start to slow significantly. And the slowdown in employment growth will have a moderating effect on the growth in personal consumption....
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