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Musings Report 2023-1 1-1-23 2023 Investment Outlook: Housing
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For those who are new to the Musings reports: they're a glimpse into my notebook, the unfiltered swamp where I organize future themes, sort through the dozens of stories and links submitted by readers, refine my own research and start connecting dots which appear later in the blog or in my books. As always, I hope the Musings spark new appraisals and insights. Thank you for supporting the site and for inviting me into your circle of correspondents.
2023 Investment Outlook: Housing
I'm going to start the New Year with a series of Investment Outlooks that are not predictions but attempts to illuminate potentially key drivers and variables of the investment/speculation universe.
Let's start with housing, traditionally the core asset of the middle class / upper-middle class and a key rung in social mobility, as owning a house has been a reliable way to build equity/wealth for the entire postwar era (1946 to the present, the past 76 years).
It's also long been a rung in the ladder of income-producing assets: buying a house for rental income rather than as a primary residence.
Starting in the mid-2000s, housing joined the ranks of purely speculative investments that were bought and "flipped" (sold) without being rented or occupied as a primary residence.
This trend was fueled by a steady decline in mortgage rates and the expansion of "easy-money" low-down-payment mortgages guaranteed by federal agencies.
The Federal Reserve supported this expansion of agency-guaranteed mortgages by purchasing $2 trillion of these mortgages via mortgage-backed securities (MBS).
This shift from traditional foundation of middle-class security to debt-fueled speculative vehicle for fast profits predictably generated credit-asset bubbles, which can be defined as prices disconnecting from the ultimate sources of valuations: demand and income.
This chart, courtesy of @Econimica (on Twitter), depicts average hourly earnings in the U.S. (a measure of earned income), housing prices and mortgage rates.
Housing bubbles occur when valuations far exceed the earned income needed to buy houses.
Note the 30-year trend of declining mortgage rates that enabled income to buy more house for the same monthly payment. (Note that mortgage rates are inverted on this chart.)
@Econimica has also provided insightful charts of the demographics and income foundations of housing.
Demand for housing typically arises from new household formation: young people start careers, start families and buy homes.
Older people (over 60 years of age) tend to downsize, selling their current residence for a smaller home or retirement unit. They provide little demand for new housing as they are selling one home to buy another.
Most demand for new houses is driven by wage-earners. If jobs decline, demand for new housing falls accordingly, as fewer people can afford to buy a new house.
The current housing bubble is unique in that all the metrics that support demand for new housing are declining even as price rocketed to unprecedented heights.
The number of jobs stagnated, as did the population of people forming new households. The gains in population were largely in the elderly, not the young.
Meanwhile, the number of new housing units being built soared, raising the per capita housing to new heights.
In other words, the number of housing units per person is higher than ever.
Now mortgage rates have doubled, drastically increasing the size of the monthly payment needed to buy homes at current prices.
While the Fed has maintained its $2 trillion of MBS, it's not expanding its mortgage holdings.
Both of the developments undermine the speculative demand for housing.
@Econimica summarized these trends for each state on Twitter. Here is Pennsylvania:
:
Pennsylvania (like so many states) has seen peak total employees (w/ a shrinking working age population) & is in secular employee decline here forward.
Since '00, PA change
--Pop +5.4% (0-64yr/olds -160k / 65+ +560k)
--Emp +5.4%
--Housing Unit +10%
=Home Prices +147%
Here is the chart for California:
In terms of traditional supply and demand, this enormous increase in price makes no sense: supply of new housing outpaced population, employment and income, and yet price increases by 150%.
This strongly suggests that much of the buying in the current bubble was speculative rather than the result of new household formation.
People with credit / cash bought second or third houses, often sight unseen, as second homes, AirBnB rentals or as speculative ventures to "park money" in a "safe" asset for capital appreciation.
This explains the large number of empty flats and homes in desirable cities and regions. The number is difficult to measure but it is likely far larger than generally assumed.
Another factor is the asymmetry of employment: most of the jobs have been created in densely populated urban regions with geographical and political constraints on developing new housing.
This is one factor fueling the massive increase in rents as young people flock to these regions for jobs.
What happens next? There are a number of variables to watch.
All else being equal, housing bubbles tend to display symmetry: they burst at the same rate that they inflated. So a three-year rise is followed by a three-year decline to trendlines.
But there are other variables in play: the extraordinary rise in mortgage rates and the potential impact of a recession which may well be the first "real recession" in 40 years.
By "real recession" I mean a broad-based decline in economic and financial activity that isn't immediately reversed by the Federal Reserve unleashing a tsunami of fresh credit while it drops interest rates far below the rate of inflation.
Recessions that the Fed can't reverse occur when inflation is running so hot that the Fed cannot lower interest rates or flood the economy with new money/credit because both these policies will only exacerbate inflation, further undermining the economy.
The last such recession occurred in the late 1970s-early 1980s, 40 years ago.
Since then, these Fed reversal-by-monetary-force policies are exhibiting diminishing returns: it takes far more extreme policies to reverse each downturn.
The last "Fed saves" required interest rates being driven to zero (unprecedented) and the creation of $8 trillion in the Fed balance sheet which enabled a far larger expansion of credit and speculative frenzy.
The unintended consequences of these "saves"--inflation and extremes of speculative excess--have closed these policy doors.
Many observers believe that inflation will drop to zero or lower, allowing the Fed to drop interest rates to zero or lower.
History suggests these observers will be wrong. Interest rates / bond yields tend to exhibit long cycles of rising and falling, and after 40 years of falling, they will likely continue rising for a long time.
Put another way, many see the 2020s as just another extension of the 40-year Bull Market of ever-lower costs of money/credit and ever-higher asset prices.
History suggests the opposite: higher costs of money/credit, the puncturing of speculative excesses and the fall of asset prices to Earth.
If a household owns a house as a primary residence, its valuation on the market doesn't really affect its utility as shelter.
Even if the value drops below the mortgage balance, as long as the house serves as shelter and the household can afford the monthly payment, there is no need to sell.
But valuation in speculative housing is the entire game. If price is dropping, speculators must exit to preserve profits (if any) or limit losses.
Those counting on rental income will come under pressure as a "real recession" reduces employment, income and spending.
As I've explained in prior Musings, housing is of course local, so highly desirable "islands" coveted by wealthy households with cash may well increase in value as most other markets fall, as the demand is being driven by the wealthy who don't need employment and who aren't buying for speculative gains.
But these "islands" are not the norm, as the pool of wealthy buyers is limited (the top 5%), as are the number of locales that tick all the boxes of desirability.
Most housing valuations are based on employment, the cost of mortgages and speculative demand. If employment declines while mortgage rates rise, demand will fall and eventually price will follow.
Extremes that become more extreme--in this case, housing bubbles--tend to collapse back to long-term trendlines, falling far lower than most observers believe possible.
The greater the percentage of housing units bought as speculative ventures, the greater the drop as speculators sell or are foreclosed/bankrupted.
Housing is famously "sticky," meaning that prices drop slowly as sellers hold out for yesterday's prices until forced to accept lower market valuations.
Demographic and income stagnation do not support a "return to the good old days" of speculative excess. Neither do constraints on central bank "saves."
Who will be the buyers on the way down? All speculation-driven markets ultimately depend on "greater fools" who believe the hype (real estate never goes down, etc.) and who will pay higher prices for assets that have untethered from prudent valuations.
Once the pool of "greater fools" dries up as fear replaces greed and higher mortgage rates reduce the number of potential buyers, there is no predictable bottom in prices.
There are variables that could modify this decline, for example, massive buying by wealthy foreigners. But wealthy foreigners have already been buying for the past 20 years, and if the global economy finally runs out of central bank "saves," wealth will decline globally.
There are no "sure things," but sticking to fundamentals of demand, demographics, employment and the cost of money will serve us better than counting on the pool of speculative buyers to continue expanding.
Highlights of the Blog
It's a New Era 12/30/22
My One Prediction for 2023 12/28/22
An Inconvenient Revolution 12/26/22
Best Thing That Happened To Me This Week
My new book "Self-Reliance in the 21st Century" is now available as an audiobook. Thank you, Mark!
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"Quality is not an act, it is a habit." ("Harry Stottle" a.k.a. Aristotle)
Thanks for reading--
charles |
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