"Housing Slowdown Continues Though Consumer Confidence and..." Market WrapUp by Chris Puplava

Housing Slowdown Continues Though Consumer Confidence and Manufacturing Hold Steady
Mid-Cycle Slowdown or Recession?
BY CHRIS PUPLAVA

A protracted period of weak housing prices will likely lead to reduced retail sales with a decline in the wealth effect and depressant on confidence, though the latter has yet to be seen. Housing prices are still searching for a bottom as are building permits, with previous bottoms in year-over-year (YOY) rates for home prices seen in prior cycle lows near 2% and building permits near 800,000 units.

Source: Moody’s Economy.com
Data: Census Bureau, National Association of Realtors

The current contraction in housing may or may not follow previous cycles, and there is no guarantee that the final bottom in YOY price change or building permits necessarily has to bottom near previous housing downturns. In the wash of liquidity and decade-low interest rates, the bottom may come sooner than many anticipate as both may help to keep a higher floor on housing than in prior downturns.

When the housing cycle peaked in 1977, the fixed-rate-mortgage (FRM) was roughly 9% and was nearly 14% at the 1984 peak in housing starts. The peak that was seen last summer corresponded with a FRM below 6%. The lower interest rates in this cycle should help stimulate demand as lower interest rates make housing more affordable.

This is currently happening as the Mortgage Bankers Association of America (MBA) released their Applications Survey which showed that purchase applications increased 2.7% last week and refinance applications increased 6.5% over the prior week. The MBA purchase index is 7% higher than a month ago, though still 14% below last year's levels while the refinance index is 15% higher than a month ago and 19% above last year's levels. The increase in the purchasing applications is likely due to the FRM falling 71 basis points from its recent high seen in the week ending June 23rd. The rise in refinance applications is likely the result of adjustable-rate-mortgage (ARM) home owners locking in lower rates as their ARMs reset, as the ARM has fallen 61 basis points from the peak seen in the week ending July 7th.

Previous housing downturn cycles seen in the bottom of the early 1980s and 1990s saw a large plunge in building permits with a corresponding contraction in construction employment. However, though current building permits have fallen sharply from 2,200,000 units to roughly 1,600,000 units (-27%), construction employment has only fallen modestly unlike previous housing downturns that saw sharp contractions with negative YOY rates of change.

As shown in the figure above, even though construction employment has contracted sharply, housing is still working out the excess demand that was seen in latest cycle that was characterized by a large amount of marginal homebuyers entering the housing market, enticed by low interest rates and opting for ARMs and interest-only mortgages to be able to afford a home. These subprime owners are feeling the pain of falling home prices and rising interest rates as they are seeing their equity (if any) evaporate, and the likelihood of rising mortgage payments as their ARMs reset at higher rates. These factors are increasing the threat to household credit quality and mortgage credit conditions. Default rates and delinquency rates bottomed in 2005 and have risen since with no sign on slowing. This is even more prevalent in subprime loans as the delinquency rates for subprime mortgages have risen sharply since the beginning of the year, though aggregate delinquency rates are still far below levels seen in previous housing downturns.

So far the housing slowdown has been different in several respects to the last housing downturn seen in the early 1990s. Construction employment and interest rate levels are one differing characteristic, but so are delinquency rates. Real estate loan delinquency rates were roughly 5% prior to the 1990s housing recession and then doubled to 10% in 1991 at the peak. The contraction in housing spurred a recession that was predominantly a consumer-led recession as opposed to a business-led recession as commercial and industrial (C & I) loans delinquency rates increased only moderately from roughly 5% to 6%. The recession of 2001 showed a completely different picture as real estate loan delinquency rates barely budged, while C & I loan delinquency rates doubled from 2% to 4%.

Presently, delinquency rates at the top 100 commercial banks for both real estate and C & I loans are not signaling a recession as neither has risen sharply. One thing to note is that, though delinquency rates haven’t risen sharply on a historical context as seem in Figure 7, homeowner’s financial obligations have risen 26% from the lows seen in 1992 from roughly 14.25% to 18% as homeowners took on more mortgage debt. Conversely, renters actually dramatically improved their financial condition with reducing their financial obligations from 31% to 25%, a roughly 20% reduction in their financial obligation percentage of disposable income. This indicates that homeowners are not positioned to handle an increase in mortgage payments as ARMs reset to higher interest rates than they were in the past, which could lead to a spike in delinquency rates and a contraction in retail sales as homeowners disposable incomes decreases.

Previous recessions that were led by a housing contraction in the early 1980s and 1990s saw consumer confidence erode sharply with the YOY rate of change in the consumer confidence index falling -20% to -30%. The economy so far appears to be handling the housing contraction well as consumer confidence has remained steady and is even rising on a YOY basis. The 1980s and 1990s mid-cycle slow down initially saw the consumer confidence index fall to between 85-90, with the YOY rate falling to roughly -5% and 0% before rebounding sharply, which also coincided with a sharp rebound in retail sales as consumers ramped up their consumption once again.

Source: Moody’s Economy.com, Data: The Conference Board, Bureau of the Census

As mentioned above, the current contraction in the economy and housing appears to resemble more of a mid-cycle slow down than an outright recession. This can be seen in Figure 10 which shows that the consumer confidence index is holding steady and retail sales have slowed, though they remain at levels above the previous two mid-cycle slow downs and haven’t fallen sharply as characteristically seen in recessions. Both consumer confidence and retail sales may receive a boost in the near future if the Fed reverses course and starts lowering interest rates. The move by the Fed to lower interest rates sharply in the mid 80s and lower rates slightly in the 90s led to a jump in both consumer confidence and retail sales as seen by Figure 10 above.

With the recent PPI report released yesterday that showed both the core and overall PPI falling, the Fed has more ammunition to justify lowering interest rates. Declines in energy components were expected for last month as both crude and natural gas prices fell, though declines in overall producer prices were much more pronounced in October than was expected. The consensus estimate provided by Thomson Financial Census was calling for the overall PPI to fall by 0.4% while the actual PPI fell by 1.6%. The price decline was broad based and seen across a wide spectrum of products in all stages of processing.

Another sign that the Fed may just be engineering a mid-cycle slowdown instead of a recession is employment. So far employment is near YOY growth rates of the previous two mid-cycle slowdowns and has yet to contract sharply, although retail sales employment is approaching previous recession levels and may be approaching some type of bottom.

As long as employment holds, and thus incomes, there shouldn’t be a major contraction in spending. Figure 12 shows employment holding steady and the other side of the coin is unemployment. Previous recessions are marked by a sharp rise in unemployment insurance initial claims, with YOY rates of change rising 40% to 70% in the last four recessions. The mid-cycle slow downs of the 80s and 90s saw the YOY rate rise 10% to 15%, and the current YOY rate of change is not sounding any recessionary alarms as it is still contracting at -10% and below previous mid-cycle slowdown rates.

The manufacturing sector is also holding up well and is not pointing to a recession. Previous recessions were marked by a reduction in the average weekly manufacturing hours with weekly hours typically falling to a tight range between 39-40 hours. Previous recessions not only showed a reduction in manufacturing weekly hours but also a contraction in manufacturing employment. Prior recessions saw the YOY rate of change fall to -6% to -10% while the mid-cycle slowdowns saw manufacturing employment fall to a 0% to -2% YOY rate of change. With manufacturing weekly hours still rising and manufacturing employment holding steady, it’s premature to call for a recession.

Higher energy prices and falling home prices are not reining in energy demand as is typically seen in previous recessions where the YOY rate of change for vehicle miles traveled contracts. The total number of vehicle miles traveled is still increasing despite a major spike in energy prices over the past years as seen by the figures below.

Source: Moody’s Economy.com
Data: Department of Transportation, Federal Reserve Bank of St. Louis

Demand for distillates is roughly 400,000 barrels per day higher currently from the same time last year due to colder temperatures. The Energy Information Administration (EIA) released its weekly petroleum report today which showed a sharp drop in distillate inventories by 3.6 million barrels, significantly above expectations for a 0.4 million barrel drawdown. Gasoline stocks also fell sharply, declining by 3.7 million barrels against expectations for no change. The culprit to the decline in distillate and gasoline inventories was a drop in refinery activity which consequently led to a rise in crude oil stocks by 1.3 million barrels against expectations for a 0.3 million barrel increase. With U.S. consumers not slowing their driving habits and a colder winter than normal forecasted for this year according to AccuWeather, energy prices may resume their bullish advance after falling from summer highs.

An interesting article was published in the Wall Street Journal (WSJ) on November 8th regarding oil industry investment, Investment by Oil Industry Stalls, 11/08/2006. The article commented on data compiled by the International Energy Agency (IEA) which showed that investment in the oil-and-gas industry was $340 billion in 2005, up 70% from 2000. What was interesting was that, remarkably, inflation accounted for nearly all of that increase. When adjusted for inflation, the oil industry's investment increased by only 5% between 2000 and 2005 according to the IEA. This lack of true capital investment will lead to moderate increases in supply instead of large incremental increases that often quench bull markets in rising energy prices.

Bhushan Bahree, author of the WSJ article provided the following commentary on findings in the IEA 2006 World Energy Outlook.

If world demand for oil rises faster than projected, or if production-capacity gains are less than expected, the result would be upward pressure on prices. But even if demand-and-supply trends conform to projections, which is unlikely, the oil industry's investments won't significantly add to the world's spare oil-production capacity, a buffer that is needed to offset supply disruptions that periodically occur because of political, natural or industrial upheaval.

Oil prices nearly doubled between 2000 and 2005, leading to a gusher of revenue and profits for oil-producing countries and companies. Among the reasons for the sharp price increase was the industry's inability to increase production capacity to match the surge in demand. That was the result of self-imposed investment restraints during the industry's lean years in previous decades, when oil prices crashed twice because of excess supply.

From 2000 to 2005, world oil consumption rose 9.3% to 83.6 million barrels a day, testing the world oil industry's ability to produce and refine so much petroleum.

The industry has faced fierce inflation in recent years, with the cost of items from cement and steel to drilling rigs and services soaring because of global demand. Among oil projects taking a huge cost hit was Royal Dutch Shell PLC's massive undertaking in Sakhalin, in Russia's far east. Investment needed for this project rose to $85,000 per barrel of oil-production capacity from the originally planned outlay of $50,000 a barrel, Mr. Birol said.

The inflation mentioned in the article that makes up nearly all of the $340 billion spent in 2005 can be clearly seen when looking at the inflation rate in oil field and gas field machinery contained in the PPI report. The inflation rate for oil and gas machinery is running at double-digit inflation rates despite active rig counts at levels not seen in over 20 years. Until a surge of real versus nominal capital investment by energy companies is seen, any incremental supply for crude oil will likely be met by incremental increases in demand from China and India, meaning the fundamental bull market in energy is alive and well.

Source: Moody’s Economy.com
Data: U.S. Bureau of Labor Statistics, Baker Hughes Incorporated

The stock market rose today on news of US Airways $8 million bid for Delta Air Lines and from momentum seen on Tuesday’s rally sparked by the PPI report. The DJIA posted a gain of 33.70 points to close at 12251.71. The S&P 500 was up 3.35 points to close at 1396.57, and the NASDAQ was also up, rising 12.09 points to close at 2442.75. The 10-year Treasury note yield rose to 4.615%, and the dollar index posted a small gain on the day, rising 0.01 points to close at 85.31. Advancing issues represented 59% and 58% for the NYSE and NASDAQ respectively, with up volume representing 68% and 64% of total volume on the NYSE and NASDAQ.

Energy commodities were up on the day, with natural gas and gasoline posting the strongest gains. Precious metals were up modestly, with gold rising $1.71/oz to $622.59/oz and silver rising to $12.90/oz.

Base metal spot prices were down with nickel and tin posting the largest declines, down 4.04% and 3.59% respectively. Agriculture and softs were mixed, with cotton posting the largest rise of 1.72% and corn putting in the largest decline, down 1.67%.

Overseas markets were mostly up, with Brazil’s Bolsa Index posting the largest gain on the day, up 1.69%. The only decline was from Japan’s Nikkei 225 index, down 0.28%.

The advance today was fairly broad based as seven of the ten S&P 500 sectors finished in the green on the day. The largest gain came from energy after the release of the EIA report, up 0.78%, with the largest decline coming from the telecommunications sector, down 1.28%.

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