I have been writing fairly consistently on the housing situation and how it relates to the economy. It is my belief that the determination of a soft versus hard landing, or even a 'goldilocks economy' for that matter, will be largely determined by the extent of the housing deceleration. Housing has been important to the economy on two fronts; job creation and consumer spending via mortgage equity withdrawal (MEW). These two factors and how they relate to the economy can be seen in the following charts.
Figure 1. Job Growth: Total and Construction %
Figure 2
Source: Asha Bangalore, Paul Kasriel, The Northern Trust Company
U.S. Economic Outlook: August, 2006
The current construction employment has not made up such a large percentage of total employment since the late 1950s, the highest levels in over 50 years. In Figure 2 we see that GDP has not seen such a large percentage of growth coming from home sales in more than 35 years. For these reasons housing needs to be monitored closely to gauge where the economy is heading.
The Economic Cycle Research Institute's (ECRI) Weekly Leading Index (WLI) is a fairly good barometer of the economy. Every time over the past 35 years the WLI reaches a -5% year-over-year (YOY) growth rate we have seen a recession.
Figure 3
Note: Grey lines indicate recessionary periods
Source: Economic Cycle Research Institute
The 1980s mid-cycle slow down as well as the 1990s mid-cycle slow down hovered around a 0% YOY growth rate before reaccelerating. Currently it is too soon to determine whether we will have a mid-cycle slow down or recession as the WLI is currently at a smoothed -1.7% annualized growth rate. Until the YOY growth rate turns more negative or whipsaws and turns positive with a continual positive trend, the verdict is still out.
The Institute for Supply Management's (ISM) Purchasing Manager's Index (PMI) has been a reliable economic indicator whose reports can move the markets. Readings near 40 have been associated with recessions in all but one occasion since 1960. Levels below 50 indicate economic contractions while levels above 50 indicate economic expansion. The PMI is currently at 54.5, still in expansion mode.
Figure 4
Note: Grey lines indicate recessionary periods
Source: Institute for Supply Management (formerly NAPM)
Although both the WLI and the PMI point to flat to weak economic growth, both retail and housing employment numbers and trends point to further economic weakness ahead that may lead to economic contraction instead of expansion. Over the last 40 years, whenever the total nonfarm employment YOY % growth rate falls into negative territory we have had a recession.
Figure 5
Note: Grey lines indicate recessionary periods
Source: Bureau of Labor Statistics
The current nonfarm employment YOY growth rate is just above 1%, but it is likely to head lower as retail trade employment is already in negative territory and retail trade employment tends to lead total nonfarm employment. The employment situation showed that 14,000 jobs were lost in retail trade last month alone, with 11,000 jobs lost in manufacturing. Another significant decline in the August job�s report was 7,100 jobs lost in transportation and warehousing. The negative job growth trend in transportation related industries may help explain the weakness in the transport indices.
Figure 6
Figure 7
Note: Grey lines indicate recessionary periods
Source: Bureau of Labor Statistics
Looking at housing-related payrolls shows a similar trend to retail trade employment. Housing-related jobs have turned negative this year with the three month moving average currently at -10,000 jobs lost per month, although payroll growth outside of housing-related industries has remained flat.
Figure 8
Figure 9
Source: Dismal Scientist
Economist Zoltan Pozsar with Moody's Economy.com had the following commentary in his recent article with the subtitle, 'The Housing Slowdown Is Snowballing.'
High-frequency indicators last week brought further evidence that the housing slowdown is alive and well. Mortgage purchase applications tumbled to a new low, and the NAR's pending home sales index fell an astonishing 7.0% in July weakness in the index foreshadows declines in actual home sales in coming months. Furthermore, residential structures investment fell by 2.0% in July, and the Saturday edition of the Wall Street Journal (subscription required) quoted the NAR's usually optimistic chief economist David Lereah as saying that he expects home prices to "generally decline during the next few months."
Existing home sales have been a reliable leading indicator as to the trends of nonfarm employment growth in that existing home sales both top and bottom before employment growth does, shown by the charts below.
Figure 10
Figure 11
Figure 10 shows the reliability and correlation of existing homes sales to employment growth over the last 40 years. Figure 11 shows a close up of the same data over a shorter time frame. Looking at prior cycles since 1980, the YOY % growth rate (1-yr moving average) in existing home sales peaks on average 18 months prior to the employment peak, and bottoms 10 months prior to the employment growth bottom (see table below).
Table 1. Existing Homes Sales and Employment Growth Cycles
The current employment growth rate peak seen in August of 2005 was 15 months after the existing home sales peak, just under the average of 18 months since 1980. We have not seen a bottom in existing home sales and have not seen an outright drop in employment growth, so neither bottom appears in the near future.
Comparing existing homes sales and employment growth peak to trough for the above cycles showed that the average lag between existing home sales peak to trough was 38 (~ 3 years) months with the average for employment growth at 30 months (2.5 years).
Table 2. Peak to Trough Lags for Existing Homes Sales and Employment Growth
If the current housing cycle follows the average of the cycles since 1980, the bottom in housing will not likely occur until July 2007. Table 1 showed that the bottom for employment growth took place 10 months after the housing bottom, putting the starting point for the next acceleration (bottom) in employment growth occurring in May of 2008. Table 2 shows that the employment bottom occurred on average 30 months after the peak, putting the next possible bottom in February of 2008.
The data from both tables point to continued weakness in housing and employment growth. The tables indicate a housing bottom in the middle of 2007 with an employment growth bottom occurring in early 2008 before the next economic expansion occurs. The data which I compiled above corresponds fairly close to that of Asha Bangalore from the Northern Trust who provides the following commentary and chart:
The House Price Index (HPI) continued to advance in the second quarter of 2006. However, the index shows a sharp deceleration on a year-to-year basis. The HPI rose 10.06% in the second quarter of 2006 compared with the HPI in the second quarter of 2005. The recent peak in the year-to-year change of HPI was in the fourth quarter of 2005 (+13.36%). Larger gains exceeding what we have seen in the current expansion were last reported in the late 1970s. In the first quarter of 1979, the HPI moved up nearly 15.0% (Figure 12) on a year-to-year basis. Following this peak, the HPI continued to show a decelerating trend until the third quarter of 1982 when the HPI posted a 1.68% increase on a year-to-year basis. In other words, it took a little over three years for home prices to turnaround.
Figure 12
Source: Asha Bangalore, The Northern Trust Company
Daily Global Commentary 09.05.2006
In summary, expect continued economic weakness ahead as the employment trends in retail trade and housing-related industries are both at negative YOY rates. Both of these sectors of the economy will likely foreshadow an outright negative trend in total nonfarm payroll employment as they are leading indicators. The housing downturn will likely continue into next year as the excess inventory of unsold homes is worked off with an employment expansion likely to occur after a housing reacceleration in early 2008 if prior housing and employment cycles are repeated.
Today's Market
The productivity report released today weighed down the markets as productivity decreased while wages increased, both pointing to continued inflationary pressures. On a YOY basis, productivity edged down to 2.5% in the second quarter from 2.7% in the first quarter. Unit labor costs continue to worsen with a surge to 5.0% YOY from 3.6% in the first quarter. Nominal compensation costs are up 7.7% YOY from 6.4% in the first quarter. The positive revision in 2nd quarter productivity from the 1.1% estimate to the revised 1.6% rate was not enough to outweigh the negative sharp revision in unit labor costs from 4.2% to 4.9%.
The ISM non-manufacturing Business Activity Index rose to 57.0 in August, up from the 54.8 July reading and above the consensus estimate of 55.0. New orders fell sharply from 55.6 in July to 52.1 in August, a three-year low. Employment also fell from 54.5 in July to 51.4 for August, both new orders and employment pointing to economic weakness. Another negative finding in the report was that the prices paid index continued to remain at elevated levels with the August reading coming in at 72.4, though below the July level of 74.8.
Figure 13
Source: Econoday
Both the productivity and costs report and the ISM non-manufacturing report put downward pressure on the markets with broad based declines seen across the markets as all ten S&P sectors fell on the day.
Advancing issues represented 19% and 23% for the NYSE and NASDAQ respectively, with up volume representing 18% and 9% of total volume on the NYSE and NASDAQ.
All of the broad market indices were down, with the DJIA posting a loss of 63.08 points to close at 11,406.20. The S&P 500 was down 12.99 points to close at 1300.26, and the NASDAQ was also down, falling 38.76 points to close at 2167.84. The 10-year Treasury note yield rose to 4.801%, and the dollar index posted a loss on the day, falling 0.13 points to close at 85.13.
Overseas markets were all down with Latin markets showing the greatest losses. Brazil's Bovespa and Mexico's Bolsa Index were both down, falling 1.76% and 1.37% respectively. Japan's Nikkei stock average fell 0.62%. London's FTSE 100 fell 0.88%, Germany's DAX index fell 1.21%, and France's CAC-40 declined 1.11%.
As mentioned above, all of the S&P 500 sectors were down on the day as the decline today was broad based. The smallest declines came from defensive sectors with consumer staples down 0.16%, utilities down 0.34%, and health care down 0.59%. The greatest losses came from energy, technology, materials, and consumer discretionary, all tied to the economy, posting losses of 2.98%, 1.82%, and 1.10% respectively.
