Various undercurrents in the economy are pointing to shifts currently underway that are hinting at trend changes in the making. Two topics that have remained of interest are nonresidential real estate and vehicle sales data and composition. It is no secret that nonresidential real estate lags residential real estate, but the actual peak in this cycle for nonresidential real estate has yet to be determined or garner main stream media attention. Additionally, another trend that appears to be in the making is that high energy prices have finally led to a shift in consumer preferences, as is the result in a free-market economy where price dictates the balance between supply and demand and affects consumer preferences. The first topic to be covered below is the likely tipping point in nonresidential real estate.
Nonresidential Real Estate: Right on Cue?
We received the first hint that nonresidential real estate may have peaked last year as the year-over-year (YOY) rate of growth had steadily declined from the peak rate of 24.5% in Q3 2006 to 17.0% in Q4 2007. The reason why monitoring nonresidential real estate is so important and why the decline in residential fixed investment has had a more muted affect on GDP growth is that the growth in real nonresidential fixed investment in 2007 completely offset the decline in residential fixed investment. In 2007, real nonresidential fixed investment grew by $97.9 billion while real residential fixed investment fell by $96.7 billion, more than offsetting the entire decline from the housing recession last year.
Though nonresidential fixed investment offset residential fixed investment last year, that may not be the case this year as nonresidential fixed investment in structures (commercial real estate) appears to be peaking right on cue with a lag of two years after residential real estate, with both likely trending down in 2008.
One caveat, the type of recession we are likely to have will be different than 2001, and thus have different outcomes to both nonresidential and residential fixed investment. The 2001 recession was a business-led recession, and so the decline in commercial real estate was much more drastic than residential real estate as seen below. Conversely, as this present recession is more likely to be characterized as a consumer-led recession resulting consumers pulling back the reigns on spending while corporate balance sheets remain healthy, commercial real estate is not likely to decline to the same degree that residential real estate has. The roles are likely to be reversed below, with the decline in commercial real estate likely to show a milder decline than residential real estate.
Figure 1
Image cannot be displayed
Source: BEA
Supporting the findings in the GDP report is the report on construction data by the BOC. Like the GDP data, the construction spending data for nonresidential real estate shows a two year lag with residential real estate and appears to have peaked. Another data set that indicates that nonresidential real estate has likely peaked is the increase in the vacancy rates for various components of nonresidential real estate, a similar trend seen prior to the 2001 recession.
Figure 2
Image cannot be displayed
Source: BOC: Construction Put-In-Place
Figure 3
Image cannot be displayed
Source: CB Commercial
Though the data last year showed a deceleration in nonresidential real estate, an outright contraction has yet to be seen. The extent of the decline will be important to monitor as a sharp decline in nonresidential real estate coupled with a continued steep decline in residential real estate may more than offset any positive effect that rising exports may have on GDP.
Thus, while nonresidential real estate will be important to monitor, the extent of the decline in residential real estate will also be important to monitor to determine if nonresidential real estate will be able to make up for the decline in residential real estate this year as it did last year. If residential real estate’s decline in 2008 is less severe than in 2007, then a small deceleration, though still positive growth, in nonresidential real estate may still be able to mask the decline in residential real estate.
Along those lines, there are several key indicators that will be monitored for some form of stabilization within residential real estate. Two are shown below that have yet to show any sign of turning around. One coincident indicator of a housing bottom is the population of total homes for sale relative to completed homes for sale. This ratio falls as homebuilders stop construction on new homes and focus on completing their works in progress. As the inventory of completed homes is worked through, the ratio begins to rise and increases further when builders begin to start new projects, indicating the cycle has turned around. This ratio has yet to bottom though it may soon as the ratio is at its lowest point in more than 35 years.
Figure 4
Image cannot be displayed
Source: U.S. Census Bureau
Another ratio that provides insight into the internal health of the industry is the ratio of new homes sales to residential real estate delinquency rates. Healthy markets are characterized by rising sales and falling delinquency rates causing the ratio to rise, while falling sales and rising delinquency rates cause the ratio to fall. The ratio is currently still declining which indicates the health of the housing market is still deteriorating with home price declines likely to continue for at least 16 more months.
Figure 5
Image cannot be displayed
Source: Standard & Poor's, Fiserv Inc. and MacroMarkets LLC / U.S. Census Bureau
There is one indicator that does show some improvement, which is housing affordability. Falling interest rates and falling home prices are making the purchase of a home more affordable. Affordability fell drastically in 2003-2005 as home appreciation rates decoupled from their link with interest rates and median incomes. After the peak in housing in 2005, housing affordability is back to 2004 levels and looks to continue to rise as home prices continue to decelerate.
Figure 6
Image cannot be displayed
Source: NAR / U.S. Board of Governors of the Federal Reserve System
Improving affordability should begin to increase demand for housing as illustrated by the figure below that shows traffic of prospective buyers typically lags improvements in the rate of change in affordability by 17 months. Thus, improving housing affordability is sowing the seeds for improvement in housing. However, the degree of improvement is uncertain at this point as any housing recovery is unlikely to return to bubble status and more likely to resemble an “L-shaped” recovery as the NASDAQ bubble did after 2003 and the Japanese housing experience in the 1990s.
Figure 7
Image cannot be displayed
Source: NAR / NAHB
The Tipping Point in Consumer Vehicle Preferences?
As the price of oil over the years continued to rise, there were many arguments that high oil prices would derail the economy. The price of oil at which economists maintained this would occur kept rising, first to oil, then oil, , , , then oil. Oil continued to rise with many economists and financial analysts baffled at the economy’s resiliency to continue to grow in the face of higher oil and gasoline prices. The ability of the economy to grow in spite of higher oil prices sparked the question, “What price of oil WILL derail the economy?” An attempt to quantify this answer showed in a previous WrapUp (U.S. Economic Energy Intensity) that the breaking point for the economy will likely be seen with oil above 0//barrel. The current resiliency of the U.S. economy to high oil prices is the result of its transition to a service economy from a manufacturing economy, leading to a decline in our petroleum consumption per unit of GDP, which has continued to decline over the last several decades.
Though the report showed that it would take oil north of 0/barrel to derail the aggregate economy, the report did not address at what price oil prices might begin to affect consumer preferences for vehicles, which would likely occur at a point before the entire economy would be derailed by higher oil prices. The release of yesterday’s March vehicle sales report sparked renewed curiosity to this question. While reading the March sales report, two trends were clearly evident; domestic auto producers continue to lose ground to foreign automakers as are truck sales relative to car sales.
Declining Domestic Auto Sales
The March auto sales report showed foreign auto makers clearly gaining ground over their domestic competitors even in the face of a decelerating economy, which is to say their growth rates weren’t as negative. For example, leading the decline was General Motors with sales falling 19%, while Honda Motor Company’s sales were down only 3.2%, fairing the best.
One of the main reasons for the weakness in domestic automaker sales relative to their foreign counterparts is their vehicle offerings. Domestic automakers are known for their SUVs and trucks while foreign automakers tend to emphasize small to large-sized cars. As oil prices increase, consumers shift their preference for more fuel efficient vehicles which tends to favor foreign automakers. This trend in foreign auto sales relative to domestic makers in relation to oil prices is seen below, with a high correlation coefficient of 94%.
Figure 8
Image cannot be displayed
Source: Autodata Corporation / DOE
The fundamental trend in relative car sales of Toyota to Ford and oil prices is reflected technically in the company’s share prices. Toyota’s relative strength to Ford has risen significantly since 1999, which also coincided with the bottom in crude oil. Since that time the pair trade of being long Toyota and short Ford would have generated a return of roughly 900% versus crude’s roughly 916% advance, a fairly good proxy for oil.
Figure 9
Image cannot be displayed
Source: StockCharts.com
The relationship shown between Toyota and Ford is true in general for foreign relative sales and oil prices going back decades. As seen below, rising oil prices in the 1970s led to foreign automakers gaining ground and the same trend has been witnessed this decade. The trend in foreign sales outperforming domestic sells is true not only collectively, but also individually as foreign car and truck sales have outperformed domestic car and truck sales over the last ten years. One pause in this new trend was seen with foreign relative truck sales declining from 2003-2005 in the height of the housing boom as the booming construction industry led to a surge in domestic truck sales (Figure 11).
Figure 10
Image cannot be displayed
Source: BEA / DOE
Figure 11
Image cannot be displayed
Source: Autodata Corporation
Truck Sales Secular Bull Market Over?
As stated above, one of the main reasons why foreign automakers relative strength has been rising over the last decade is that they offer more fuel-efficient cars than trucks relative to domestic automakers. This trend in car sales gaining strength relative to truck sales is not confined to domestic automakers but also witnessed by foreign automakers. For example, Toyota truck sales were down 14% in March while car sales were down a lesser amount, down 7%. Honda Motor Co. saw a 12% decline in truck sales while car sales rose 3%. Nissan Motor Co. saw SUV sales plunge 20%, its Nissan Titan pickup sales down 45%, its Nissan Armada SUV down 43%, while its car sales were up 10%.
The recent strength in car sales relative to truck sales is likely to mark the end of the long-term sales outperformance of truck sales that began in the early 1980s when oil prices peaked. The secular decline in oil prices that began in 1980 recently bottomed in the beginning of the century, though truck sales still gained strength over car sales. The likely cause of this as mentioned above was the housing boom that led to a surge in truck purchases from the construction industry.
Figure 12
Image cannot be displayed
Source: BEA / DOE
The sensitivity of car sales to truck sales could still be seen during the secular relative sales bull market in trucks from 1980-2000 by looking at the YOY change in the ratio of car to truck sales with oil prices. Though the YOY percent change from 1980-2000 spent most of the time in negative territory, it did show movements that generally tracked the price of oil.
Figure 13
Image cannot be displayed
Source: BEA / DOE
As shown above, it appears as though both nonresidential real estate and consumer vehicle preferences are at tipping points. The implication for a deceleration in nonresidential real estate is that nonresidential real estate is likely to turn from an economic tailwind into an economic headwind and weigh on GDP in future quarters. The implication of a shift in consumer vehicle purchases from trucks to cars to compensate for higher gasoline prices means that domestic automakers are likely to continue to lose market share to their foreign competitors until fuel-efficient cars make up a great proportion of their vehicle offerings and total sales. The positive implication of this shift is that the incremental growth in gasoline demand should decelerate going forward as U.S. consumers replace less fuel-efficient cars and trucks with higher fuel-efficient cars.
What is important to note is that the market has done its job in terms of affecting the balance between supply and demand and shifting consumer preferences. After the oil crisis in the 1970s with OPEC wielding its supplier might, European governments imposed huge tax increases to raise the cost of driving to their consumers to force consumer demand to shift to more fuel-efficient vehicles. Adam Smith would be proud to see his invisible hand is achieving the same results without government interference in our country.
By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.
Adam Smith, The Wealth of Nations, 1776
Today’s Markets
The markets paired yesterday’s strong advances with a mild decline today as they digested Fed Chairman Bernanke’s comments before the Joint Economic Committee. Bernanke’s comment that real GDP may contract in the first half of the year coupled with the International Monetary Fund cutting its global GDP forecast from 4.1% down to 3.7% led to profit taking in the markets.
However, commodities staged a comeback today with weakness in the dollar. The dollar index fell 0.47% to 72.22, pushing gold over $900/oz to $903.30/oz (+2.31%), silver up 3.08% to $17.41/oz, and WTIC rose $3.81/barrel to $104.83/barrel.
The Dow Jones Industrial Average fell 45.44 points to close at 12608.92 (-0.36%), the S&P 500 lost 2.65 points to close at 1367.53 (-0.19%), and the NASDAQ shed 1.35 points to close at 2361.40 (-0.06%). Advancing issues represented 57% and 51% for the NYSE and NASDAQ respectively, reflecting a mostly mixed market.
