US falling house prices – impact on global economy

— Citigroup explains why this time should be less painful than the last

 

By Fiona Mullen, Sapienta Economics Ltd

 

The outlook for the US housing market is not good. According to the Office of Federal Housing Enterprise Oversight (OFHEO), annualised quarterly house price inflation growth in the US decelerated from a peak of 17.57% in the third quarter of 2003 to 4.11% in the third quarter and 4.47% in the fourth quarter of 2006.

Some regions are already experiencing a decline in prices and private forecasters are expecting an overall fall for US house prices in 2007.

In April, David Lereah, chief economist for the National Association of Realtors, was forecasting only a small average fall in single-family existing home prices of 0.7% in 2007 but, depending on how it is measured, others are forecasting more.

Moreover, some of Lereah’s indicators were much more dramatic: he expects existing home sales to fall by 2.2%, new home sales to fall by 14.1%, housing starts to fall by 18.4% and spending on residential construction to fall by 13.6%.

The prevailing theory for the past few years has been that as soon as the booming US housing market bursts, the rest of the world will feel the pain. US consumers will curtail spending as they can no longer use the rise in the value of their house as collateral; US retailers will reduce imports because there is no market; and the rest of the world will have no market for its exports.

Memories of the last downturn in the US housing market in the late 1980s also underscore the pessimism.

However, in an interview with the Financial Mirror last week, Jürgen Michels, Director, Economic and Market Analysis at Citigroup, explained why the global impact of this weakening of the housing market might not be as bad as the last one.

 

— Economic conditions are more benign

 

One of the key reasons is that the impact on US growth is unlikely to be as severe because of underlying economics conditions today compared with those of the late 1980s.

 “We think that they [house prices] will be down by around 3% using the OFHEO index by the start of 2008. That fall in house prices will actually be similar to the previous house price corrections in the US that we have seen in the late 1980s,” said Michels.

“In contrast to the previous period, this time prices went up more, but the overall economic conditions are more benign than they were in that period.”

These conditions include the labour market and overall financial conditions. In the previous period both unemployment and interest rates were already high, meaning that the impact of falling prices was harsher.

“There are risks of course … but if you look at the balance sheets of the non-financial sector these look really robust at the end of an interest-rate tightening cycle.” 

Michels added that bank capitalisation is also sound, “so there is little risk from that side.”

 

— But growth will still be weaker

 

Growth in the US will still be weaker than in the previous, however. 

“Growth is going to stay weak for a while because there is a negative wealth effect from falling house prices, which affects consumption, but that will stabilise,” he said.

Citigroup is forecasting real GDP growth to slow from 3.3% in 2006 to 2.4% in 2007, before picking up again to 3% in 2008.

“Our view on the US is therefore not as bad as many of our competitors expect.”

 

— “Decoupling” and emerging China

 

Another reason for less pessimism, which the Financial Mirror touched on last week, is that the rest of the world is not quite as dependent on the US for growth as it was 20 or even ten years ago.

Demand in China and India is booming, while high oil prices have created strong demand in some of the major oil-exporting countries in the Middle East and Russia.

“Having this slowdown in the US creates quite a tough environment for the euro area and Europe. But we have seen in recent years that, on the export side, Europe is not as dependent on US developments as it used to be,” said Michels.

“We have some sort of decoupling.”

To answer the question ‘who is driving the world economy’ Michels said that we have more support from developing countries than from the US.

“The fast growing developing countries really are the drivers of the world economy and with its right product mix Europe is very well positioned to deliver a huge amount of capital goods to the markets such as the Far East,” he said.

Thus, while Citigroup expects a sharp slowdown in US growth in 2007, the slowdown in the euro area will be rather milder, from 2.8% in 2006 to 2.4% in 2007 and 2.3% in 2008.

 

— Europe’s housing market more mixed

 

The impact of a weaker US housing market on the euro area housing market and other factors such as rising interest rates is a bit mixed, given the varying performance in different countries.

In countries like Spain, Italy and France the increases in ECB rates have had an impact on domestic demand, leading to a slowdown in housing activity and probably also consumption.

Housing starts have fallen rapidly in Spain and France and the Spanish market has been particularly hit because of the high proportion of borrowers on floating-rate mortgages.

However, interest rates rises have not affected affect Germany so much.

“Germany did not have this huge boom in housing that was credit-financed,” noted Michels. House prices in fact fell and may stabilise this year for the first time in many years.

The good news for borrowers is that Michels believes that interest rates in the euro area have reached their peak.

Noting a stronger currency and absence of wage pressure, Michels said that he expected one more rate rise in June but that “4% will probably be the peak”.