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Marcuard's Market update by GaveKal Dragonomics
By Tan Kai Xian
US home prices are on the up, having climbed 6% over the 12 months to February. Yet housebuilding has failed to keep pace with the rise in prices. Although construction has made a positive contribution to GDP growth over the last couple of quarters, activity has built from a very low base.
Housing starts in March were an annualised 1.215 mln, with a consensus forecast for April of 1.25 mln. Both figures are well below the long term pre-crisis US average of around 1.55 mln, and below Gavekal’s projected household formation rate of 1.4 mln. Yet even though vacancy rates are low and the current inventory of new houses for sale is only enough to cover five months of current sales, there is little prospect of a pick-up in construction in the mid-term. The headwinds are too strong.
The biggest factor constraining new housing supply is the difficulty builders face in obtaining construction loans. Historically, US residential construction investment has closely tracked the standards for commercial real estate lending (which includes loans to homebuilders). According to the Federal Reserve’s senior loan officer survey for the second quarter, which was released last week, the net percentage of banks tightening their standards on construction and land development loans (which include loans for one to four-family units) rose to 32.4%. The net percentage tightening standards on commercial real estate loans secured by multi-family properties rose to 36.1%.
With access to credit tight, many homebuilders find themselves unable to fund new projects. Despite the buoyant state of current housing demand, the Fed’s survey illustrates that the majority of US banks are concerned about the outlook for the US housing market. As a result, commercial real estate loan growth is likely to remain low, which implies continued weakness in housing construction.
The bankers may have a point. Yes, demand is solid at the moment, the US jobs market is strong, and the tightness of the labour market promises to push wage growth gradually higher. However, the demand for new houses is still likely to face mounting headwinds going forward. Since the beginning of November last year 10-year US treasury yields have risen by some 60bp. This increase has pushed up US mortgage rates from roughly 3.5% before November’s election to 4% now. And as mortgage rates have risen, housing affordability has fallen below its long run neutral level (see chart).
With construction activity sensitive to housing affordability, and affordability highly sensitive to interest rates, the trajectory of long term interest rates will have a major impact on building activity in the coming quarters. Following their immediate post-election upward move, US treasury yields have tracked sideways this year as investors have revised down their expectations of the ability of Donald Trump’s administration to push through major fiscal and regulatory reforms.
Nevertheless, even without stimulative reforms, the outlook for US growth remains reasonable, if not spectacular, with moderate inflation pressure. With the Fed slowly tightening monetary policy, and the cyclical upswing in Europe gaining momentum, US treasury yields are likely to rise gradually from here. That means US mortgage rates are set to head higher, and affordability lower.
In real terms, US residential fixed investment growth has fallen from 13.1% YoY in 4Q15 to 2.4% in 1Q this year. With tighter lending standards suppressing the supply of new housing, and diminished affordability likely to weigh on demand going forward, US housing construction is set to remain weak in the mid-term. The longer term structural outlook for the US housing sector is still positive. But for now, the cyclical headwinds will prevail.
