The Independent Market Observer

Economic Update

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jul 10, 2012 7:44:12 AM

and tagged Market Updates

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Just finished giving a talk on the economy at Commonwealth Live!, so thought that might be a good thing to share for general comment.

Let’s start with overall business conditions. They are terrible. The Fed has said things are terrible; it is keeping rates low and has said it will continue to do so. There is terrific regulatory, political, and tax uncertainty, with the fiscal cliff rushing toward us, the debt ceiling debacle looming, Europe seeming to melt down again every couple of weeks, and China now looking a lot weaker. Terrible.

Not only that, but the statistics are also terrible. We only added 80,000 jobs last month. Retail sales aren’t up much. The personal savings rate is increasing again. Housing starts and prices are only ticking up by a small amount. GDP is only increasing by less than 2 percent.

Wait a minute. You mean employment is increasing, spending is rising, and the economy is growing, even with all of the bad stuff?

That’s right. Let’s look at the past two years: we had a good first quarter two years ago, then got whacked; we had a good first quarter this year, then got whacked again. In spite of it all, the economy continues to grow and to heal. At some point, growth will resume at a faster rate. I am certainly not always an optimist, but I do recognize trends, and the trends right now are starting to point in the right direction.

The most important trend is in housing. Housing typically leads a recovery for several reasons. First is the wealth effect—as housing stabilizes and starts to grow, people feel wealthier and spend more. Second is the multiplier effect—as people buy houses, they have to buy other things as well. (Before I bought my first house, for example, I never thought of myself as a lawnmower owner.) Third is the employment generated by housing construction, which will be particularly important this cycle, as quite a bit of the long-term unemployed are from the housing construction industry.

To this point, housing has been a drag on the recovery rather than a contributor. That has started to change, and there is reason to believe it is sustainable. Housing starts have begun to increase. Sales and prices of existing homes are starting to increase in many markets. Supplies of homes for sale are actually below historical levels in some areas. Housing is close to being as affordable as it has ever been.

Housing bears will acknowledge all this but counter with the shadow inventory out there: homes that have been foreclosed but are not yet on the market, and homes that are now worth less than the mortgage, with owners who will presumably default soon. When that hits the market, the bears say, prices will resume their decline.

The shadow inventory issue is real, which is why I do not expect major systemic price growth in the near future. Because the foreclosure supply will continue to come on the market over time, though, I do not expect a sudden supply shock that will result in a renewed decrease in prices. The effect will be to slow the growth in housing prices, rather than to shock them to the downside.

I also question the logic of the presumed default of the underwater borrowers. First of all, let’s walk through the decision process. If I am underwater on my mortgage and decide to default, what do I do? Well, first of all, I have to find a place to live. Unless I plan to move back in with Mom and Dad, I will need to rent a place. Problem is, renting is now more expensive than owning in many markets. As a result, defaulting makes no sense on a current cash flow basis.

The other factor reducing the attractiveness of the strategic default is that leverage on housing prices works both ways. Owner’s equity got hit hard by price declines; price increases can have the opposite effect. Even if we are not there yet, it certainly seems probable in many markets.

The incentives for many strategic defaulters are therefore to stay, not to default, which will reduce the problem of the shadow housing market. That, combined with the slow disposition of existing foreclosures and the resumption of growth in household formation, which just ticked up as well, should help the housing market to recover faster than many expect. And all of this will, in turn, help the general economy.

There are other positive factors as well, which I will discuss over the next couple of days, but housing alone offers grounds for cautious optimism. We will also, of course, get to the grounds for pessimism.

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