The Bubble In The US Housing Sector
Investors have every right to share Federal Reserve Chairman Alan Greenspan’s concerns regarding the bubble conditions in the US residential property market. True, property isn’t bubbling everywhere, but in certain key coastal locations on both eastern and western seaboards property prices have risen to such an extent that Mr Greenspan has felt moved to make another “irrational exuberance” type speech regarding the threat of a crash were prices to continue their inexorable upward march. Mr Greenspan is right.
The US Fed Chairman was speaking at Jackson Hole in Wyoming, a location that has probably played a full part in the seemingly endless thirst on the part of the US citizen for residential property at almost any price. Mr Greenspan warned that investing in houses was not a one-way bet and that “history had not dealt kindly” with those who kept ignoring the risks.
The Fed has now raised its Fed funds rate eleven times over the current monetary tightening cycle, from 1.0% to the current 3.75%. In real terms US rates are closing in on levels perceived as being “neutral” in terms of their effect on the overall economy. Inevitably, the ultra-low interest rates of the past few years spawned a deluge of cheap property-related loans for consumers. Now that base rates have risen, it is only the Fed’s continued management of medium and long-term inflation expectations that is keeping those all-important long bond yields (on which many mortgage offers are based) down.
Significantly, Mr Greenspan has drawn an important linkage in his analysis of the situation. He states not only that the ongoing process of monetary tightening could throw the escalating housing market into reverse, but that the presence of the still gigantic current account and fiscal deficits could restrict the Open Market Committee’s room for manoeuvre, were a housing market downturn to hit spending.
Significant Linkage
Understanding the logic behind these linkages is critical to understanding how the US economy is evolving and the consequent implications for financial markets. Perhaps the key question facing US and global economists right now is what impact US household’s historically low savings rates and historically high debt levels will have on growth. Short rates have moved smartly higher over the past couple of years and are no longer in negative territory in real terms. While they were in negative territory it was interesting to note that economic activity, although robust, was not as strong as that which one might normally expect in such conditions.
The decline in the savings rate since the mid-1990’s and the rise in debt levels since the mid-1950’s (and the past twenty five years in particular), have added to growth and the palpable feeling of prosperity. While many US homeowners may view the future simply as an extension of the past, the starting point today is very different. As the savings rate rises, growth will be slower, as it would be were debt levels to tail off. It is always possible that consumers might be prepared to save even less and take on even more debt, but eventually a point must be reached when that can no longer happen. At that point the consequence will be weak growth, no matter how easy monetary policy is.
Aware of the fact that this drop in demand could be triggered by an unwillingness on the part of overseas investors to continue propping up the US current account deficit, the Federal Reserve has doggedly pursued its monetary tightening agenda, using the argument that a counterweight is required to offset the positive (and near-term) economic impact of $62.5bn fiscal stimulation in the wake of Hurricane Katrina (and perhaps Rita) somewhat remarkably approved by Congress without demur.
Were overseas investors and central banks to prove unwilling to finance a deficit approximating 6% of overall GDP then clearly households, the corporate sector and government would have to reduce spending. Alternatively, a reversal in the US real estate market could shut down borrowing (because of the high level of consumers’ exposure to house prices). The exact timing is, of course, unknown but what we do know is that whilst US household wealth increased through the 1990s, consumers felt better off and saved less. As the tech bubble burst, so did that feeling of prosperity. Wealth declined with the stock market, but massive monetary stimulation on the part of the Fed kept savings rates from rising.
Closer Analysis of Household Debt
For a more accurate gauge of the exposure (and vulnerability) of the US homeowner it is necessary to break household liabilities down between mortgage liabilities and other liabilities. Over the fifty year period from 1955 overall household liabilities have risen as a percentage of disposable income from 37% to 115%. Mortgage liabilities have risen from 21% of disposable income to 82% while other liabilities have risen fro16% to 33%. Debt accumulation remains very strong, in large part because of the ongoing surge in house prices but also due to homeowners’ increasing willingness to leverage through housing.
Breaking the analysis down between real estate assets and wealth as a percentage of personal disposable income reveals that assets have expanded by around a third over the past four years, taking them in excess of 220% of disposable income. Yet despite this surge in house prices, real estate wealth is up by less than half that amount over the same period and is still well below the peaks of the 1980s. The difference between the two is, of course, mortgage debt.
Clearly, therefore, if house prices were to fall sharply, the experience for homeowners would be more traumatic than a similar fall in equity prices. Mr Greenspan is right to be concerned. The US residential property market has become extremely stretched. This is manageable while overseas investors continue to plough funds into the US. Equally, there is nothing magical in the current savings rate that precludes a further drop, however, the fact that it took massive amounts of stimulation to bring the economy back from the brink even during periods of negative real short-term interest rates suggests that, in an even more highly indebted situation such as that prevailing today, the extent of the dislocation when the roof does eventually cave in could be both severe and protracted.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley Equity Researc
