Date: 5/31/2022
Author: Mr. X
All of us know the way the economy collapsed last time. Overvaluation of real estate created an asset crisis when the bottom fell out. Dr. Kent Moors has warned that we might see something similar resulting from crypto. Some may say the collapse has already happened. Terra Luna, once considered one of the most lucrative cryptos, became practically worthless after its associated stablecoin disintegrated.
Yet even as we talk about crypto, we shouldn’t lose sight of the housing market. Here, we are starting to see some signs that the market is cooling.
The Dallas Fed warned all the way back in late March 2022:
“[T] there is growing concern that U.S. house prices are again becoming unhinged from fundamentals… [R]eal house prices can diverge from market fundamentals when there is widespread belief that today’s robust price increases will continue. If many buyers share this belief, purchases arising from a “fear of missing out” can drive up prices and heighten expectations of strong house-price gains.
This self-fulfilling mechanism leads to price growth that may become exponential (or explosive), resulting in the housing market becoming progressively misaligned from fundamentals until investors become cautious, policymakers intervene, the flow of money into housing dries up and a housing correction or even a bust occurs.
The Dallas Fed said that there is little possibility of the kind of financial crisis that practically crippled the global economy in 2007-2008. However, it noted that the ratio of house prices to disposable income was becoming unsustainable, if not yet “exuberant.”
It does look like the market is responding by lowering prices as Americans increasingly lack enough disposable income. The average interest rate for a fixed 30-year home loan hit 5.3% last week. That’s a 13-year high. Sales of newly built homes declined by more than 16% from March to April and more than 25% compared to April year-over-year.
According to Moody’s Analytics chief economist Mark Sandi, we are in a “housing correction.” “In terms of home sales, they’re falling sharply,” he said. “Housing demand is going down fast. Home price growth [will] go flat here pretty quickly; we will see [home] price declines in a significant number of markets.” We already seeing some proof of that decline, as almost 20% of home sellers lowered their prices in the four week period ending May 22.
However, housing prices may not be falling enough for most buyers. The median asking price for a home, according to Realtor.com, is $425,000, a significant increase over last year (and more than 32% from 2020). Prices are still historically high, even if we consider the recent price reductions. In late March 2022, NPR, the closest we have to state media, reported that the United States is still suffering from a housing shortage. It’s estimated that the country would need three million homes to meet demand.
Last month the growth of inflation hit the highest level in 40 years. With increasing interest rates, it’s also may be more expensive for many existing homeowners to pay their mortgages and rents.
The nightmare would be if we see a large increase in foreclosures. The bad news is that this has already begun. According to ATTOM, foreclosures in the first quarter of 2022 are up 39% from the previous quarter and up an astonishing 132% year-by-year.
Foreclosure activity is still low compared to the first quarter of 2020, before the COVID-19 pandemic. It’s barely noticeable compared to 2007-2008. We should keep this in perspective.
Yet there is still a major problem because the strength of the housing market is what some people are counting on to keep the United States out of recession.
Last month, Fannie Mae said that it expected a “modest recession in the latter half of 2023” because the Federal Reserve is tightening monetary policy. The goal of a “soft landing,” with low inflation (the Fed has announced a two percent target) without destroying economic growth, may be too much to ask for. “While a ‘soft landing’ for the economy is possible… historically such an outcome is an exception, not the norm,” said Fannie Mae. It continued:
With the most recent inflation readings at levels not seen since the early 1980s and wage growth exceeding that which is consistent with a 2-percent inflation objective, we believe the odds of a soft landing are even lower. Returning to the Fed’s policy target, therefore, likely necessitates economic growth slowing sufficiently to lead to a rise in the unemployment rate, which would cool wage and price pressures.
GDP unexpectedly declined by 1.5% in the first quarter, making recession projections seem even more plausible.
The main reason to be skeptical of the Fed’s ability to stick a “soft landing” is that the inflation isn’t just being driven by federal spending. The Russian invasion of Ukraine, and continuing problems with supply chains because of COVID-19 (and China’s unrealistic “zero-COVID” policy) means that the Fed does not really have control over what’s happening.
Energy prices are also going to be more expensive because the European Union has finally agreed to exclude most Russian crude imports. Prices of raw materials will continue to go up because of underlying factors, not just because of anything the Fed does or doesn’t do. There’s also no sign that the war in Ukraine will end soon. If anything, Russia seems to be winning now.
This isn’t a critique of Fed Chairman Jerome Powell. He’s admitted that the Fed doesn’t have control over everything that could cause rising prices. And even if people think that the Fed was too slow to confront inflation (as I do), one can’t fault their current policies. Just yesterday Federal Reserve Governor Christopher Waller committed the central bank to continuing rate hikes.
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The question is what happens if we get continuing inflation and a global slowdown regardless of what the Fed does or not. At this point, with inflation hitting Germany and the massive economic blow the Continent is going to deal itself on energy, many of the world’s leading economies are probably going to experience a recession. China’s production halts in Shanghai are also going to hit that country’s projected growth. It’s naïve to think that the United States alone will be able to avoid recession.
It’s also naïve to think this isn’t going to hit the housing market. The British and Canadian real estate markets are already shaky. America’s may follow. Inventory is already increasing and the time for houses to stay on the market is rising as well.
One could argue that this might be a good thing, as more Americans could afford homes. The problem is that the real estate market is propping up large sectors of the economy. The problem isn’t nearly as bad as it was in 2007-2008. However, we will probably see falling prices at the same time we see falling prices in the stock market.
Most Americans build wealth through the value of their homes, and, long term, through their 401(k) or other retirement plans. With housing, stocks, and the inflation hedge of crypto teetering, Americans may not face a sudden “financial crisis.” Instead, they risk being trapped in a web of declining financial instruments. The only bright spot is the jobs market, which remains strong. Unfortunately, wages are not keeping pace with inflation – and for those who are retired or on a set income, it doesn’t matter.
While we are not seeing a true real estate crash, many Americans are going to see their net worth drop. And while I don’t want to compare the magnitude of what’s happening to 2007-2008, one retrospective is worth keeping in mind. Amir Sufi and Atif Mian noted in 2014:
Despite seeing similar nominal dollar losses, the housing crash led to the Great Recession, while the dot-com crash led to a mild recession. Part of this difference can be seen in consumer spending. The housing crash killed retail spending, which collapsed 8 percent from 2007 to 2009, one of the largest two-year drops in recorded American history.2 The bursting of the tech bubble, on the other hand, had almost no effect at all; retail spending from 2000 to 2002 actually increased by 5 percent.
What explains these different outcomes? In our forthcoming book, “House of Debt,” we argue that it was the distribution of losses that made the housing crash so much more severe than the dot-com crash. The sharp decline in home prices starting in 2007 concentrated losses on people with the least capacity to bear them, disproportionately affecting poor homeowners who then stopped spending. What about the tech crash? In 2001, stocks were held almost exclusively by the rich. The tech crash concentrated losses on the rich, but the rich had almost no debt and didn’t need to cut back their spending.
There are some factors this time that may make a collapse in the housing market even worse. The surge of retail trading and cryptocurrency during the pandemic means that losses in these markets won’t just be concentrated on the rich. Instead, they will be combined with a fall in net worth as housing prices decline. Finally, we already saw consumer sentiment hit its lowest level in the early May. The consumer spending everyone is relying on can’t be taken for granted.
What’s keeping the economy going? There’s a strong jobs market and Americans are reported to have relatively strong levels of savings. Yet more than half of Americans have less than $5,000 in savings. The median is just $4,500 dollars. Investors need to be focusing hard on the jobs market, because if that starts to wobble, recession is practically inevitable.
The combination of the Fed increasing interest rates and the recession that will hit many developed economies will smash the housing market. The process has already begun. Worse, even as prices decline, most Americans may still be unable to buy a home, especially with higher interest rates for mortgages. It’s just going to be another part of a societal wealth drain. Those who suffer most will be those who heavily leveraged themselves during the pandemic-era stock market and real estate boom.
What investors need to understand is that they can’t stand still on a moving train. Investment strategies that can profit from the volatility, including shorts, are a necessity just to keep place with inflation… and the wealth drain that is coming fast. All investors must make a choice. Doing nothing is the wrong choice. We have to act – just to stay in place.
Mr. X is an investment analyst working in the Washington DC area who specializes in the intersection of business and public policy. After fifteen years working in politics, he writes on a classified basis for RogueInvesting.com to bring you news on what those with power are debating, planning, and doing.
