Slumping U.S. housing market could herald a recession

Thursday, December 28th, 2006

Jay Bryan

There have been lots of headlines across North America recently about signs that the U.S. housing bubble is not just leaking air, but could be collapsing.

That’s worrisome, but there’s a second chapter that is far more important. Indeed, those who focus only on the woes of homebuilders are missing the most important part of this story.

The story begins with the latest shock to emerge from this battered industry: The fact that home-construction activity, far from showing signs of levelling off as some analysts expected, plunged by an unexpectedly steep 14.6 per cent in October. That leaves housing starts at the lowest level in more than six years.

Already, housing has gnawed away painfully at the pace of U.S. economic growth, cutting it by nearly half during the third quarter, to a feeble 1.6 per cent. There will be a similar impact in the fourth quarter, many forecasters believe.

So far, the picture is sombre, but since the U.S. economy needs a breather to subdue inflationary pressures, it’s not alarming.

The alarming part is what could come next.

Home construction itself represents only about six per cent of U.S. economic activity, but if its hard landing infects the rest of the economy, look out.

That’s why Clement Gignac, chief economist at National Bank Financial, says the latest plunge in housing starts “supports my concern that we are headed for tough times next year.”

First, while homebuilders are only a small chunk of the economy, their hiring over the past five years represented a hefty 20 per cent of job creation in the U.S. When this job machine goes into reverse, as it will in the coming months, unemployment can be expected to rise, Gignac believes.

Those who comfort themselves by noting that U.S. job creation remains healthy might be forgetting something: That job losses are more likely to follow economic turning points than to precede them.

The latest drop in housing starts, for example, won’t show up in construction employment for another few months, because that’s how long it will take to complete the homes that were started in previous months. By early next year, Gignac expects to see big construction layoffs and a rising unemployment rate.

The next domino to watch is U.S. housing prices. Unlike the still-healthy Canadian real-estate market, housing prices in the U.S. have already slammed into reverse during the past year.

So far, they’re only down about two per cent, which may not sound like much. But when you’ve grown accustomed to the previous year’s 13-per-cent gain, it’s a huge change.

Economists express this by pointing to what they call the “real” mortgage rate for a homebuyer. That’s the rate your payments are based on, maybe six or seven per cent, adjusted for the pace at which your home’s value is changing.

In Canada, healthy price gains mean that even after paying interest on a mortgage, a typical homeowner made a “profit” over the past year, notes Ted Carmichael, chief Canadian economist at J.P. Morgan Securities. In effect, the rising home value more than paid the mortgage interest.

In the U.S., with its rapid price gains, this happy situation was true for the past several years. But no more. Today, falling home values make the real mortgage rate even higher than the one you signed on for.

Gignac predicts that the house-price domino will fall if price declines in the U.S. worsen to as much as 10 per cent annually.

If this happened, it would signal a serious erosion of homeowners’ financial position, almost certainly bringing a sharp cutback in consumer spending. The likely outcome: A recession.

That’s not the unanimous view, by any means. At J.P. Morgan, the forecast is for a slowdown in growth, but no recession, partly because the housing collapse is expected to end after maybe six months.

Gignac’s prediction is that there are so many excess homes on the market after years of overbuilding and speculative buying that it will take about two years to wring out the excesses, meaning a long, significant economic slowdown even if there’s no recession.

We should know which view is closer to reality within the next few months, and one early hint will be how well Christmas sales have held up.

© The Vancouver Sun 2006


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