The Transition is Smooth--The Problems Remain Comstock Partners, Inc. Thursday, February 16, 2006
Bernanke’s first testimony before Congress as the new Fed Chairman indicates that the superficial elements of the transition will be smooth, but that the underlying economic and financial problems remain. To be sure, the economy is on track to grow about 5% in the first quarter after expanding by only 1% in the fourth. This, however, is more a function of the dislocations caused by hurricane Katrina in late August and the natural rebound from that calamity, followed by the seasonal abnormalities caused by the warmest January in 100 years. The major problems facing the economy are the heavy dependence on the currently weakening housing sector as the main driver for growth and the related ongoing bout of tightening monetary policy that is not yet finished, as hinted at by Bernanke. As we have illustrated on numerous occasions, the growth of employment, wages and salaries have been far weaker in the current expansion than in any other post-war period. In order to maintain their standard of living, consumers have been spending in excess of their income by converting their rising home prices to cash by means of outright home sales, home equity loans or cash-out refinancing. This practice has come to be known by the overall term, mortgage equity withdrawals (MEW).
A recent Federal Reserve staff study—significantly one of only two ever co-authored by Greenspan—estimated that “discretionary extraction of home equity accounts for about four-fifths of the rise in home equity mortgage debt.” They further estimated that about one-quarter to one-third of MEW directly financed consumer expenditures. Other estimates run as high as 50 or 60%. The Greenspan study went on to say that if mortgage rates rise and loan affordability drops further, MEW would decline and the subsequent fall in consumer spending would lead to a drop in consumer goods imports as well as the intermediate goods associated with them. He estimated that MEW was about $600 billion in 2004, an amount equal to 7% of GDP, and that the accumulative MEW accounted for the entire decline in the household savings rate since 1995. In addition to the direct contribution of MEW to consumer spending, an additional study by Northern Trust estimated that a large portion of even the sub-par rise in employment over the last few years was a result of the boom in housing. This includes employment in industries such as home building, supplies, real estate and mortgage financing services. The problem is that the housing market has already shown definite signs of weakening.
The Naional Association of Home Builders (NAHB) housing market index has dropped to 57 from a June peak of 72. This index is a combination of customer traffic at new home sites, current single family home sales, and expectations of single family home sales over the next six months. Purchase applications have declined 14% over the last five weeks. The housing affordability index has dropped sharply to its lowest level since 1991. The supply of new homes amounts to almost five months of sales, the most since 1997. This week KB Homes reported an increase in the number of cancelled home orders and a drop in new home sales in the first two months of the year. This comes upon the heels of Toll Brothers’ warning that home orders had dropped by 21% so far ion the first quarter. The robust number of January housing starts announced today is probably a result of the unseasonable warm weather. If not, it only adds to an already serious problem of burgeoning inventories since these are starts, not necessarily sales.
Adding to the housing problem is the ongoing series of interest rate hikes by the Fed and the flattened yield curve. Judging from Bernanke’s testimony, other Fed speeches and the last FOMC statement, it appears that another rate rise is highly likely in March with subsequent decisions dependent on the incoming data. As we have pointed out in previous comments, all past periods of flat to negative yield curves and rising interest rates have led to at least economic weakness and, in most cases, recession. Since Fed rate hikes generally lead the economy by anywhere from 6 to 18 months the Fed seldom knows when to stop. Most often the Fed continues to raise rates until something negative occurs, and by that time the last few rate increases continue to kick in for some time to come. In our view the combination of a softening housing market and tight monetary policy will most likely result in a weakening economy and highly disappointing earnings, bringing an end to the cyclical bull market that started in October 2002. The prospect of 5% growth in the first quarter is already built into the market and does not change this view. The GDP grew at an annualized rate of 6.4% in the first quarter of 2000, but declined in the second and did not reach 3% again for three years. The stock market, too, peaked in the same quarter as GDP, and remains well under that peak today.
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