US Property Market - Sept'05 Outlook

The peak in US equity markets peaked long ago, but since the property market is booming, and about 30% bigger than equity markets, and much more alligned to the consumer perception of wealth creation (ie. wealth effect), its inexstricably tied to consumer spending. I have always said that the US economic boom will collapse when US property prices peak. That point is not far away for the following reasons:

1. Sales of existing houses in the US dropped by 2.6% in Jul05
2. The Fed Reserve is increasing short interest rates, though they are not yet flowing through to long rates for reasons mentioned in another essay. It will ultimately be inflation that drives interest rates higher.
3. Oil prices are continuing to defy economists arguing that oil prices fill fall back soon. They said they would fall back to $28/bbl about a year ago, now they are saying $50/bbl. Its all double-speak....`watch the cards, not my hands`. Oil prices were never supposed to go above $50/bbl and now they are $68/bbl and heading for $US75/bbl. This is having a big impact on US and global consumer spending.

Mind you housing prices in the US have not ceased to rise, but one does get the impression that its not far anyway. Some economists argue this will be a soft landing because of the strong economy and full unemployment, but they are the conditions that precede a fall. ie. Pride before the fall so to speak.

Recently I have been considering the prospects for a housing-led recovery in Japan....but this seems less likely as the US slows because the Japanese economy is still in low gear. There was always the promise of high property yields and record low interest rates stimulating the housing market and consumption, but incomes are not rising significantly, and its mostly tied to export growth (US & China). They are also being hit by high oil prices. Economic reform was always a possibility, but for the short term, it has died with the LDP party`s internal opposition to Postal Savings privatisation. This is perhaps the least contraversial reform that the government could make, so being stalled on this issue pushes back any likelihood of productivity-based stimulus to the Japanese economy, but it will come eventually. There are encouraging signs of a pro-reform agenda developing which will see significant structural reform over the next 5 years - and this will feed into the next economic boom. During this period Japan, China, India and the rest of Asia will be leading consumption - with or without the EC. The US will be replacing its bandages - recovering from its indebtedness, but after 5years, higher savings levels will mean its better positioned to recover. The early part of the cycle will be slow....until the US and EC join. The EC is also running a reform agenda but because it encompasses many governments - it will be slower, but the Eastern EU bloc should perform well.

US Property Market
Due to fierce competition, banks are under tremendous pressure to lower their mortgage lending standards. If they don’t, they will quickly lose market share in the mortgage business and that means lower earnings and falling stock prices (for the banks), which they don’t want. The banks don’t mind easing the lending requirements for new mortgages because after writing up a new mortgage they turn around and sell it to an investment bank that packages similar mortgages into securities (called mortgage backed assets) that are then sold to pension funds, hedge funds and other investors. As interest rates on government and corporate bonds declined the demand for mortgage backed assets has increased, thereby supplying more capital to fuel the real estate boom. But during all this the systemic risk has increased dramatically.

Its questionable how long this can last since there are other compelling reasons for property markets to fall. And there is little scope for US government stimulus after recent tax cuts, rising interest rates on debt (40% owed offshore - causing alot of money to leave the country), declining tax receipts (due to softer economy), not to mention a deficit-burdened public and private sector. Consumption will need to be cut GREATLY in favour of savings and eventually tax increases.

Latests Statistics
The US property bubble appears to have come to an end – or is it just a pause in the face of poor economic data and natural disasters. Home construction fell for the 2nd consecutive month and new building permits declined in Aug’05. The National Association of Home Builders’ New Home Sales Index for single family homes fell in Sept’05 reflecting a decline in sentiment among US home builders. Of more concern, the 30-year fixed mortgage rate rose again and the supply of new houses for sale increased suggesting an overhang in the market. The median price for a new home fell in July’05. Does this all suggest that the US market has topped?
Change in sentiment is a big concern because rising home prices have driven corporate earnings as well. Bonds and equity values are highly priced at the moment. Its not an easy call to pick the top of the market – but rest assured its going to correlate with home prices or contraction in money supply. In as much as money supply requires the liquidation of credit, this indicator requires a rise in bankruptcies, so is likely to be a lagging indicator.
According to the Fed, interest rates need to be raised to a point where economic growth is neither promoted nor hindered. US consumption is financed by credit – but the money supply only grows because:

1. Chinese & Japanese creditors are rewarded with higher import penetration into the US market.
2. Chinese & Japanese creditors receive a high yield on their bonds, ie. They feel they are receiving an adequate risk premium.
3. US households believe property is a good investment because sentiment is positive, incomes are rising, employment levels are stable, interest rates are low.

Certainly households are likely to stop buying property if prices start falling…..but will Asian central banks stop financing US consumption? It might be expected that central banks will buy more gold and diversify away from new US treasury issues causing global interest rates to rise. Higher interest rates will cause US consumption to slump, reducing the need for foreign financing as well. Asset values will fall – gold will remain strong as a safe haven against bursting asset values and a lower $US. A falling $US will eventually be inflationary since imports become more expensive, but eventually losses will be absorbed by Chinese exporters and US distributors (corporations), since they will lack pricing power.