Stocks rose slightly yesterday, following through from Monday’s sharp rally. Monday’s gains in the stock market essentially erased the losses last week that followed the FOMC meeting. Long-term interest rates also returned to pre-FOMC meeting levels. The biggest change over the past week has been a slight flattening of the yield curve, and a subtle shift in leadership from cyclicals back to the large-cap growth names.
As investors step back and digest what they learned last week, it seems, despite the fanfare, that not much has changed from an economic point of view. The Fed acknowledged what we already knew. The economy has been recovering a bit faster than previously expected, and inflation was running a bit hotter. While some commodities, notably lumber and copper, have receded from recent highs, others, like oil, remain strong for now. Today’s shortages and supply chain disruptions will eventually be fixed. As a result, inflation, currently running well over 3%, is likely to fall back a bit as commodity prices fall back, although not necessarily to pre-pandemic levels.
There are many demand surges in our economy as we escape from our collective cocoons, with the benefit of vaccines and low summertime infection rates. While we see news of Covid-19 surges in some parts of the world, infection rates and death counts are back to levels not seen since March of last year. Demand for everything from cars, airline trips, vacation bookings and apparel are taking off.
But nowhere has the surge been more apparent than in the housing market. Homes are sold within a week of listing. Owners receive multiple bids, often above asking price and often without any conditions. Just a year ago who would have thought that a home would be sold without inspection or mortgage contingencies?
The mismatch in supply and demand will dissipate in the housing market over time, just as it does everywhere else. But the mismatch has taken over a decade to build and it will take years to change this market from one favoring sellers to one favoring buyers. There are twin culprits: the mortgage crisis of 2007-2009, and demographics.
Baby boomers born after the Second World War never experienced an extended period when housing prices fell. They learned that home ownership was about the best investment they could make. President George W. Bush wanted to see every American own a home. That wish and overly easy Fed monetary policy fed the boom that collapsed during the mortgage crisis of 2007 and beyond. For a generation, America averaged about 1.5-1.6 million housing starts per year, enough to meet the demand for new homes and the demolition of old housing stock no longer suitable for habitation.
But then came the bust. Several things suddenly happened. The recession and home foreclosures led to families forced to move in together. Housing formations fell. Weak prices wiped out equity for many homeowners. While some persisted in paying mortgages to stay in place, many couldn’t move and recover any equity stake. The inventory of good homes for sale collapsed.
But perhaps the biggest factor was the collapse in home prices. To new prospective home buyers, that meant that the economic value of home ownership was no longer a certainty. In fact, from the start of the Great Recession until almost 2015, it was questionable whether homes were a good economic value at all.
For the most part, home ownership has been a lifestyle choice. Americans for decades, maybe centuries, have been seeking more space, a backyard, and proximity to good schools. Owning a home that appreciated was a big plus and an added incentive to buy. But lifestyle choices trumped all.
That brings me to the demographic part of the answer. After the Great Recession, the millennial generation simply had great difficulty finding good jobs. As a result, they doubled up, lived with parents, and rented, lacking capital for a down payment. They also married later, in part related to lifestyle, but also driven by economics. As the Great Recession became a faded memory, this new generation found its footing. They found good jobs, started to accumulate an asset base, got married and had kids. They also learned to love a new lifestyle of hanging out in restaurants and bars, and enjoying a city life close to friends.
But then came the pandemic. Living together was now a liability. Favored restaurants and bars were closed. It was time to rethink. Babies were now kids walking around. They craved more space. The ability to defer rents and relief checks from the government helped, so did the ability to work from home. Housing demand had started to pick up, notably in 2018-2020, but once again thanks to the pandemic, change accelerated. Demand for houses shot up at a time when the inventory of homes for sale was near all-time lows. In this regard, housing isn’t much different than toilet paper or washing machines. Demand/supply imbalances created the lines at Open Houses that we witness today.
That won’t continue for very long. High prices will entice some current owners to sell. They will also preclude others from buying. But the true shortage will take years to correct. As noted earlier, since World War II, new housing starts averaged about 1.5 million per year. They surged briefly in the years just prior to the mortgage bust. But in the aftermath of the collapse, starts only averaged about 600,000 per year in 2008-2012. They never reached 1.5 million again until late 2019. Thus, when the buyers started to arrive, there was precious little inventory of new, or relatively new, homes for sale. Estimates of the supply/demand mismatch vary from as little as 1.5 million to as high as 5.5 million.
A year ago, when everyone was craving a mask, a cottage industry sprang up to make masks. There is no cottage industry to make houses. To build a home requires a lot of capital. It requires finished lots to build on. In some states, like New Jersey, it could take almost a decade to convert a plot of 100 acres into a new home community.
Higher prices will help to restore balance. They will tempt owners to sell, trade down or rent, and pocket the difference. But the gap is likely to be closed by builders and it will take time.
A home is built on a lot. Thus there are two components, the land and the structure. The structure depreciates. It wears out over time. The appreciation is all in the land. Go to a shore community. The home on the beach is worth several times what a similar home two blocks away will sell for. It’s all about land and location. Home builders have 3-6 years of land either owned or under option. Remembering that it takes years to convert raw land into developable home sites, that’s part of doing business. Yesterday a report showed that average home prices are up 24% from last year. Even if the pace of increasing prices slows in the months ahead, homebuilders will benefit from the massive buildup in the value of the land they control.
Economically, all this matters to our nation’s overall growth. The average price of a home today is now over $350,000. If housing starts average in 2021-2025 about 1.6 million, or about what they are today, that would add about $350 billion to GDP compared to a decade ago. Our nation’s total GDP is $21.5 trillion. Thus, the $350 billion addition equates to about 1.6% of GDP. And that doesn’t include other home-related expenses like furnishings. Even if compared to more recent years, a sustained home construction market of 1.6 million starts per year would elevate GDP by 0.5-1.0%. That’s not insignificant.
New home buyers are pursuing life style change. But now they are further incentivized by rising prices. For the first time in over 15 years, it looks like a home is a good investment. Longer term history suggests that home values rise at or slightly below the rate of inflation. Land keeps pace, but structures depreciate. But it is likely that price strength will continue until the supply/demand mismatch closes further. If the current frenzy continues, there could be some overshoot in some very hot markets. But demographic trends are likely to keep demand strong for many years.
We are living in an economy that is at peak growth and peak inflation. That is also true for housing in general. Young families seek new communities and fresh new homes. Builders probably have the wind at their backs for several more years. The whole economy will benefit.
Today, Frances McDormand turns 64. Justice Clarence Thomas is 73.