The US economy is signalling contradictions that have confounded many analysts, journalists, economists, academicians and casual observers alike.
Despite the US Federal Reserve’s aggressive interest rate hikes, economic growth has stayed relatively robust, defying widely held expectations for an imminent recession. Interest rates have risen from near zero to 5.25%-5.5% in less than one and a half years. Textbook economics tells us that higher interest rates (borrowing costs) will slow economic activities — by forcing consumers and businesses to cut back on spending. Oftentimes, this will also lead to higher unemployment. But the US unemployment rate has, thus far, remained near record lows. Indeed, workers appear to be gaining more bargaining power, considering the multiple union strikes for better wages this year.
Despite rising prices — highest inflation since the 1980s — consumers have kept spending. And corporate earnings and margins have come in better than expected, underpinning the rally in US stocks. Again, defying bearish expectations for the stock market. Although the S&P 500 is off its high for the year, it is still up 10.6% year to date.
The housing market, a sector that is highly sensitive to interest rate changes, is also demonstrating unexpected resilience. The sharp increase in mortgage rates is hurting homeownership affordability and demand. Yet, the S&P Case-Shiller US National Home Price Index has risen anew, hitting an all- time high in July after a brief six-month decline last year.
What is happening? Is this time really going to be different? Or are the effects of higher interest rates simply delayed, taking longer to transmit through the economy because of the anomalies of the Covid-19 pandemic and historically low interest rates since the global financial crisis (GFC)?
We have discussed the sustainability of the US stock market rally in our previous articles. In a nutshell, a recession may or may not happen. But the risk-reward proposition for stocks is unattractive as we think valuations are too high. The best risk-reward proposition right now is cash and short-term Treasuries, where nominal yields exceed 5% — offering positive real returns after inflation — for minimal to no risk. That has not happened in the past 16 years. Cash is king.
What of the housing market? Are current rising prices sustainable?
US home prices hit all-time record high despite rising mortgage rates
The US housing market has been unexpectedly resilient against the backdrop of rising interest rates. Following a brief six-month period of decline, the S&P Case-Shiller US National Home Price Index has rebounded swiftly since January and is at a fresh all-time high (see Chart 1). This contradicts conventional wisdom, which says rising interest rates would lead to a drop in home prices. This raises the question: What caused the rebound in home prices?
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Mortgage rates in the US have been rising in tandem with the federal funds rate. The average 30-year fixed-rate mortgage rate, for example, rose from 2.67% at the close of 2020 to a whopping 7.18% in September, the highest recorded since 2002 (see Chart 2). This surge in mortgage rates has significantly eroded home affordability.
According to the National Association of Realtors (NAR), monthly mortgage payments on median-priced existing single-family homes have doubled, from US$1,035 in 2020 to US$2,177 ($2,986) in July. This 110% surge in mortgage payments is due to the combination of a 37% increase in median home prices and, notably, a 53% increase in interest charges. Consequently, the qualifying income for a median-priced existing single-family home rose from US$49,680 in 2020 to US$104,496 in July (see Table 1).
Meanwhile, the median household income only increased by a modest 9% during the same period — effectively making homeownership less affordable for many potential buyers. Indeed, the Mortgage Bankers Purchase Index, which tracks the volume of mortgage loan applications, reflects this declining demand for housing. The index dropped by more than half, from 313.8 in December 2020 to 144.9 in August, which is the lowest level since 1995 (see Chart 3).
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If demand is clearly falling, what then is driving home prices higher?
The answer lies in the supply of homes
The US housing market is dominated by 30-year fixed-rate mortgages, which offer borrowers the certainty of paying the same interest rate for the entire duration of the loan. This contrasts with the Malaysia and Singapore housing markets, which are dominated by variable-rate mortgages, whereby the monthly mortgage payments change with interest rate fluctuations. This means homeowners are immediately hurt when interest rate rises, as is the case right now, which could lead to a severe financial strain on lower-income households. Perhaps Malaysia-Singapore could look towards offering more fixed rate mortgages, to reduce risks for homeowners.
Fixed-rate mortgages are generally not attractive to lenders, as they will have to bear the risks of fluctuating funding costs, which may exceed their fixed interest income (from the mortgage) during such a long tenure. However, long-term fixed rate mortgages are widely available in the US, thanks in large part to government-sponsored agencies such as Ginnie Mae, Fannie Mae and Freddie Mac. These agencies buy and securitise mortgages from banks, subsequently selling them as mortgage-backed securities to investors. This allows banks to pass on the risks of fixed rate mortgages to sophisticated portfolio managers who have the tools to manage them. Knowing there are ready buyers, banks are willing to offer fixed-rate mortgages.
US homebuyers have shown an increasing preference for fixed-rate mortgages since the GFC, given the steady decline in interest rates, and especially during the pandemic when rates fell to historic lows. As a result, fixed-rate mortgages have become very popular, accounting for more than 95% of all mortgages in the US. It was this widespread adoption of fixed-rate mortgages that contributed to the latest rally in home prices. How?
The majority of existing homes were transacted prior to 2021 when interest rates were low and falling. Many homeowners also refinanced their mortgages during the pandemic to take advantage of the historic low interest rates. Since the mortgage rates are fixed, these homeowners are unaffected by the current rate hikes and continue to pay low monthly mortgage payments. However, these low-rate mortgages are not transferable. That means, if they sell their current homes and buy new ones, they will also have to give up the low-interest mortgages. The new mortgage will be priced at prevailing (and much higher) rates.
Obviously, this creates a huge disincentive for homeowners to sell their homes. As a result, the supply of available homes for sale has been shrinking, as evidenced by the decline in active house listings, which have fallen by nearly half compared to the pre-pandemic levels (see Chart 4). And it is this sharp contraction in the housing supply that has fuelled the rally in home prices. But can it last?
Is the rally in home prices sustainable?
The supply of existing homes should remain low in the near term. The 4% difference in interest rates between new and existing mortgages will continue to deter people from switching homes, unless it is necessary. However, the supply of new homes is increasing and should, in time, ease the market tightness. There is a large number of new homes currently undergoing construction, higher than that in 2019 by 46%, on average (see Chart 5).
Notably, although construction costs have been rising too, homebuilders have not only managed to pass on the higher costs, but also taken advantage of the supply tightness to raise selling prices beyond their cost increases. Case in point, gross margins and return on assets for the sector are higher now compared to pre-pandemic (see Chart 6). This is yet another example of the “greedflation” we wrote about recently, where corporate greed for higher profits caused inflation to be higher than it otherwise would be. (See our article titled “‘Greedflation’, stock prices and the policy implications”, published in The Edge on Sept 25, 2023).
Homebuilders are launching new projects, driven by their higher profitability. As mentioned above, the number of housing starts and permits has been increasing since the beginning of the year, signalling higher incoming supply of new homes down the road.
At the same time, demand is softening. As we have shown above, higher mortgage rates and home prices have made homeownership less affordable — and less attractive for potential buyers. Plus, as concerns for the economy grows, financial institutions too are tightening lending standards, contributing to the decline in mortgage approvals.
Even for those who can afford to buy a home, it may be more rational to rent instead of buy, as rentals have not increased by as much as home prices. (We suspect this is also due to the fixed-rate mortgages — since the mortgage costs to landlords have not increased, there is no “need” to raise rentals). This is evidenced by the home price-to-rent ratio, which is near all-time highs (see Chart 7). Coupled with the increased mortgage rate, the difference between rental and monthly mortgage payment has widened significantly, making it much cheaper to rent, for now.
The divergence between rental and home prices also suggests that the high property prices do not reflect the “real” underlying supply and demand for shelter.
The housing market is illiquid, where only a small fraction of existing homes is transacted annually. Our back-of-the-envelope calculations show the annual value of homes transacted account for less than 6% of the total value of homes.
Due to its illiquid nature, the housing market is also inefficient in the short term.
Furthermore, the housing market is an upward-biased market, where every party in the value chain — that is, the developers, property agents, bankers and homeowners — have vested interests in driving up prices. It is also possible that these market participants have overestimated the severity of the supply crunch, further spurring the current price rally.
In conclusion, although supply of existing homes will remain low, given the falling demand and rising supply of new homes, house prices will begin to fall — especially since gross margin for developers is at an all-time high. The price correction, however, will be limited due to elevated labour costs and shortage of labour. Additionally, more granular data indicates nuances in the housing market, which also suggest that a “rolling correction” is already happening under the hood.
The S&P Case-Shiller US National Home Price Index is a composite of home prices nationally. While useful, this “averaging” methodology can mask regional differences. For instance, when we drill down to the 20 metropolitan regions, as reported in the S&P Case-Shiller Metro Area data, the home price changes diverge. In the latest July 2023 figures, eight of the 20 cities tracked have actually seen home prices decline year on year even as the nationwide benchmark index hits fresh all-time highs (see Table 2).
There is also evidence that while demand for houses around the median price — typically entry-level homes for first-time buyers — has been relatively resilient, rising interest rates and falling affordability has affected higher-priced “move-up” homes, where transacted prices have seen larger declines. Underscoring softening demand in this market segment, developers are providing incentives, including mortgage buydowns through in-house lenders (effectively prepaying some interest for buyers to reduce the mortgage rate) to drive sales. This rolling correction will help mute the broader housing market correction, barring a significantly more severe recession.
On housing starts, or new builds, they should remain fairly robust in the near term due to the high level of developer profitability. The renovation market will also be resilient with a high level of net equity for homes plus a fairly healthy household balance sheet.
The Malaysian Portfolio fell 0.2% last week, slightly beating the benchmark FBM KLCI, which fell 0.3%, thanks to our high cash holdings. Shares for Insas fell 1.1% for the week. Total portfolio returns now stand at 157.9% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 21.2%, by a long, long way.
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