How the US housing slump will affect us all

published 16 October 2007

I have been arguing for nearly two years now that equities across the world are cheap. I still believe that to be the case in the medium to long term. In the short term, however, there is something of a dark storm cloud marring the previously perfect azure horizon, something that makes me believe that now is not the best time to put new money into the market. The cause of this cloud? The fact that markets' expectations that US companies will see double-digit profit growth 10.4% for next year are wrong.

What is behind US stock market highs?

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So it's bad news that the supply of unsold houses is now equivalent to nearly seven months' worth of normal sales. There is usually only three to four months' worth of inventory; even at the peak of the last recession, there was only nine months' supply. Another indicator is the National Association of Home Builders' index. This measures present sales, buyer traffic and expected future sales, and it has shown itself (particularly in 1990 and 1995) to be a good lead indicator for real year-on-year US GDP growth. This index has also fallen off a cliff since the start of the year. If history is any guide, it suggests a slowdown in the US economy really is on the way.

But the housing market isn't the only source of worrying numbers. US spending on consumer durables (big ticket' items, such as furniture and cars) has just gone negative, adjusted for inflation. This series is closely related to wider consumption and implies that real GDP growth might well be heading below 2%. And it's not just consumer spending: the recent Philadelphia Fed report on manufacturing and figures on disposable income growth, to say nothing of most consumer confidence surveys, have all been weakening. Two crucial factors stand out. First, growth rates in all these areas are lower than those we have seen over the last 12 quarters (which have all been in the 3.2% to 4.5% growth range). Second, these predictive indicators are still heading south (that is, the situation is still worsening): economists have already lowered their GDP growth forecasts for the second half of the year to 2.7%, compared to first-half growth of 4.25%.

None of this dismal news should come as a surprise. Since consumption accounts for more than 70% of US GDP, it is surely inevitable that a deteriorating housing market feeds directly and significantly into lower economic growth. There was some hope that increased investment by the business sector might replace the consumption contribution, but unfortunately this has been dashed: corporate capital expenditure is also

Taken together, all of this tells us one thing: that there are downward earnings revisions on the way in the US. What's worse is that it tells us that we can soon expect slower GDP growth, and hence profits growth, across the rest of the world. Historically, whenever the US economy has slowed, the workshop economies of Asia have slumped in response. China's growth rate dropped to 6.6% (remember, it is more accustomed to growing at 10% plus) in the late 2001 "recession", and at that time US GDP growth didn't even go negative it simply reached a low of 0.23%.

The real question now is: what does the coming drop-off in global GDP growth mean for markets? The answer from the indices, it seems, is a pretty cheerful one: last week, the Dow Jones Industrial Average (DJIA) hit record highs. But I'm not sure that investors should be so upbeat. All markets hate negative news flow and with the US housing market imploding I think we're going to see a lot of it in the coming months. Now is probably not the time to be buying too heavily into stockmarkets.

But what of my medium-term conviction that markets are cheap? Does it still stand? Yes, it does. If equity markets were fairly valued right now, I would say that these concerns over growth and profits would make equities an outright sell (as they almost always are in the first year of a cycle downturn). However, there is an outstanding case to be made this time around that equities have not started out at fair value, but are at quite a substantial discount to fair value.

I base this assertion on what's known as the Fed Model, my favourite valuation technique, popularised by Prudential Securities strategist Ed Yardeni. He believes it is the US Federal Reserve's preferred model for deciding whether stocks are under- or over-valued at any given time, compared to bonds. The idea is that the Fed looks at the earnings yield (one divided by the p/e ratio) on the equity market as a whole, then compares it to bond yields to see which, relatively speaking, is most expensive.

What the Fed model emphatically shows us at the moment is what the private-equity guys, who have been borrowing as much as they can to buy the equity market, already know. Debt currently yields very little (it's cheap to borrow money, but the returns on offer to lenders and savers are pretty minimal), whereas equity earnings yield a lot right now: you can borrow money at a rate that is much lower than the return on equities.

that inflationary pressures from metal and oil price rises are finally feeding through into wage hikes. But there are good reasons to consider such fears overblown. In the 1970s and early 1980s, commodity inflation did indeed feed through into wages (what the economists call wage-cost-push inflation). But what we are seeing now is much more like profit-push inflation, where profit margins are at near-record highs, but labour costs have been (at least until very recently) moderate. The difference between the two is the speed with which inflation drops once rate hikes (such as we've seen in the US) start to slow the economy (it usually takes up to 12 months for rate hikes to take effect).

In the case of wage-cost-push inflation, companies are forced to push prices up, even in the face of the slower demand brought about by higher rates. This is because their most significant cost labour keeps demanding more. Eventually, some labour forces are forced to strike and some companies are forced to retaliate by calling their bluff and closing factories. Anyone who remembers the 1970s knows what I'm talking about. But with profit-push inflation, when demand starts to sag, company profit margins are healthy enough to allow them to trim prices almost at once to try and boost flagging sales. This yanks the rug from under inflation's feet almost immediately. Given this, interest rates should stay low enough for equities to look very cheap for some time.

Another reason for the FTSE's failure to reflect its constituents' good earnings is that there are hotter games in town. Equity investors have been shy of returning to stocks in the wake of the dotcom bubble bursting. They have instead been seduced by the new pastures of high-yield bonds, emerging markets, commodities and (in particular) property. This means that equities, even though they've been rising, remain significantly below where fundamentals imply they should be trading.

The next few months could see some choppy times in stockmarkets as investors become increasingly anxious about the global economy. But this will simply spell opportunity. Stocks are cheap already, but there is nothing wrong with waiting a bit until they are even cheaper. Not every sector in the market is going to do well over the next few years (some such as tobacco are overvalued already), but good stocks with sustainable earnings have the potential to be great performers over the next two years whatever happens to the price of a house in America.

The National Association of Realtors' (NAR) official response to these nasty numbers was simply to say "we think housing has now hit bottom". They gave no reasons to support their optimism probably because there aren't any. But there are several reasons why house prices could keep falling for a couple of years, particularly given how insanely expensive they still are. The NAR's composite housing affordability index has dropped to its lowest reading in 20 years.

So why can't they just stay expensive (as appears to be happening in the UK)? The first reason for this is oversupply. House sales (demand, in other words) peaked in June 2005, but builders didn't begin to curb production in time (unlike in the UK, where they have been cleverer): new supply didn't peak until February this year. No wonder then that there is a record number of new houses for sale (569,000) and that the number of both existing and new-build houses for sale are at record levels, equal to seven or eight months of current sales. That's a massive inventory overhang to clear and the developers know it: they've begun to offer incentives and to cut prices fast. US investment bank Merrill Lynch claims that if you annualise the rate at which builders have been slashing prices since April, it's equivalent to a 22% drop.

The next thing to bear in mind is that there's a limit to how much more American home-buyers can afford. What matters to house buyers is not house prices or even mortgage rates, but how much it actually costs them every month to service their debts. The debt service burden (house price times the mortgage rate expressed as a ratio of disposable income) is the number we need to look at if we really want to understand the state of the market.

The Federal Reserve's quarterly debt service ratio (DSR) update for the second quarter is due out in a week. However, we already know that at the end of March, debt payments on mortgages and consumer debt were estimated to take up 14% of the disposable income of the average American; that's a record high. Add in all other financial obligations (such as car leases, insurance, property tax) and you find that compulsory payments take up about 19% of the average disposable income.

And that number might be about to get a whole lot higher. Up until just a few years ago, US homeowners were the envy of the world. Why? Because they could take out 30-year fixed rate mortgages that never got re-fixed upwards, but which sometimes re-fixed downwards. From the day they took out their mortgage, they knew their payments could fall but never rise. However, as prices have risen, buyers have been looking for ways to cut their payments, abandoning the fix in droves and taking out adjustable-rate mortgages (ARMs) instead. The ARMs available have tended to offer lower monthly payments (usually via two-year discounts) but at the expense of uncertainty, and even increased mortgage debt later (some deals even allow the buyer to pay less than the interest due each month initially, which means, incredibly, that the capital sum you owe goes up, not down, every month). Most such ARMs were sold with two-year resets and they started being sold around 2004.

There's one final piece of bad news for America's over-indebted: most initial mortgages are non-recourse loans (if you can't make your payments the lender gets the house, but that's all he gets). However, refinanced mortgages in many states, including California, are recourse loans. So if you're unable to make your payments, the lender gets your house. But if that's not enough to cover your debt, he can take your car and furniture too.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.