How will the US property slump hit consumers?

The latest statistics suggest that US housing market activity is slowing dramatically, say Andrew Selsby and John Robson of RH Asset Management. Usually this would have a relatively minor effect on US economic growth. But US consumers have never relied on rising house prices to fund their standard of living to this extent before. If house prices start falling now, the impact on economic growth could be drastic...

Central to the world's economy is the buoyancy of US consumers and their willingness to borrow and spend. To do this, the US housing market is key:

More than $2 trillion of US mortgage debt, about 25% of all mortgage loans, comes up for interest rate resets in 2006 and 2007. That means that mortgage payments will rise.

The Mortgage Bankers' Association expects mortgage applications to buy property to fall by 20% in 2006 and mortgages to re-finance to fall by 40%.

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Californian house transactions in January were down 24% compared to January 2005.

The total number of homes for sale was 25% higher than a year ago at 3.3 million, according to David Rosenerg of Merrill Lynch.

The University of Michigan's index of the intention of people to buy a home in the future is at its lowest level for 15 years.

Sales of existing homes and condos have fallen 10% since June 2005, whilst new home sales have fallen 5%. report that the number of houses on the market in December 2005 following foreclosures was 10% higher than December 2004.

US house builders appear to be relatively optimistic based on the high level of new building permits. However, the fundamentals of the situation are simple. In many parts of the USA, it is much cheaper to rent than to buy, a situation that is bound to impose itself upon peoples' attitudes.

After such large increases in price, why would anybody pay a lot more to own a house than rent it, unless he felt sure that the property market will rise very considerably, which even the most optimistic must think is very unlikely.

Woody Brock is one of our favourite economists, a considerable intellect matched by his public speaking qualities. His company, Strategic Economic Decisions Inc., wonderfully describe themselves as Leaders in the economics of uncertainty'. Their opinion is always worth hearing. In his February report, Woody talks about the potential softening of the US house market and its potential impact on consumer spending. We quote directly from his report:

'Traditionally, the impact of a soft housing market would take the form of a "wealth effect" on household spending: feeling less wealthy, consumers retrench. In a benign interest rate environment, the wealth effect from constant or slightly lower house prices should be very modest, in the range of 0.3% to 0.5% of GDP!

'In today's environment, however, the impact of changes in house prices on spending has been complicated by new "income effects" that did not exist in the past. These effects are a by-product of the rapid democratisation of credit markets during the past decade. When house prices rise significantly, as they have, homeowners of all stripes can withdraw some of their gains and spend them, via an array of new credit instruments. The Fed estimates that, during 2005, US households withdrew some $600 billion of the new wealth created by a (lagged) double-digit rise in house prices, and spent approximately 50% of it. (Goldman Sachs apparently estimates this spending quotient to be 70%, the highest estimate we know of.)

'What have these new forms of borrow-and-binge behaviour done to GDP growth in recent years? Between the years 1996 and 2000, home equity-induced spending raised GDP by about 0.7% per year. During 2001 through 2005, however, such spending raised GDP growth by an average 2.4% per year 2005 being the most egregious year with a boost of about 3.1%. This is utterly without historical precedent, as we have noted in the past.

'All in all, we would expect US consumption growth to slow by about 1.1% due to the wealth-and-income effect of flat to falling housing prices. This estimate is based upon a projection that home equity extraction this year will fall to about $350 billion from $600 billion in 2005. This wealth-and-income effect is consistent with what has happened in the UK during the past year, and is also consistent with Fannie Mae's most recent assessment.

'Caveat: Our 1.1% estimate here is highly tentative. Should interest rates rise a lot or house prices fall significantly, or oil prices rise back to $70, or CAPX spending fall, or some combination of these events occur, then the wealth-and-income effect could depress GDP growth by 2% to 3%. The crucial observation here is that this wealth-and-income impact is a highly non-lineal function of the extent of economic distress. This reflects the critical role of extensive leverage in the real estate market.'

It is very interesting to read Woody's writings on this important issue particularly because of the connection made by Joe Ellis that consumer spending is a very important stock market indicator. For more on this, click here: Why US stocks face a bear market until 2016

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

For more from RHAM, visit