Market Commentary | June 27, 2022

Can't Find My Way Home

It is difficult to find a market that has captured the zeitgeist of the pandemic, inflationary rebound, and attendant affordability crisis better than the housing sector. While home sales initially collapsed under the weight of the global economic shutdown, they rebounded at an incredibly sharp rate for a host of reasons—not least being the desire for individuals to look for more space, accommodative monetary and fiscal policy, and consumers' lack of ability to spend on services during the depths of the shutdown phase.

Bust, boom, bust

What started as a rebound has turned into an acute affordability crisis for an increasing number of buyers. Suppressed inventories, bidding wars, and hotter demand created a perfect storm for surging home sales and prices. After falling by nearly 28% during the pandemic-induced recession in early 2020, existing home sales spiked by 63% in just eight months, as shown in the chart below. New home sales experienced a shallower drop during the recession but surged by 78% in just four months off the pandemic low.

The boom seems to be over for now, as existing and new home sales have rolled over considerably from their peaks by 19% and 33%, respectively. For what it's worth, declines of both magnitudes from 2005-2007 preceded the broader economy's drop into recession; though, as we'll explain later in this report, the prospects of a housing crisis akin to the mid-2000s are low.

Not much wind in the sales

From their pandemic peaks, existing and new homes sales have declined by 19% and 33%, respectively.

Source: Charles Schwab, Bloomberg, National Association of Realtors, U.S. Census Bureau, as of 5/31/2022.

Unsurprisingly, the sharp rebound in home sales coincided with a surge in home prices. As shown below, both existing and new home prices have increased at double-digit annual rates (six-month averages are shown for smoothing purposes) beyond what we saw during the lead-in to the housing crisis more than a decade ago.

We like to remind investors that, as it pertains to economic data, rate of change is key whenever analyzing trend shifts. Further, the change in the rate of change helps identify key inflection points. As such, with the peak in home price growth likely behind us, the trend is moving in the right direction for buyers. However, existing home price growth has stabilized of late, maintaining a double-digit average growth rate above 15%. That cannot last in perpetuity, but as the increase in prices stays near the stratosphere, demand may fall at a faster pace.

Higher highs in price growth

Growth rates for existing and new single-family home prices are off their peaks but remain elevated (and are well into double-digit percentage territory).

Source: Charles Schwab, Bloomberg, National Association of Realtors, U.S. Census Bureau, as of 5/31/2022.

Historic price growth has left many consumers asking how we got here. As with all markets, it often boils down to a supply-demand imbalance. In the aftermath of the housing market's collapse during the Global Financial Crisis (GFC), builders reduced the pace of home construction by a significant degree, leaving housing supply relatively low. As shown below, monthly supply for existing homes (the number of months it would take to sell all homes on the market at the current sales pace) has been in a chronic downtrend since the GFC, while new home supply has moved up marginally (though it's a smaller share of the overall market).

A split supply recovery

Since the end of the 2007-2009 recession, existing home supply has been in a chronic downtrend, while new home supply has improved slowly.

Source: Charles Schwab, Bloomberg, National Association of Realtors, U.S. Census Bureau, as of 5/31/2022.

Relatively suppressed supply was never a major issue until the pandemic unleashed a massive home demand shock on the upside. That said, there were hints of a brewing imbalance in the lead-in to the pandemic, given the U.S. homeownership rate troughed in 2016 and has since been increasing. A solid driver of that was the demographic push, as millennials' aging and increase in buying power propelled them to buy homes. The spike higher was accelerated by the pandemic, as shown below; though it has largely reversed, the longer-term uptrend hasn't been broken.

No vacancy

The homeownership rate has increased since its trough in 2016, while the renters vacancy rate has been in a persistent downtrend since 2009.

Source: Charles Schwab, U.S. Census Bureau, of 3/31/2022.

While an increase in homeownership has been a welcome development, the renters' vacancy rate has continued to plunge, underscoring another crisis: would-be buyers have piled into the rental market, putting further pressure on supply and driving prices higher. When looking at the dispersion in home sales by price growth, this isn't too surprising, but remains worrisome. As shown below, the number of new homes sold for $150k-$200k has evaporated, while sales have decisively favored those selling for more than $500k.

(Un)affordable housing

The number of new homes sold for $150k-$200k has plunged, while sales have decisively favored those selling for more than $500k.

Source: Charles Schwab, St. Louis Fed, as of 5/31/2022.

The affordability crisis

The lack of rental availability has put sustained, upward pressure on rent prices, which has contributed to hotter overall inflation. The owners' equivalent rent (OER) and rent of primary residence components of the consumer price index (CPI) are increasing at their fastest annual rates since 1991 and 1987, respectively. As shown below, the lead-lag relationship between home price growth (measured by the Case-Shiller Home Price Index in green) and the CPI's rent components is such that rental prices are expected to maintain their upward climb. To be sure, rents have reacted much faster to the upside in the current cycle; thus, if home price growth cools in relatively short order, it may help arrest the upward trend in rents. Yet, with current supply constraints, we don't think a fast move to the downside is imminent.

Catch me if you can

With the increase in home prices leading rents by about 18 months, the rent components of the consumer price index (CPI) are expected to continue to increase.

Source: Charles Schwab, Bloomberg.  Owners' equivalent rent (OER) and rent of primary residence as of 5/31/2022. Case-Shiller as of 4/30/2022. Forecast contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

With the aforementioned price and supply issues plaguing the market, it is understandable why consumers' confidence in buying homes has plummeted. As shown below, the buying conditions component of the University of Michigan's Consumer Sentiment Index has fallen to its lowest since 1982. What began as a price crisis has now morphed into a rates crisis as well, shown by the two drivers of sour sentiment in yellow and green, respectively.

Back to the future

Buying conditions for homes as measured by the University of Michigan have plummeted the worst since 1982, exacerbated by higher prices and rates.

Source: Charles Schwab, Bloomberg, as of 6/24/2022.

To be or not to be the GFC

The pricing pressures early in the pandemic dented consumer confidence; but in terms of actual dollars, buying power wasn't impacted drastically. In fact, it wasn't until rates started surging that affordability came under significant pressure. The chart below shows that monthly affordability—what many individuals/families depend on when it comes to housing costs—has reached its most-elevated level since 2007.

Considering the conditions shown in the box within the chart, the average worker in the United States had to work nearly 47 hours to cover a monthly mortgage payment at this time last year. That figure has shot up to 66, the same level at which the housing bubble was starting to burst in 2005. This underscores the acute affordability crisis many Americans are now facing. Both prices and rates have put homeownership out of reach for a broad swath of the population, which has been exacerbated by a 40-year high in inflation and aggressive monetary policy.

Multiple affordability hits

A year ago, it took the average U.S. worker nearly 47 hours to cover a monthly mortgage payment (when considering interest rates and the existing median single-family home price). That has increased lately to 66 hours.

Source: Charles Schwab, Bloomberg, as of 5/31/2022.

While comparisons to the GFC abound, we take comfort in the fact that the amount of leverage tied to the housing market—be it in risky lending or securities—is nowhere near what we saw in the subprime bubble. Looking at mortgage originations alone, as shown below, lending has been decisively in favor of those with superior credit scores. In addition, housing as a percentage of gross domestic product (GDP) has fallen significantly since the GFC, housing supply is not raging alongside demand, and household balance sheets are in much better shape (the household sector has in fact led the charge in deleveraging since 2008).

The higher score wins

Mortgage originations have been concentrated largely in buyers with the best credit scores, a marked reversal from lead-in to the housing crisis more than a decade ago.

Source: Charles Schwab, Bloomberg, as of 3/31/2022.

In sum

Longer-term, we remain fairly optimistic on the housing supply front, but are also keenly aware that the imbalance may take quite some time to correct. As shown below, we have never seen such a wide spread between housing completions and the number of units under construction. The good news is that—from an overbuilding perspective—we are in a mirror-image scenario relative to 2005, which should dampen the potential economic ripple effects from a fallout in housing.

Backlogs pile up

The spread between housing completions and units under construction has never been more negative, meaning supply is incredibly constrained.

Source: Charles Schwab, Bloomberg, U.S. Census Bureau, as of 5/31/2022.

Yet, the bad news is that housing starts have maintained their long-term upward climb as completions have lagged. That puts the housing market in an increasingly precarious scenario. Starts have eased lately, and while the coming supply of completed units will provide opportunities for prospective buyers, a decline in prices and housing-start activity may exacerbate weakness in the broader economy.

With tension having built on both the supply and demand side, it's difficult to envision what the elixir for housing is. A drop in prices would be welcome for several segments of buyers, but it may be a symptom—perhaps even a cause—of a broader economic slowdown as worsening confidence and income growth hold back consumers' abilities to make large purchases. As economic growth continues to slow, the Federal Reserve hikes rates aggressively near-term, and asset markets remain weak, we continue to think the needle points to further economic weakness—elevating the chances of a recession sooner rather than later.