S&P Viewpoint

Continued declines in home sales show that the housing market remains under downward pressure. We still expect housing starts to bottom out this fall at 1.30 million, which is about 10% below the current level and down 39% from their peak in winter 2006. Housing prices will likely keep sliding into the spring of 2008, ending down 8% over the two-year period. Currently, the Standard & Poor's/Case-Shiller index shows home prices down 2.8% from May 2006. Losses and foreclosures are not likely to peak until early 2009. We expect the cumulative losses on the 2006 vintage subprime adjustable-rate first mortgages to reach 11%-14%, at least double the 5.5% rate for the 2000 vintage, which was previously the worst.

Regardless, this remains a mild housing recession by historical standards. It is the first major housing downturn in the U.S. since 1991-1992, so it seems more severe than it is. (In the 2001 recession, the Federal Reserve's sharp interest rate cuts kept the housing market strong.) Housing cycles tend to be dramatic, with major recessions showing declines of more than 50% in housing starts.

The unusual element of this housing downturn is the drop in home prices. In the recessions of the mid 1970s and early 1980s, high national inflation rates meant that home prices actually continued to increase in nominal terms. In the 1991-1992 recession, however, inflation was relatively low, and home prices fell 6.5% peak to trough, according to the Standard & Poor's/Case-Shiller index. We expect the current cycle to be even worse because of the 106% run-up in home prices from 2000 through mid-2006. The average home price rose to a record 3.4x average household income in mid 2006. Given our expected 8% drop over two years, that would still leave the ratio slightly above its 50-year average of 2.6x. Interest rates remain low by historical standards, which should support a slightly elevated price/income ratio.

The sharp rise in home prices was a worldwide phenomenon, spurred by low interest rates. To most buyers, the price of a home is essentially the monthly payment, and with U.S. mortgage rates at 5% in 2004, Americans could buy a lot of home for only a small monthly payment. But as interest rates rose with the Fed tightening, the monthly payments increased, and homeowners who were selling found that prospective new buyers couldn't pay as much. Some homebuyers dropped out as a result: The home ownership rate has fallen over the last two years after having risen to a record 69.2% in 2005 from its 1994 low. Other households are buying smaller homes or just staying where they are.

 Chart 1

The large inventory of unsold homes is likely to delay any recovery in building activity. We expect starts to hit bottom later this year, and they will stay near the bottom through most of 2008. However, prices will continue to drop even after activity levels off because of the large inventory of unsold homes on the market. Losses on mortgage loans and securities will trail even farther and might not peak until early 2009.

The major worry is that the housing market weakness will spill over into consumer spending. The new GDP data put a somewhat different perspective on the consumer. Despite Americans' best efforts to overspend, they did manage to save a little over the last two years. The revised saving rate is still low (1.5% in the second quarter of 2007), but at least it's positive. The revision raised the estimate of personal income, largely based on new data from the IRS, and lowered consumer spending.

Many observers, including Standard & Poor's, expected that the housing market weakness would lead consumers to cut back, both because of its impact on household wealth and because of the dominance of housing-secured credit. Home prices and increased home ownership have been major contributors of household wealth since the stock-market plunge in 2000-2002. With home prices now dropping, wealth won't go up as rapidly. Over the last year, however, the 14% rise in stock prices (S&P 500, as of Aug. 10) has largely offset the weakness in home prices.

Borrowing against your home to renovate it is a time-honored tradition but has been increasing in importance in recent years because of climbing home prices, low interest rates, and the tax advantages attached to mortgage debt. Last year, homeowners took $640 billion out of their homes in the form of cash-out refinancings or home equity loans. The largest use of this money was still for home remodeling (about 40% of respondents gave this as the main reason for taking out the loan). Alteration activity has not dropped off very much, however, perhaps because there were so many people who wanted to remodel but had trouble finding a contractor during the strong housing years. Now, contractors are willing to take on these smaller jobs, which is one of the reasons why construction employment hasn't dropped nearly as much as housing starts have.

Consumers have trimmed spending on housing-related items such as building materials, furniture, and appliances. Furniture and building materials stores were the only retail categories to register declines in sales over the 12 months ending in June. The only other sector to show weakness recently is automobiles, but we believe that can be traced to gasoline prices, not home prices.

 Chart 2

With consumer confidence high as a result of the strong labor market, we believe Americans will continue to spend—but at a slightly slower pace. The newly positive saving rate will drift up only gradually from its recent lows.

Spending on capital equipment has softened but has been replaced by stronger spending on construction. Several factors—including higher hotel and office occupancy rates, the new federal highway bill, and the need for energy investment—have boosted nonresidential construction activity. In the winter, declines in computer and motor vehicle sales hurt equipment spending. Fewer sales to rental fleets were partially responsible for the lower vehicle spending by businesses, as Ford Motor Co. and General Motors Corp. tried to cut back on that unprofitable business. The culprits behind lower truck sales were higher gasoline prices and—even more so—the decline in residential construction. Contractors are the largest category of pickup truck buyers, and the weakness in pickup sales can probably be traced more to construction than to gasoline problems.

On the other hand, higher office and hotel occupancy rates have led to a surge in construction. The 2006 hotel occupancy rate rose to 63.4%, finally back above its 2000 level. The need for more capacity and higher earnings in the sector have boosted hotel construction contracts to 83 million square feet in 2006 from 49 million in 2005. This year is likely to match last year's level.

Office vacancies have dropped back down to less than 11% in major downtown markets, according to the CB Ellis realty firm. Office contracts jumped 21% in 2006 and will likely rise another 4% this year. The level remains 30% lower than the 1998-1999 peak, but it is clearly rebounding from the lows following the events of Sept. 11, 2001.

On the trade front, the deficit has been shrinking slowly since its October 2005 peak of $67.1 billion, to $60.0 billion in May and an average of $59.1 billion for the first five months of 2007. The picture is clearer if energy products are excluded because oil price swings have created substantial volatility. Excluding petroleum, the deficit shrank to $42.7 billion in May 2007 from $46.1 billion in January 2006. The trade deficit has narrowed in response to three major changes: the fall in the dollar, the weaker U.S. economy, and stronger overseas growth.

The weaker dollar is clearly part of the reason for the improvement. The well-known J-Curve phenomenon says that it takes about 18 months for a drop in the dollar to turn the trade gap around. The major dollar decline was from early 2003 through early 2004, and the trade gap hit its record about 21 months later. The first impact of a weaker dollar on the deficit comes from higher import and lower export prices, which tend to worsen the deficit in the short term. Only in the longer run do higher export and lower import volumes offset this price effect.

The second major change contributing to a smaller trade gap has been the softening of the U.S. economy. As growth slowed to 2% from 3%, demand for imports cooled as well. Imports of goods rose 6.6% in 2005 but fell back to only 1.8% over the last four quarters (2000 chain-weighted dollars).

The third factor is the continued improvement in the world economy, particularly in Japan and Europe. In 2005, the Eurozone's real GDP rose a meager 1.6%; this year, we expect 2.7%. Similarly, Japanese growth was 1.9% in 2005, and it is 2.3% this year. These figures are especially important because the U.S. exports mostly to the industrial countries, while it imports from non-Japan Asia and the Americas.

We expect slow ongoing improvement in the trade balance, especially in real terms. From 2003 through 2005, the trade gap subtracted an average of 0.5 percentage points from GDP growth. Over the last four quarters, it has added 0.4 percentage points, and we expect the recent trend to continue.

The decline in the federal deficit has been a major surprise. We expect that the gap will be $179 billion in fiscal 2007 (down from $428 billion in fiscal 2002), which is only 1.6% of the U.S. GDP. Strong revenues—not less spending—have narrowed the deficit because government spending rose faster than GDP over the past four years. We expect spending to slow, primarily because of the expected decline in defense outlays, but that projection depends on developments in the Middle East. The budget deficit should remain near its current level for the next few years.

State and local governments also appear healthy, again largely because of strong revenue growth. The aggregate state and local budgets have moved back into surplus on an operating basis. However, heavy infrastructure spending, in large part spurred by the 2004 highway bill, is keeping their borrowing high.

The inflation rate is running at a relatively moderate level. The Fed's preferred measure—the consumer expenditures price index excluding food and energy items—was up only 1.9% from a year earlier in June, which is within the Fed's comfort zone. The Fed remains nervous about inflation, but the threat does not seem imminent. One worry, however, is that the downward revision to real GDP growth in the most recent data implies that productivity growth has been running about 0.25 percentage points lower than previous projections, which would reduce the estimated trend growth for the economy to about 3% from the 3.25% we had been assuming. This would also revise unit labor costs higher, suggesting more inflationary pressure.

But with the continuing housing problems and sluggish economic growth, we don't see the Fed tightening this year. On the other hand, inflation is still on the high end of its comfort zone, and labor markets remain tight. The result is likely to be no change in Fed policy in the near term; we anticipate a cut early next year because we expect the unemployment rate to drift higher.

 Chart 3

Government bond yields have dropped recently because worries about the mortgage market spurred a flight to quality. Corporate bond yields have risen because investors are getting nervous about risks in nonmortgage markets as well. So far, the quality spreads still remain below historical averages. We have been saying for several years that the market has been too complacent about risk, and that complacency has now been shaken.

The spread between U.S. and European bond yields has narrowed and seems too low to attract the funds needed to finance the U.S. trade gap. The 10-year U.S. Treasury note is yielding only 0.46 percentage points more than the equivalent euro bonds, which is less than half of last year's spread. U.S. yields are likely to rise in response to the higher European yields, even if the Fed begins to cut short-term rates early next year.

The economic expansion has slowed, which should not be a surprise after 17 consecutive Fed rate hikes. The growth remains solidly positive, resembling the 1995-1996 period, when real GDP fell back to 2% for a year and then reaccelerated. So far, the slowdown is mostly confined to the housing market, with the consumer continuing to spend confidently. However, the risk remains that higher oil prices or a sharper rise in bond yields, which could in turn further damage the housing market, might still turn lower growth into a recession.