“There’s many a pessimist who got that way by financing the optimist.” – Anonymous
In times of uncertainty, human nature leans toward assessing risk before reward. In this sense, investors may be considered daredevils in our world. Great investors, however, consider themselves strategists, creating opportunities others do not see. There is a buzz, even amongst great investors, of another “bubble” in the housing market and a recession looming. The supporting evidence of an impending recession may seem compelling at first, though, other data may indicate otherwise. Here, we discuss evidence for and against a looming recession and a real estate “bubble-burst.” Our opinion has been formed using data from Treasury spreads, home prices, consumer behavior, labor statistics, and lending practices.
In May of 2022, the University of Michigan consumer sentiment index dropped to 58.4 (the lowest level since August of 2011). Consumers reported fears of inflation, geo-political risk, and current real estate buying conditions. This lower consumer sentiment data has recently been used by many economists to support their claims of an impending recession. It is our belief that this consumer sentiment survey is a fluid gauge of sentiment, and liable to change upon the first news of positive economic data. As of June 9, 2022, we believe the consumer sentiment index has dropped due primarily to higher inflation in goods and gas prices, and is likely not an indicator of a recession forthcoming. Instead, we believe market prices have already factored in the lower consumer sentiment levels.
The latest data from the Bureau of Economic Analysis from April and May supports our thesis of a strong consumer, showing an increase in personal discretionary expenditures across durable and nondurable items (namely restaurants and bars, household items, utilities, and travel). Although the GDP in Q1 of 2022 was negative, a closer look at the numbers indicates that a cut in government spending and a trade imbalance (lower exports, higher imports) were the primary drivers. While exports are an addition to GDP, net imports are a subtraction. In the upcoming Q2 GDP data, we believe personal consumption expenditures will be a stronger economic indicator. If, however, imports increasingly outweigh exports and government spending continues to shrink in Q2, there can be the possibility that the U.S falls into a recession as two negative GDP quarters, by definition, constitute a recession.
In addition to higher consumer spending, the comeback of lagging sectors (hospitality, leisure, and etc) will create additional jobs in an already supply-heavy job market. Today’s job market touts the largest ratio of job openings per job seeker in the last four decades. As of March, 2022, there are two job openings for every unemployed American.
Home prices today have also surged. Historically, the average multiple of median household income to average home purchase price ratio is 5x. For example, if the national median household income is $50,000, the average home price would be $250,000. In 2006, the ratio hit 7x. Today, the US Cash-Schiller Home Price Index is at all-time highs and nearing a multiple of 8x. This may indicate a housing bubble that could lead to a cooling of home prices.
During the COVID-19 pandemic, the United States also witnessed a migration flock to the southern states. In particular, Americans moved to southern states with lower income tax brackets, including Florida, Texas, Arizona, and the Carolinas. As higher-earning city-dwellers pooled in southern states, the competition for housing started bidding wars. Bidding wars inflated home prices, though, not beyond what was ‘affordable’ at the time. This pattern also led to competition between two generations: millennials looking for starter homes, and Baby Boomers looking to downsize. We believe it was this “competition” and excess affordability that led to rising home prices within these regions, affecting the broader real estate index across the country.
Although home prices have risen dramatically since 2021, home price affordability has only recently touched the “overvalued” level. (Though, not much above its long-term average.) Home price affordability is defined by a household's ability to afford the monthly mortgage payments, despite the purchase price of the home. Lower interest rates and rising wages have helped home affordability levels remain in line, even with rising home prices. However, with the Fed’s hawkish tone on rate hikes, we may likely see a leveling-off of home prices as affordability moves out of reach.
We do not, however, foresee a bear market for home prices. As stated in our previous article, it is our position that the Federal Reserve is raising rates not only to combat inflation, but also as a necessity in the case of a recession. In recessionary periods, the Fed will loosen the money supply via Quantitative Easing (QE) policies and lower interest rates to entice investors to borrow and invest. Our team has feared a mild Fed-led recession as a result of the speed and intensity of rate hikes, though current rates do not seem to suggest a need for concern.
Treasury Spreads and Lending
The spread between the two- and the 10-year treasury has been widely accepted as an indicator of a looming economic downturn. By this theory, an inversion of the two- and 10-year rates signals an upcoming recession. When 10-year rates drop below the two-year rates, it is as a response to investor sentiment that there is more certainty in the long-term economy than the short-term economy. As investors sell shorter-term notes, their yields rise (yields move inversely to bond price).
While the two- and 10-year spreads are considered an economic indicator of a recession, the three-month and five-year spread may be a better historical recession indicator. The majority of previous recession periods were preceded by an inversion of the two- and 10-year rates, however, there have been three periods in which we have witnessed an inversion of these rates without a recession. Even in times that this indicator has correlated with a recession, the time lapse between the inversion of the two- and 10-year rates occurred anywhere from three months to over two years before the actual recession took place. The three-month and five-year spread has been a far more accurate indicator, with a lower time-lapse between inversion and actual realized recession. Today, the three-month and five-year yields maintain a healthy spread.
Source: U.S. Federal Reserve Bank of St. Louis.
Another potential indicator of a recessive era is consumer loan default. After the Great Recession of 2008, lending standards were significantly tightened. Moreover, internal bank policies have been steadily tightening their lending standards since 2020, meaning loans are being given to borrowers with stronger balance sheets and higher debt-service-coverage ratios. In the first quarter of 2022, the typical credit score for mortgage borrowers was a healthy 776, according to the Federal Reserve Bank of New York. The delinquency rate for mortgages is in line with long-term averages, as seen below.
Source: U.S. Federal Reserve Bank of St. Louis.
We propose that the appreciation of home prices was supported by strong buyer profiles and pandemic-led migration. The market does seem to be approaching levels of overvaluation in specific areas, though, the broader states remain near the long-term averages for housing affordability. As rates increase, market prices will naturally move through a ‘cooling-off’ period, as witnessed in Q1 of 2022.
As we weigh the evidence for and against the probability of an economic recession, it is not our contention that there is an overarching housing bubble or disastrous recession in the near future. If we do happen to realize another negative quarter after Q2, 2022 (which will officially place the U.S. in a recession) it will likely be driven by government cuts in spending and/or higher imports versus exports. The Institute for Supply Management (ISM) recently released strong manufacturing data for May, 2022, signaling growth and strength in manufacturing. The ISM PMI index is considered to be a leading indicator.
We will continue to monitor the weaker points of the American consumer economy, including consumer credit (which has ticked up in recent months), personal savings, and the most recent changes in personal income. In the first Quarter of 2022, U.S. productivity witnessed its steepest annualized percentage decline since Q3 of 1947 (likely due to work-from-home policies). This trend is expected to reverse as workers make their return to the office. Considering all the aforementioned points in this article, the American consumer appears strong.
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