Residential Investment: Reversal Ahead?

Welcome to The Observatory. The Observatory is how we at Prometheus monitor the evolution of the economy and financial markets in real-time. The insights provided here are slivers of our research process that are integrated algorithmically into our systems to create rules-based portfolios.

Our primary takeaways are as follows:

• The latest data for August showed that housing activity was somewhat mixed.  Housing permits increased,  starts decreased, and completions increased. At the same time, new single-family home sales declined.
• We think this mixed data is consistent with the cross-current coming from strong nominal activity and tightening borrowing conditions. Income and employment continue to support nominal activity, which flows to homebuilder equities, which have performed robustly. Conversely, higher interest rates continue to increase debt service costs. 
•  Looking forward, the effects of tightening are likely to accelerate, while the effects of nominal spending are more likely to decrease. The combination of these factors will likely weigh on the residential sector. 
• However, it is not until the residential sector once again begins to contract that we will see enough pressure on the broader economy. This will continue to support stocks & commodities relative to bonds until activity decisively turns. 

Let us dive into the data driving this assessment. The latest data for August showed housing permits increased by 6.93%, housing starts decreased by -11.33%, and housing completions increased by 5.32%. Below, we show the current levels for the same:

Zooming into the data, housing permits increased by 6.93%, surprising consensus expectations of -1.57%. Below, we show the sequential evolution of the data, along with the smoothed one-quarter change in the most recent data. We provide the smoothed version as monthly housing data contains significant noise.

For further context, we zoom out to show the contributions from single-family homes (64), two-family homes (8), and multi-family homes (-115) to the fall (-43) in total permits over the last year:

In contrast to the permits data, housing starts data showed starts decreased by -11.33%, disappointing consensus expectations of -0.76%. Below, we show the sequential evolution of the data, along with the smoothed one-quarter change in the most recent data. We provide the smoothed version as monthly housing data contain significant noise.

To illustrate the bigger picture, we show the contributions from single-family homes (-42), two-family homes (-12), and multi-family homes (-232) to the fall (-222) in total starts over the last year:

Last, in our sequential analysis, we turn to housing completions data, which showed completions increase by 5.32%. Below, we show the sequential evolution of the data, along with the smoothed one-quarter change in the most recent data. We provide the smoothed version as monthly housing data contain significant noise.

We show the contributions from single-family homes (-68), two-family homes (5), and multi-family homes (105) to the rise (51) in total completions over the last year:

To get a better sense of where we are in the housing cycle, we examine how many construction projects have been approved but not yet started. According to the latest data, 18% of projects are yet to begin construction. Looking through history, housing-led recessions usually begin when this measure of construction slack is around 15%, suggesting that we are within the ballpark of a recession.

We conclude by examining another measure of housing weakness, i.e., permit slowdowns- which measures how much building permits have fallen from their cycle highs. Large drops in permits bode ill for the broader residential investment complex & GDP. The latest data shows that building permits are off their cycle highs by -20.79%. Typically, housing-led recessions usually begin when this measure of cyclical weakness is around -35%, suggesting that we are well-removed from outside recessionary territory.

Now that we have examined the flow of permits to completions, we now turn to home sales in the form of new single-family home sales.  The single-family market is the largest component of residential investment. As housing completions have held up well recently, so have new home sales over the last few months. However, the most recent sequential data showed housing sales declined by -1.4% in August:

This increase in sales relative to construction activity has decreased housing inventories. Elevated inventories relative to sales are typically an indication of weak demand. This is currently not the case, with home sales increasing while existing home stock is depleted. We show this below:

Putting all these factors together, the picture for residential investment remains one of resilience with a broader cyclical contraction. Our latest monthly estimate places real residential investment at -7.01% versus one year ago.

Residential investment provides significant insight into the state of the business cycle, which allows us to better understand the drivers of current equity market pricing. Today, equity market returns are inconsistent with residential investment trends over the last year. We show this below:

Now, while we have seen resilience in recent data, we think pressures remain in place to create further weakness in residential activity.  The latest data shows a sequential weakening in our weekly tracking of mortgage applications. Our latest estimate suggests downward pressure on mortgage borrowing and residential investment. Our latest estimates show mortgage applications down by -40.93% compared to one year prior. We present this information below:

To assess the borrowing conditions driving these changes in mortgage applications, we turn to mortgage spreads. According to our measures, mortgage spreads are rising. Spreads have begun to rise since February 2022. Since then, the 30-year mortgage yield relative to 10-year Treasury yields has increased by 1.21%. Below, we present the 30-Year Mortgages relative to 10 & 30-Year Treasuries:

While mortgage applications and mortgage spreads are an important barometer of housing demand conditions, we now turn to market-based measures of the health of the supply side, i.e., the performance of homebuilder stocks relative to broader equities. Home builder stocks have outperformed broad equities significantly over the last six months considerably. However, this trend has reversed over the last eight weeks, suggesting the beginnings of a potential reversal:

Overall, nominal incomes and employment have kept residential spending far more resilient than typical tightening cycles. However, without a reacceleration in nominal incomes, the tightening of interest rates is likely to begin to have a more marginal impact on activity than the maintenance of nominal incomes. This will likely push residential investment further. Only after a significant amount of weakness in the residential sector will the broader economy experience pain consistent with a recession. Until then, stocks and commodities likely outperform bonds. Until next time.