Economic Trends and Risks

Housing: Positive Sales but Foreclosures

Just as home sales begin to find some lift we're reminded of the worsening state of housing foreclosures which continue to threaten a sustained housing recovery.

The big picture is that residential investment finally showed a gain in the third quarter (20% annualized) after years of declines as housing starts and construction spending turned higher.  Despite a stunning October decline in housing starts they remain 10% above the April low.

The rise in supply followed a strengthening of demand.  Home sales have risen in six of the last seven months as tax credits helped to lift existing home sales 20% since August.

 
Home prices continue to fall but at a slower pace.   In October, new homes were prices just -0.5% below the year ago level.  Existing homes prices, under the drag of foreclosures, were down -7% from a year earlier.

 
As house values fall so does the ratio of home equity to mortgage principle.  Negative equity, when that ratio is below 1.0, reached nearly 10.7 million homeowners in the third quarter.  That is a large 23% of mortgages outstanding. 

These underwater mortgages are more likely to find their way to foreclosure and thereby further boost the inventory of homes for sale, helping to push prices still lower and self-perpetuating the foreclosure and housing problems.   Even those who bought as recently as this year are showing an 11% rate of negative equity.

For now watch the price moves as the best indicator of trouble in housing.  Low prices, low mortgage rates and the tax credit for first time home buyers has provided the lift to underlying demand.  But the price decline continues and pulls foreclosures and typically low quality inventory in with it.

Inflation Outlook Subdued

Inflation fears remain high as the Fed's extremely generous supply of reserves and policy stance provides the risk. However, the overload of economic slack (10%+ unemployment, sub-71% industrial capacity use) and a sharp -3.6% annual decline in labor costs provides the forecast direction for the Fed and private forecasters despite the rise in commodity prices.

Today's consumer price report and even more so, the November CPI report, may heighten market fears.  From a deflationary rate of -2% in July the annual rate rose to -0.2% in October and is expected to reach almost 2% yoy in November -- all due to the run off of the year ago drop in energy prices.

 
In short, the brief drop in annual CPI deflation will end in November as the sharp drop in year ago energy prices is removed from the annual calculations and drifts off in to history.  While energy costs amount to just 8% of the CPI, its effects have been large given the collapse of energy prices in the fourth quarter of 2008.

The downward trend in core (ex food and energy) prices sets the stage for overall inflation growth as volatile food and energy prices provide some noise.   While few seem to believe the forecasters, the group the Philadelphia Fed surveys expects sub 2% consumer price growth throughout 2010 as core growth expectations are centered near 1.5%.  Even the 5-year expectations stand below 2%. 

The Federal Reserve's official estimates for personal consumption inflation also stand below 2% through 2011 and over the "longer" term.  These are the folks with the inflation insight and the ability to direct price growth -- their chief objective.

 

The Laggards

This blog has largely focused on the changing trends in key economic indicators.  While the 3.5% jump in last quarter's GDP growth largely confirms the start of economic expansion there are still many measures which haven't shown any evidence of turning yet. 

 
Unemployment carries the largest weight and is expected to start a downward trend by the first quarter of 2010 -- hopefully sooner.  By slowing income growth, unemployment also weighs on consumer confidence, slows sales and weighs on consumer credit. 

Consumer credit is not only weighed down by demand but supply as banks continue to tighten lending standards.  While the rising stock market is helping to lift demand the massive plunge in household wealth and the quarter century high in unemployment will continue to hold back spending and credit demand. 

 
In contrast, the government is on a credit binge after adding $1.7 trillion to the public debt over the last fiscal year.  Total outstanding debt is now nipping at the $12.1 trillion debt limit as the annual budget deficits aren't expected to fall below 1/2 trillion dollars over the next decade.  Pressure is building on the Administration to find (create?) some solutions here.  

 

Fed Policy Statement and Employment

The Fed did not answer market questions of the timing and type of operations that Fed policy would eventually demand.  The policy statement released today was little changed from September's. 

No detail was given to how the Fed intended to drain the excessive reserves from the banking system or provided any insight on when the policy rate will rise from its near zero target.  The statement again noted that economic conditions were likely to warrant exceptionally low levels of the federal funds (policy) rate for an extended period.  The wait continues for some change in the Fed's language as I suspect the Fed is wary of exciting the market.  After all, the early moves only lessen the amount of Fed generosity on a path toward a more normal real (inflation adjusted) funds rate. 

The Fed has been testing reverse repo operations since mid October but no mention of that was in the statement.  The Fed will complete the $1.25 trillion of mortgage backed security purchases and a smaller $175 bln of GSE debt purchases by the end of the first quarter of 2010.  The $25 bln downward adjustment to agency debt is tied to limited availability.  The $300 bln purchase of Government debt is already complete.

Friday's Employment Report

The continued uptrend in the unemployment rate is believed to be one constraint on the Fed's policy direction.  The early employment indicators offer no clear reason to expect a change from the very slow improvement seen to date.  The consensus forecast may be a bit too bright at -175,000 lost jobs.

The best forward indicator for monthly payroll growth comes from ADP -- the private company that distributes payrolls for many large companies.  ADP's -203.000 estimate for October's decline in private employment may be the sixth consecutive overestimate, as the recent downtrend in non-included government payrolls adds further weakness to the full payroll report.

 
Modest improvement in the weekly unemployment benefits claims also argue for small improvement from the -232,000 average decline of the last two months.  Initial claims (a good indicator of layoffs) still holds above 525,000 as a level closer to 400,000 typically marks gains in payrolls.  Both initial and continued unemployment claims remain above their peaks of the last two recessions suggesting continued weakness at least through year end.

The least accurate employment indicators come from the ISM employment surveys which showed a surprising rise from manufacturing (despite over 3 years of monthly declines and an October manufacturing drag in the ADP index) as the large majority in the non-manufacturing index fell to a five month low -- well below the positive growth marker.

The turn toward growth in payrolls may wait for mid-2010 as the unemployment rate turn should be earlier, possibly in the first quarter.  The financial markets (and politicians) will continue to worry as the slow improvement in labor conditions continues despite clear growth in the economy overall.