A P: US housing - Lessons from other countries

If it were to follow the pattern of the UK and Australia, a slowdown in US housing will be enough to rattle global financial markets.

A key issue in 2006 will be the pace of slowdown in the US housing markets and the impact this will have on the US consumer, economic growth, and asset markets.

In 2005, consumer spending in the US grew at 6.5%, two percentage points higher than disposable personal income growth (driving the savings rate in the US into negative territory). This gap, the highest since 1999, was filled by cash extracted from appreciated homes, occurring when these homes change ownership. Nationwide in 2005, home prices in the US rose by 12%, with over a third of regional markets exceeding this number (unprecedented breadth). This broad-based appreciation was converted into spendable cash by a 10% housing turnover rate (the fastest in 25 years).

While the strong housing market provided a strong tailwind for consumption growth in the US, the signs are evident that property markets in the US are beginning to hit resistance. Housing turnover has begun to slow, inventories are building, incentives are on the rise, and a whole slew of other leading indicators show a peaking near.

Given the importance of this issue to anyone's global economic and market outlook, it is worth spending time examining the lessons thrown up by other economies which have recently gone through a housing slowdown.

The experience of the UK and Australia can give a good sense of how consumer and housing dynamics have played out when property markets slow and the impact of this on asset markets. These two countries are good case studies as they share a great deal in common with the US housing situation but go further along in their adjustment process and can provide clues as to what may lie ahead for the US.

The commonality between these two countries and the US is a background of very sharp increases in house prices, significant home equity withdrawal, and robust consumption confronted by policy tightening. The UK and Australia have had a housing price boom as significant as the US, household debt burdens at similarly elevated levels, and record mortgage equity withdrawals. The only difference is that they both began their adjustment process 12-18 months ago.

So what exactly happened in the UK and Australia and what lessons do they hold for the upcoming US housing slowdown?

The major housing price series in the UK peaked in Q3 2004 and in Q2 2004 for Australia. The peak in housing price inflation and mortgage equity withdrawal (MEW) occurred a little ahead of this point. MEW in fact peaked about three quarters ahead of the levelling of house prices.

In both the economies, the levelling of house prices occurred about four quarters after monetary tightening began. Policy rates and therefore mortgage rates (in both economies mortgages are primarily floating and thus immediately impacted by rises in short rates, unlike the US, wherein mortgages are generally fixed and thus more impacted by movements in the 10-year yields) rose by 100 basis points in Australia and 125 basis points in the UK.

While we have yet to see a peak in housing price inflation or mortgage equity withdrawal in the recent US data (both hit new highs in Q3 2005), it is reasonable to think that Q3 2005 may have marked the peak in both variables. Mortgage rates in the US (more linked to 10-year yields rather short rates) bottomed only in July 2005. Taking the lags exhibited in both these variables (MEW and interest rates) from the experience of Australia/UK, US home prices should start levelling off by Q2 2006.

Once the levelling-off point is established, the behaviour of most activity-based variables to a housing slowdown is quite consistent across both the economies studied.

1. Consumer spending growth slows by 2-3 percentage points in the four quarters following the levelling point (source: Goldman Sachs' Global Economics Weekly).

2. Retail sales growth declines even more sharply, with the growth in the UK and Australia slowing by as much as five percentage points.

3. The overall economy also slows, by 1.5-2% (in both economies) the following year. This growth slowdown occurred despite a very benign global economic backdrop and sky-high commodity prices (helping Australia). Critically, though both economies slowed, there was no recession.

4. Despite the slowdown in consumption, labour markets held up, with stable unemployment in the UK and actually accelerating jobs growth and falling unemployment in Australia.

5. In both cases long-term rates declined quite significantly within 12 months of housing prices levelling off.

6. Equity markets in both the countries handled the slowdown quite well, as they continued to rise even after growth slowed. Given the performance of global equities in 2005, this benign background may have played a large role in this outcome.

As to how closely the US will follow the pattern described above it is hard to tell, but clearly there is enough similarity between these three countries to take the lessons seriously.

While there are differences between the US and the other economies, most notably in the structure of mortgage rates (the US has more fixed mortgages and is thus less exposed to rising short rates), post-hurricane rebuilding in the US provided an offset to slowing consumption and a more regional concentration of overvaluation. There are negative offsets as well, most importantly the UK and Australia underwent their adjustment during a period of strong global growth and equity markets, which provided strong support. Given the importance of the US consumer and economy to global economic growth and equity markets, it is difficult to imagine such strong external support for the US itself as it goes down the path of adjustment.

If Q3 2005 turns out to have been the peak in MEW and housing price inflation in the US, then expect the American consumer to follow into the footsteps of his/her Anglo Saxon cousins by the middle of 2006.

Housing prices will flatten out, consumer spending and retail sales growth will dip significantly, and GDP growth also will slow. A recession is unlikely and the growth damage may not last much beyond 12 months. Are global equity markets prepared? More importantly, are current levels of risk taking sustainable in such a scenario? For, inevitably markets will overshoot on the downside and herald the collapse of the American consumer (at last!!). All the bears will come out of the closet saying I told you so. Market volatility (another danger to current inflated levels of risk appetite) will rise.

The slowdown in US housing is upon us, as is the correction in US consumption; while not the doomsday that many predict, it will be enough to rattle global financial markets.