Last night on K&C, Larry asked me about the improvement — after 5 down months — in New Home Starts. My answer was a single data point does not make a trend. Besides, rates are still historically cheap compared to the 1990s, when mortgages were primarily above 8%. (I also failed to mention in the allotted time that this is a notoriously noisy data series, with very inconsistent reporting standards; see this for more on that subject).
The way Real Estate’s growth rate has cooled is very consistent with our expectation for a "slow motion slow down" in the economy. But I did not have time for the specifics as to why I believe a decelleration, and then outright reversal, in Real Estate will matter so much to the economy. Let’s flesh this out a bit more:
Its long been a tenet of our economic outlook that the prime driver of the 2002-05 recovery has been the Fed. They slashed interest rates to 46 year lows, bringing the Fed Funds rate down to 1%, while cranking up the printing presses. Then, they kept rates low for a long time. Cheap money sent all sorts of hard assets — oil, gold, real estate, other commodities — soaring. This stimulus — and not tax cuts, as Rich Lowry incorrectly claims — was the key driver of the economy. Hey, I like tax cuts as much as the next guy, and personally benefitted ALOT from the dividend tax rate of 15% (before the AMT got me). But I calls ‘em as I sees ‘em, and it was historically ULTRA-low interest rates, and not the marginal change in top rates, that have been the prime domestic engine. (China was a close second, with the weak dollar right behind it).
Where was I? Oh, yes, Real Estate. When we first started prosletyzing this perspective of RE as the key, the skepticism was thick and the pushback was fierce. Now, this viewpoint has become fairly well established. Even the mechanism of MEW — Mortgage Equity Withdrawal — has gotten recognition as it put trillions of dollars into the hands of consumers, where it has been transmogrified into SUVs, new Kitchens, and HDTV plasma screens.
The mechanism for how this plays out is less well understood by Wall Street and the general public, and is slowly becoming accepted. It has begun to infiltrate the collective consciousness of investors. How the prime mechanism of the growth engine plays out, where its trending, and how it is likely to shift
over time will be the key to if we ultimately end up with an economic soft landing, a hard landing, or an outright crash.
To get a sense of how important MEW is, look at what GDP would be like without it. (Pretty scary, huh?). The usage patterns of consumers is the key to understanding where this can go.
Here’s where it gets tricky: Despite the rise in interest rates and the cooling of real estate, US Mortgage Equity withdrawal has remained robust. According to an article in Economy.com by Zoltan Pozsar, in Q1 2006, gross equity extraction slipped sequentially from $1.033 trillion to $996.8 billion (annual run rate). This is still "way up in the stratosphere" to quote Joanie. MEW represented 8.4% of personal income in Q1, and is a very meaningful source of spending cash with incomes flat and real incomes negative.
The Penebscott Princess puts it this way:
"How does John Q. get his hands on some MEW? 1. sale of home. 2. refis 3. HELOCs. (In that order, btw.) Okay, since the sale of a home is the largest factor, what is truly bad news then, is a deceleration in the pace of home sales and of course, any evidence that prices are softening as well.
And we know that both are in the works. So yesterday’s HMI release, a real dog, was unwelcome news, while acknowledging that it reflects new home sales only. Because face it. If they ain’t linin’ up to buy new ones, fat chance the used ones are flyin’ off the shelves either.
Bottomline, the increase in interest rates is depressing sales and prices in the housing industry. In turn, this should eventually become evident in John Q.’s spending habits as the well runs dry. But for the moment, we now have one mystery solved as to where he’s gettin’ his funding: he’s either sellin’ or hockin’ the ranch."
So how does all this fit in with our concept of a "slow motion slow down?" Spending patterns following mortgage equity withdrawals. The extra MEW green in consumers pocket is typically spent over 2 to 3 quarters. That implies the $249B or so extracted in Q1 will be spent from then to Q3. If Q2 slows even more, that gets spent from then thru Q4, and so on.
Even as MEW slows, it will still be stimulative, albeit at a decreasing rate, for the foreseeable future. This will continue until something stops the spending — most likely, a sentiment panic that freezes consumers from spending, with a religous epiphany involving saving money (hard to even imagine tho that may be).
I suspect that will occur slowly — much later this year or early 2007. The market’s action in May could even be the beginning of discounting that consumer slow down.
Mortgage Equity Extraction, components
Bottom line: Without something else to take the place of MEW, the consumer cannot drive the US economy at these levels for very much longer. Unless business spending ramps up dramatically, there is nothing else on the horizon to take the spending baton.
That spells trouble for GDP.
UPDATE: June 21, 2006 9:54am
The request goes up for the MEW GDP chart, and courtesy of Calculated Risk, here it is:
click for larger chart
UPDATE June 21, 2006 2pm
The WSJ picks this up in Market Beat: Mew Mix
Estimates of Home Mortgage Originations, Repayments, and Debt On One-to-Four-Family Residences
Alan Greenspan and James Kennedy
Federal Reserve Board, Staff working papers in the Finance and Economics Discussion Series (FEDS)
US Mortgage Equity Withdrawal Remains Strong
Zoltan Pozsar in West Chester
Economy.com, June 16, 2006
Softer Housing Sector Is Seen,But Data Don’t Point to Collapse
CHRISTOPHER CONKEY and MICHAEL CORKERY
WSJ, June 21, 2006; Page A2
I frequently discuss Microsoft, and for many many reasons: They are a tech bellwether, a huge part of the S&P and Nasdaq 100 (and a smaller part of the Dow). They have also been a thorn in the side of new technology development and innovation, but now that so much of it has moved to the web, its gotten away from them.
This is a good thing.
One of the commenters said some time ago that I was "irrational in my hatred for Microsoft." That’s hardly the case; Microsoft has put a lot of cash in my pocket, so at worst, I should be grateful to them for the windfall.
However, I am still an objective observer, and I believe that Mister Softee is not what most investors think it is: They are hardly innovators; rather, they copy other people’s work relentlessly, until by default they own the standard. Their products are kludgy, bloated and anti-instinctive; They are hardly the elegant, easy to use software first dreampt up by science fiction writers decades ago.
From an investing standpoint, their fastest growth days are behind
them, yet they are hardly a value stock — yet. (Cody and I have disagreed about this for some time). The leaders of the last bull Market are rarely the leaders of the next. Despite this, Wall Street still loves
them, with 28 of
are widely owned by active mutual fund managers and closet Indexers.
Many people think of them as this well run money machine; In reality, they are very poorly managed by a group of techno-nerds with very little in the way of management skills. Even their vaunted money making abilities are profoundly misunderstood: Its primarily their monopolies in Operating Systems (Windows) and Productivity Software (Office) that generates the vast majority of their revenue and profits. Their Server software and SQL Database make money, but hardly the big bucks of Windows or Office. MSN is a loser, MSNBC is a dud, their Windows CE is hardly a barn burner — even X-Box has cost them billions more than it is likely to generate in profits over the next 5 years.
Lest you think its just me who thinks this way, consider no less an authority than Robert X. Cringely. He is the author of the best-selling book Accidental Empires (How the Boys of Silicon Valley Make Their Millions, Battle Foreign Competition, and Still Can’t Get a Date). He has starred in several PBS specials, including Triumph of the Nerds: A history of the PC industry.
After Gates resignation, Cringely wrote this:
"Microsoft is in crisis, and crises sometimes demand bold action. The company is demoralized, and most assuredly HAS seen its best days in terms of market
dominance. In short, being Microsoft isn’t fun anymore, which probably means that being Bill Gates isn’t fun anymore, either. But that, alone, is not reason enough for Gates to leave. Whether he instigated the change or someone else did, Gates had no choice but to take this action to support the value of his own Microsoft shares.
Let me explain through an illustration. Here’s how Jeff Angus described Microsoft in an earlier age in his brilliant business book, Managing by Baseball:
"When I worked for a few years at Microsoft Corporation in the early ’80s, the company had no decision-making rules whatsoever. Almost none of its managers had management training, and few had even a shred of management aptitude. When it came to what looked like less important decisions, most just guessed. When it came to the more important ones, they typically tried to model their choices on powerful people above them in the hierarchy. Almost nothing operational was written down…The tragedy wasn’t that so many poor decisions got made — as a functional monopoly, Microsoft had the cash flow to insulate itself from the most severe consequences — but that no one cared to track and codify past failures as a way to help managers create guidelines of paths to follow and avoid."
Fine, you say, but that was Microsoft more than 20 years ago. How about today?
Nothing has changed except that the company is 10 times bigger, which means it is 10 times more screwed-up.