Keith Wade, Chief Economist at Schroders
“The US housing market is certainly picking up pace with a 15% jump in new builds in September. The signs are that this will continue with permits also rising and the National Association of Homebuilders (NAHB) survey consistent with new builds getting back above the one million annualised rate. Quite an improvement from 2009 when new builds were running at half that rate.
“Housing has been at the heart of the crisis with the initial sub-prime lending boom taking home building to multi-decade highs. Residential investment as a share of GDP exceeded 6% in 2006 before plunging to just 2% of GDP in 2010. That obviously weighed on GDP growth, but the impact went beyond the drag from residential investment as falling house prices weighed on consumer balance sheets, an adverse wealth effect which drove the savings rate up and consumption down. The same applies to the banking sector, which cut back on lending in response to the decline in the value of their mortgage assets.
“Stronger residential investment and a pick up in construction employment will help the recovery. However, having shrunk to a fraction of its previous size, the housing sector’s ability to impact wider GDP has been diminished. From a base of 2% of GDP, spending has to rise significantly to have an impact at the whole economy level.
“Another important factor is that the upswing does not seem to have been accompanied by a significant pick up in mortgage borrowing. Mortgage applications for purchase remain flat as households continue to de-leverage. From this perspective, the Federal Reserve’s Quantitative Easing (QE) programme and Operation Twist have had little impact.
“This suggests that cash buyers are driving the revival in the housing market. So, whilst QE may not be stimulating stronger borrowing, it is helping to drive investors out of low yielding cash and bonds and into higher yielding assets such as property. Such a portfolio balance effect was mentioned by Fed chairman Ben Bernanke in his assessment of QE at Jackson Hole.
“For a revival in mortgage lending we will probably need to see a sustained rise in house prices as negative equity is one of the key factors holding back the willingness and ability to take on more debt. House prices have fallen significantly in the US, with the mortgage value exceeding the value of their property.
“In a recent report, CoreLogic (a US data and analytics company) suggest that the number of residential properties in negative equity at the end of the second quarter was 10.8 million (22.3%), down from 11.4 million (23.7%) at the end of the first quarter. The report added that around 1.3 million households have moved out of negative equity since the beginning of 2012, although 2.3 million remain in “near-negative” equity (less than 5% equity in the property). For these homeowners the incentive is to pay down debt before looking to borrow again.
“However, although negative equity is a drag, there is light at the end of the tunnel. The Case-Shiller index of house prices in 20 cities has been rising since February and the sales to stock ratio suggests that further house price gains are in store - an outcome which would ease the burden of negative equity.”
Fiscal headwinds: watch out for the multiplier
“Stronger housing will help lift growth, but in judging the outlook for the wider economy we need to assess the impact of the impending tightening of fiscal policy. Whilst we expect the US to avoid the fiscal cliff with a deal being achieved in Congress before year end, we are still looking for a tightening of fiscal policy of 1.5% in 2013. This is still substantial and will weigh on activity, particularly in the first half of next year.
“The impact of fiscal austerity on growth has attracted increased focus following the disappointing performance of countries pursuing austerity policies. In their latest outlook for the world economy, the IMF find a strong relationship between countries falling short on their growth forecasts and the degree of fiscal tightening implemented. This does not seem to be due to other factors (such as increased financial market stress, systemic banking problems or current account imbalances) indicating that the effect of tighter fiscal policy is stronger than in the past. For example, most econometric models assume a fiscal multiplier of 0.5 (i.e. for every 1% of GDP tightening in fiscal policy, GDP growth is half a percentage point lower) whereas recent behaviour is consistent with 0.9 to 1.7.
“In many respects this is not surprising as the principal counter to tighter fiscal policy is monetary stimulus through lower interest rates. In the current environment, with policy rates close to zero and an impaired transmission mechanism from monetary policy to the economy, this offset is weak.
“In addition with several countries currently tightening fiscal policy together, external demand is also likely to be weak, so limiting the ability of the economy to grow through the export channel. This effect is often enhanced by a fall in the exchange rate of the country tightening fiscal policy, an effect which is likely to be muted or even absent when several countries are tightening their budgets simultaneously.
“This suggests that even with a fiscal tightening of 1.5% of GDP, the US economy will struggle to grow much above 2% in 2013 and the outcome could be worse.
“We review our outlook for global growth next month and evidence of a strengthening housing market could lead to an upgrade to US growth forecasts. However, whilst we are encouraged by stronger housing, its impact pales in comparison with the approaching headwind of fiscal tightening. Even if the US dodges the fiscal cliff, recent evidence suggests that higher taxes and cuts in public spending can be a more significant dampener on growth than in the past.
Impact of Hurricane Sandy
“In addition we are currently assessing the damage of Hurricane Sandy that has hit the US Eastern coast. The disruption to activity is likely to mean a significant impact to growth in the fourth quarter, followed by a rebound in the first quarter from reconstruction activity.”
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