Housing prices in many of the biggest U.S. cities are overheating, laying the groundwork for a dangerous house-of-cards scenario where even a small dip in prices could significantly slow economic growth and hurt profits, according to a report from Merrill Lynch & Co.
"Since more people own a home than a stock, and because so much of the activity is leveraged... the consequences of even a small decline in home prices could be just as severe as the fallout we saw in stocks back in 2000-2001," said David Rosenberg, the chief North American economist for Merrill Lynch in New York.
Mr. Rosenberg said that "even small incremental shifts in interest rates and home prices this cycle could result in some destabilizing economic and financial conditions."
Citigroup Smith Barney senior economist Steven Wieting, however, pointed out in a note to clients that many things appear more rational in housing-related industries than in previous housing-and non-housing related bubbles.
"Ex-tech, U.S. growth could be described as rather weak in the late 1990s. The U.S. economy today is not so weak ex-housing," he said Monday. Components of housing supply have grown at rates implying "unusual caution."
Housing prices have shot up 40 per cent since the U.S. central bank started to cut rates in 2001, the Merrill report said. The housing boom has been fuelled by record-low interest rates and a proliferation of accessible "buy now, pay later" mortgage products.
During that period, real estate prices have fallen out of touch with income growth, and over 30 per cent of U.S. households are spending about one-third of their income on mortgage payments, according to the Merrill Lynch report.
Federal Reserve Chairman Alan Greenspan recently said that the U.S. has no national housing bubble, but there are "signs of froth in some local markets."
But according to Mr. Rosenberg, the overheated U.S. "metro bubbles" make up enough of the national economic activity that a drop or slowdown in prices would have a serious impact.
"Since the U.S. economy has become so dependent on the housing market IV-drip," even a levelling off in housing prices would potentially shave GDP growth by almost half a percentage point in 2005, to 2.9 per cent from 3.3 per cent, and by more than a full percentage point in 2006, to 2 per cent from 3.1 per cent, Mr. Rosenberg said. A 10-per-cent drop in housing prices would put the U.S. economy into a recession-type environment.
If the pace of rising house prices slowed to 0 from 15 per cent in the next six months, consumers would trim discretionary spending, reign in their consumption of services, home-building related sectors, and consumer discretionary sectors.
The U.S. personal savings rate would rise to 2.4 per cent instead of 1.8 per cent from its current level of 0.8 per cent, as households realize the need to save more out of current income rather than tapping into notional home price appreciation, Merrill said.
Corporate earnings would also take a hit, with per-share earnings growth falling by 0.5 per cent this year and 1 per cent next year, the report said.
In the United Kingdom, where housing prices have receded in the last year, Mr. Rosenberg said that shares of banks and retailers have lagged the broader equity market. "So these are sectors to watch out for — the former benefited from the credit growth associated with the housing bubble and the latter was bolstered from the now-defunct wealth effect."
The Merrill Lynch research found that more than half of the 52 largest U.S. cities show signs of overheating, with housing prices outstripping personal income gains by at least one deviation above normal, the Merrill report found. Using that same price-to-income ratio, the report found that almost one-third of the cities were white hot, at least three standard deviations from the non-bubble average.
For example, housing prices in Miami have soared 85 per cent since the start of 2001 and 21 per cent in the first quarter of 2005, the Merrill report found. It noted that home price inflation has outstripped per capita income growth, which averaged around 3 per cent early this year, suggesting a significant deterioration in housing affordability.
© The Globe and Mail
Only GlobeinvestorGOLD combines the strength of powerful investing tools with the insight of The Globe and Mail.
Discover a wealth of investment information and and exclusive features.
