Week in Review
The S&P 500 put up strong gains into the holiday and finished up 2 percent for the week. This quarter has been marked by the return of volatility with the market posting daily gains or losses in excess of 1 percent on 22 different occasions. To put this in perspective, there were just eight of these instances in all of 2017. Similarly, the S&P finished the quarter down 0.75 percent, the first negative quarter since the summer of 2015. Despite the recent volatility, the continued whirlwind of melodramatic headlines out of Washington D.C. and nascent signs of increasing inflation, corporate earnings and the global economy remain on solid footing. In fact, with earnings expectations rising and the market relatively flat, stocks are 9 percent less expensive than they were to start the year.
There's No Place Like Home
While the recently enacted Tax Cuts and Jobs Act fattened the pockets of consumers and corporations alike, the legislation was not as friendly to the housing market. First, the cap on mortgage interest deductibility was decreased from $1,000,000 to $750,000 which lowers the tax shield provided by financed homeownership. Additionally, a $10,000 maximum was placed on the deductibility of State and Local taxes, including property taxes which again decreases the homeowners tax shield. The standard deduction for joint filers was increased from $12,000 to $24,000. This increase will cause fewer taxpayers to itemize their taxes which decreases the attractiveness of switching from renting to owning a home. Add higher interest rates to the equation and the mosaic for the housing market might look gloomy in comparison to an otherwise robust U.S. economic backdrop. In fact, economic data on the U.S. housing market has been choppy so far this year. Existing home sales, building permits and housing starts, all indicators of the health of the housing market, have come up short relative to expectations. However, arguably the most important housing indicator, home price appreciation, continues to increase and has done so at an accelerating pace in recent months.
To better understand these mixed signals, we look at the supply and demand picture. If housing starts and turnover are weak and home prices are declining (or increasing at a slower rate) it would suggest that demand is weakening, a bad omen for the broader economy. If starts and turnover are strong and home prices are stable it says that demand is solid and there is ample supply in the marketplace. Yet, the current backdrop of soft starts and turnover against accelerating price appreciation shows that strong demand is coupled with an undersupply of new homes and existing homes for sale.
Demand is increasing for a variety of reasons. First, unemployment is sitting at generational lows. More jobs mean a greater number of people can afford a home. Next, consumer confidence is at its highest level in almost 15 years. It takes confidence to buy a home. While the tax code is less friendly to the housing market, it did increase paychecks, thereby increasing affordability. Lastly, millennials are finally moving out of “mom’s basement.” This can be seen by the inflection in the homeownership rate which has been declining for the greater part of 15 years (chart below).
As for weak supply, permitting has become more burdensome for homebuilders which lowers the attractiveness of building low-end homes. Last year’s tariffs on imported lumber have also made it more expensive to build. The flipside of low unemployment is that there is a shortage in the supply of construction labor, making it more difficult for builders to source jobs at a reasonable price. Perhaps most importantly, builders have not forgotten the housing crisis a decade ago and have been more conservative in their decisions to start new developments.
Taking this all together, soft housing data to begin the year is not a demand issue but rather a supply issue. This is comforting when evaluating economic prospects. Increasing prices and strong housing demand argues that the positive effects of low unemployment, high consumer confidence and an inflection in homeownership are easily overcoming the marginally negative changes in the tax code and higher interest rates. Eventually, increasing prices will give home builders the confidence needed to generate adequate supply and bring the housing market into balance.
Takeaways for the Week
- For the first time since the third quarter of 2015, the S&P 500 posted a negative return
- The U.S. housing market remains on solid footing