Monday, November 26, 2007

The "R" Word

LA At Night, Wikipedia
With the S&P 500 falling one hundred points off its September high, a growing number of economists are warming up to the idea of a US based recession. The other more optimistic portion continues to place faith in an esoteric soft landing where the economy becomes sluggish, nearly stagnant, while remaining free from the grasp of an actual recession. Although this is an enticing idea in theory, emerging circumstances deem it highly unlikely. What is more realistic is the likelihood of the US's first consumer lead recession in nearly two decades.

The primary risk for our economy is the imploding housing market. Since its peak in early 2006, home builders, lenders and those directly connected to the market have felt the pain. This has lead to housing starts falling by 47% and home prices by 8% (inflation adjusted). Compared to the nearly 100% (adjusted) price appreciation seen from 2006-1997, it would appear as though the housing market has much farther to fall before we witness a true correction. Given the magnitude of unsold homes and tremendous backlog of residential construction, it becomes apparent that construction investments and prices must fall further to become rebalanced for supply.

For the housing market to affect the overall economy, its retraction must influence consumers' spending habits. Consumers spending patterns are affected by employment, financial wealth and housing wealth, just to name a few. According to The Economist, consumers are more influenced by changes in housing wealth; although it normally takes longer to materialize. "A $100 fall in financial wealth is traditionally associated with a $3-5 decline in spending. An equivalent fall in housing wealth, it seems, eventually reduces spending by between $4-9." When we take note of the wealth amassed within America's residential housing, a 10% reduction over the next few years will eventually equate to a sizable reduction in consumer spending.

This delay might be a result of the perceived value of a home by consumers. According to The Economist, "house prices are often sticky as homeowners are slow to acknowledge their houses are now worth less." Unlike the modern equities markets which reflect price changes rapidly, the price of a home is slower to react to supply and demand imbalances. Ultimately, this leaves us with a growing number of consumers realizing their housing wealth is decreasing. Even worse off are the speculators, laden with debt and dependent on continuous residential price appreciation. With the housing market in ruin, these flippers are left with mortgage calls, absentee buyers and properties they can't afford. While the housing sector has noticeably begun to unravel, its eventual effect on consumer spending habits has yet to be witnessed. Given that 70% of GDP is comprised by the consumer, a serious reduction in their spending will have profound economic reverberations.

45 comments:

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