Contrarian View: Housing Slump WILL Affect Spending

Jeff, Just as we discussed today, here is something that showed up on Barrons that makes the point. Economists are almost always wrong, that is one thing I have learned. Notice how they acknowledge they were wrong in the short run, but still don’t concede they will also be wrong in the long run. This is the consensus, so the opposite is more likely to happen:


Housing Slump Won't Mow Down Spending

UBS Investment Research

WE CONTINUE TO EXPECT WEAKENING in housing to lead to a noticeable slowing in overall growth but not an economy-wide recession.

Our "soft landing" forecast counts on 100 basis points easing [of short-term interest rates] by the Federal Reserve in 2007, with the bond market likely to move ahead of the Fed. Ten-year Treasury yields have already dropped below 5%; we expect a 4.4% yield by the end of 2006.

Our forecast also reflects the expectation that the indirect effects of the weakening in housing, through slowing home prices and a decline in home-equity extraction, will be significant but not sizable enough to cause consumer-spending growth to weaken dramatically. The size and speed of such wealth effects are major sources of uncertainty, however.

Housing appears to be weakening even more than we expected and, on Aug. 18, we reduced our forecast for real Gross Domestic Product (GDP) growth in the second half of 2006 to a 2.0% annual rate, down from 2.5% (still no recession). We also trimmed our 2007 growth forecast to 2.4% down from 2.6% on a fourth-quarter-over-quarter basis (and to 2.2% down from 2.5% on a calendar-year average basis).

The auto sector also looks poised to be a near-term drag on GDP growth, although the drag appears to reflect more of a short-term inventory correction, with much less potential for sizable indirect effects, than the weakening in housing. We estimate that auto production will subtract about 0.5 point from annualized GDP growth in the second half of 2006.

We forecast a 100,000 rise in payrolls in the August report, consistent with some slowing in growth but no collapse. We expect the unemployment rate to reverse 0.1 point of last month's 0.2-point rise. In contrast to housing, growth in the manufacturing sector still looks solid; we expect the Institute for Supply Management index slipped to 54.0 from 54.8 in July. Core personal consumption expenditures (PCE) prices probably rose just 0.1% in July, keeping the change from a year ago at 2.4%.

We expect second-quarter real GDP growth to be revised up to a 3.0% pace from 2.5%, with much of the revision concentrated in inventories. The minutes to the Aug. 8 Federal Open Market Committee meeting will be released on Aug. 29.

By itself, that weakening in residential investment would not appear to suggest a significant risk of a broad recession. Historically, however, housing downturns have been associated with economy-wide recessions. Meanwhile, housing's indirect effects on growth appear to have been unusually large in the current cycle when housing was growing, raising the potential for more related weakness as housing contracts.

As with most issues in economics, there are plenty of points and counterpoints, and every cycle is different (This Time is Different, haven’t we heard that before!!??). The business sector looks strong financially, the broad stock market has shown resilience, inventories are reasonably lean, global growth looks healthy, the trend in core inflation is tame, and interest rates are not especially high.

The big question: to what extent will slowing in home prices cause consumer-spending growth to weaken? The sharp slowing in home prices raises the possibility that home-equity extraction (HEE) and the spending that has been financed by HEE will plunge in coming quarters. We estimate home-equity extraction totaled 7% of disposable income in the first quarter of this year.

We expect the slowing in HEE will be more gradual than the slowing in prices. We also believe the impact on household spending, which we define as consumer spending plus residential investment (which includes home-improvement construction) will be smaller than the decline in HEE.

Some of the surge in HEE has been used to pay off more-expensive credit-card debt or for investment in financial assets rather than for financing increased household spending. In round numbers, we expect housing's indirect effects on consumption, much of which is through HEE, to swing from adding about 0.5 percentage point to the rate of growth in spending to subtracting 0.5 point. This issue is a major source of uncertainty, however.

So far, consumer spending has shown no sign of dramatic weakening. Indeed, the latest retail-sales data were strong. Also, in the very near term at least, the drag on spending power from rising energy prices is likely to decline, thanks to the drop in gasoline prices in recent weeks. That said, we expect the weakening in housing to have enough of an impact on employment growth, as well home-equity extraction, to pull consumer-spending growth down to around a 2.5% trend from what was a 3.5%-4% trend until recently.

In gauging whether our forecast is on track, we will be especially focused on consumer- and labor-market data.

-- Maury N. Harris, chief U.S. economist
-- James O'Sullivan, senior U.S. economist
-- Samuel Coffin, U.S. economist

Contrarian View: Housing Slump WILL Affect Spending

Jeff, Just as we discussed today, here is something that showed up on Barrons that makes the point. Economists are almost always wrong, that is one thing I have learned. Notice how they acknowledge they were wrong in the short run, but still don’t concede they will also be wrong in the long run. This is the consensus, so the opposite is more likely to happen:

Housing Slump Won't Mow Down Spending

UBS Investment Research

WE CONTINUE TO EXPECT WEAKENING in housing to lead to a noticeable slowing in overall growth but not an economy-wide recession.

Our "soft landing" forecast counts on 100 basis points easing [of short-term interest rates] by the Federal Reserve in 2007, with the bond market likely to move ahead of the Fed. Ten-year Treasury yields have already dropped below 5%; we expect a 4.4% yield by the end of 2006.

Our forecast also reflects the expectation that the indirect effects of the weakening in housing, through slowing home prices and a decline in home-equity extraction, will be significant but not sizable enough to cause consumer-spending growth to weaken dramatically. The size and speed of such wealth effects are major sources of uncertainty, however.

Housing appears to be weakening even more than we expected and, on Aug. 18, we reduced our forecast for real Gross Domestic Product (GDP) growth in the second half of 2006 to a 2.0% annual rate, down from 2.5% (still no recession). We also trimmed our 2007 growth forecast to 2.4% down from 2.6% on a fourth-quarter-over-quarter basis (and to 2.2% down from 2.5% on a calendar-year average basis).

The auto sector also looks poised to be a near-term drag on GDP growth, although the drag appears to reflect more of a short-term inventory correction, with much less potential for sizable indirect effects, than the weakening in housing. We estimate that auto production will subtract about 0.5 point from annualized GDP growth in the second half of 2006.

We forecast a 100,000 rise in payrolls in the August report, consistent with some slowing in growth but no collapse. We expect the unemployment rate to reverse 0.1 point of last month's 0.2-point rise. In contrast to housing, growth in the manufacturing sector still looks solid; we expect the Institute for Supply Management index slipped to 54.0 from 54.8 in July. Core personal consumption expenditures (PCE) prices probably rose just 0.1% in July, keeping the change from a year ago at 2.4%.

We expect second-quarter real GDP growth to be revised up to a 3.0% pace from 2.5%, with much of the revision concentrated in inventories. The minutes to the Aug. 8 Federal Open Market Committee meeting will be released on Aug. 29.

By itself, that weakening in residential investment would not appear to suggest a significant risk of a broad recession. Historically, however, housing downturns have been associated with economy-wide recessions. Meanwhile, housing's indirect effects on growth appear to have been unusually large in the current cycle when housing was growing, raising the potential for more related weakness as housing contracts.

As with most issues in economics, there are plenty of points and counterpoints, and every cycle is different (This Time is Different, haven’t we heard that before!!??). The business sector looks strong financially, the broad stock market has shown resilience, inventories are reasonably lean, global growth looks healthy, the trend in core inflation is tame, and interest rates are not especially high.

The big question: to what extent will slowing in home prices cause consumer-spending growth to weaken? The sharp slowing in home prices raises the possibility that home-equity extraction (HEE) and the spending that has been financed by HEE will plunge in coming quarters. We estimate home-equity extraction totaled 7% of disposable income in the first quarter of this year.

We expect the slowing in HEE will be more gradual than the slowing in prices. We also believe the impact on household spending, which we define as consumer spending plus residential investment (which includes home-improvement construction) will be smaller than the decline in HEE.

Some of the surge in HEE has been used to pay off more-expensive credit-card debt or for investment in financial assets rather than for financing increased household spending. In round numbers, we expect housing's indirect effects on consumption, much of which is through HEE, to swing from adding about 0.5 percentage point to the rate of growth in spending to subtracting 0.5 point. This issue is a major source of uncertainty, however.

So far, consumer spending has shown no sign of dramatic weakening. Indeed, the latest retail-sales data were strong. Also, in the very near term at least, the drag on spending power from rising energy prices is likely to decline, thanks to the drop in gasoline prices in recent weeks. That said, we expect the weakening in housing to have enough of an impact on employment growth, as well home-equity extraction, to pull consumer-spending growth down to around a 2.5% trend from what was a 3.5%-4% trend until recently.

In gauging whether our forecast is on track, we will be especially focused on consumer- and labor-market data.

-- Maury N. Harris, chief U.S. economist
-- James O'Sullivan, senior U.S. economist
-- Samuel Coffin, U.S. economist