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“I don’t want to be too sophisticated here, but 2007 is going to suck, all 12 months of the calendar year. Our future is not as bright as what we would like it to be.”
— D.R. Horton, Chief Executive Officer, Donald Tomnitz

It’s not often that one gets such candor from a CEO. But the question that the current state of the housing market begs is: Will housing bring down the economy?

The current housing market is repeatedly called a “bubble” in the business press. Unlike Internet bubble stocks, people still need housing and the demand for housing continues to grow. Population growth creates the need for 1 to 1.2 million new units. Tear-downs and depreciation add another 300K to 500K units, and second-home buying can add another 200K to 400K units or more each and every year. Even in a weak demand year, that adds up to 1.5 million units, and in a strong year, more than 2 million.

There are a lot of reasons why home prices have been rising in this decade. Demographics remain favorable, financing is still cheap, land-use restrictions continue to tighten, second-home buying continues to rise, and urban gentrification is making for better neighborhoods. All of these have to do with the fundamentals of supply and demand.

Why Housing Won’t Sink the Economy
While the action in housing prices in no way resembles a bubble, housing nonetheless has been hurting over the past year. Overbuilding and a slowdown in home sales due to higher interest rates and tighter lending standards have created an overhang of unsold inventory. Housing starts have fallen more than 30 percent. Home price appreciation has slowed and, by some measures, has declined. Both new and existing home sales are down.

Declines in housing construction in the past have been an early warning sign of a pending recession in the broad economy. Over the past year, the declines in home construction have taken 1 percent off of top line GDP growth. That loss has slowed real GDP growth from the 3–3.5 percent range down to the 2–2.5 percent range. It means that the economy is more at risk for a recession, but by itself, not enough to cause a recession.

At its peak, home construction made up a little more than 6 percent of GDP. To get a full-blown recession, the problems in housing have to spill over into some other sector of the economy. The most likely candidate for that spillover is the consumer. Making up 70 percent of GDP, any loss of consumer spending could take the economy down.
One of the remarkable characteristics about American consumers is that if you give them cash, they go out and spend it. Real consumer spending has not declined on a quarterly basis since the fourth quarter of 1991. Through currency crises, government shut-downs, natural disasters, stock market meltdowns, accounting and financial scandals, terrorist attacks, and real recessions, American consumers continued to spend. As Morgan Stanley’s chronically bearish Stephen Roach has pointed out:
“The forecasting landscape has long been littered with carcasses of those who have been dumb enough to bet against the American consumer. From time to time, there have been unconfirmed sightings of my skeletal remains in that heap.”

Much is made of the wealth effects of falling housing prices and the loss of refinance money. Refinance activity peaked in the fourth quarter of 2005 and has declined by half since then. Real consumer spending has slowed, but continues to grow at a 3.5 percent clip. Refi could go to zero, but even if that did happen, it is not likely to have much more of an impact on consumer spending than it already has, which is very little.
Declining home prices could make consumers feel poorer and, through a wealth effect, dampen spending. However, back in 2001-02, when household wealth really did decline following the breaking of the NASDAQ bubble, consumers continued to spend. And so far, despite the worries of the bubbleheads at places like iTulip, household net worth has risen by some $5 trillion since mid-2005.

Employment and Real Wage Growth
% Change, Year-to-Year


Source: U.S. Department of Labor

What will keep consumers spending is cash flow. Right now, consumer cash flow is getting a dual boost from the somewhat unusual combination of steady employment growth and rising real wages.

Conclusions and Observations
No business cycle lasts forever and the current one will be no different. In the middle of the expansions of the 1960s, 1980s and 1990s, the Federal Reserve tightened credit policy to dampen inflation. Interest rate-sensitive sectors of the economy in general and housing in particular slowed. The weakness in economic growth allowed the Fed to ease policy, producing a jump in the stock market and several more years of growth.

While a recession at this point in the business cycle cannot be ruled out completely, given the strength of the labor market and consumer spending, continued slow growth in the economy seems the most likely outcome.

For retailers, the challenge ahead will be balancing the increase in labor costs against a more modest rate of revenue growth. Pressures on margins and profit growth can only increase under these conditions.