Sheltering a Storm

Wednesday's data show real estate growth continues to outstrip its foundation.
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April's surge in new-home sales and improved orders for durable goods trace a familiar pattern. Growth in the housing sector is outstripping the rest of the economy, promising more leveraged consumption.

The latest tally of new orders for durable goods -- products such as airplanes, automobiles and washing machines -- showed an expected rebound from a weak March. Economists point out that this year's early Easter contributed to the noise.

Orders rose 1.9% in April, above most economists' forecasts, which ranged from a gain of 1.3% to 1.5%. Transportation equipment, led by nondefense aircraft and parts, showed the biggest increase. Ex-transportation, new orders fell 0.2%, below the consensus for a 1% gain. Meanwhile, March's core number was revised to a 0.2% gain from a 0.1% drop.

After ironing out the Easter quirks, the trend points to flattish orders, says Ian Shepherdson, chief U.S. economist at High Frequency Economics. The report confirms weakness seen in manufacturing activity as evidenced in the April survey of the Institute for Supply Management, as well as the surveys in the Philadelphia and New York regions.

"We expect no near-term improvement," says Shepherdson. "The soft patch is not over."

But with the strong rebound seen in April employment and retail sales, whatever impact soaring energy costs may have had on the economy in the first four months of the year seems to have been weathered fairly well. The return of interest rates to a more neutral level can in itself explain slowing growth.

"Clearly, the nation's industrial base has come off its highs and now growth is much slower," says Joel Naroff, president of Naroff Economic Advisors. But the recent batch of strong, or semistrong data, shows that the economy is not "sliding backward," he says. "It is still growing, but more moderately."

Based on recent data, the

Federal Reserve

can therefore safely continue raising rates without risking breaking the back of an economy that's been made too soft by soaring energy prices.

Moderation, however, has a different meaning for the housing sector. New-home sales rose less than expected in April, adding 0.2% in the month to a seasonally adjusted annual rate of 1.316 million homes. The number was below expectations for a rise to an annual rate of 1.328 million. Still, it's the highest rate on record.

Then, the details: Sales surged 37.2% in the Northeast, a small market; and rose 2.8% in the West. They fell in the South and the Midwest. As even Fed Chairman Alan Greenspan has noted, there is, at the very least, "a little froth" in the real estate market.

On Tuesday, existing-home sales rose to a record 7.18 million units in April, up from 6.87 million in March, and above consensus forecasts of 6.90 million. And the median price for existing homes is up 15.1% from last year, marking the largest price appreciation in nearly 25 years.

According to many economists, housing demand and prices are well above what demographic trends should support, a clear sign that the historically low interest rates of the past few years are fueling excess.

"A correction in housing activity, meaning sales and ultimately construction, is therefore inevitable," says Goldman Sachs economist Ed McKelvey. So far, the supply of homes remains fairly tight, and inventories of unsold homes are low, which "do not suggest that the correction is imminent."

But "when it comes, it could be a doozie," McKelvey says. Soaring home equity has been a cash cow for Americans, spurring a consumption binge that began in 2002. And that leverage is getting increasingly extended through interest-only and variable-rate loans that could come back to bite the consumer as rates increase.

According to McKelvey, decreases in residential investment together with the hit to consumer spending could take away up to 3% of GDP growth, 50% more than the aggregate value of the 2001 and 2003 income tax cuts.

Maybe that's what the flattening yield curve of the bond market is predicting for 2006.

Regardless, the Fed must continue raising rates just to bring them back to around 4%, considered a neutral level. If not, it risks encouraging further asset-based inflation not only in housing but also in commodities. The low interest rates of the past few years have underpinned dollar weakness, which in turn have helped fuel commodity-price increases.

Some of the Fed's hawks believe commodity-price inflation and other asset-based inflation warrant further rate hikes in and of themselves.

Chicago Fed President Michael Moskow indicated that much in a speech Tuesday night.

"We still have more ground to cover," Moskow said. "Otherwise, we risk that some of the increased pressure we have seen recently from higher costs for energy and other items will become permanently embedded in the inflationary mentality of firms and households."

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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