2016 – We’ll See…..

“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.” – Lao Tzu

As 2016 kicks off, I’m reminded of one of my favorite lines from the end of the film Charlie Wilson’s War, after the Soviets have been defeated in Afghanistan and are retreating:

On his sixteenth birthday a boy gets a horse as a present. All of the people in the village say, “Oh, how wonderful!”

The Zen master says, “We’ll see.”

One day, the boy is riding and gets thrown off the horse and hurts his leg. He’s no longer able to walk, so all of the villagers say, “How terrible!”

The Zen master says, “We’ll see.”

Some time passes and the village goes to war. All of the other young men get sent off to fight, but this boy can’t fight because his leg is messed up. All of the villagers say, “How wonderful!”

The Zen master says, “We’ll see.”

In the film, the Americans and allies are celebrating getting the better of their Soviet adversary through covert action and fail to understand that the power void in a nation torn apart by war will have dire consequences.

The parable is an illustration of the fact that what happens in the present may appear positive or negative at the time but the true impact cannot and will not be known until time passes.  The world is complicated and often maddening place.

Back in the crisis years, existing housing inventory ballooned to 12-months of supply, causing new home development and construction to grind to a virtual halt.  In the years that followed, new home starts remained low as distressed existing homes were gradually bought up, taking inventory off the market.  This altered the ratio of new to existing home sales that had been in place since the 90s, forming what Bill McBride of Calculated Risk coined “The Distressing Gap.”  New home sales have stayed at a depressed level ever since, recovering only modestly.

The initial marketplace response was that this was both a good and necessary trend since the market had to get back to the point where inventory was at a “healthy” level in order to set the foundation for a sustainable housing recovery. Well, the reduction in inventory happened.  The healthy recovery, not so much.

To get some more historical perspective, let’s take a look at what has happened to new single family home sales since the 1960s from Doug Short at Advisor Perspectives:

The level of new home sales in that graph is troublesome enough as it is.  However, the reality is worse since there were approximately 189MM people in the US in 1963 and approximately 301MM people in the US today. When you adjust for population, things look even worse:

“New single-family home sales are about 17% below the 1963 start of this data series. The population-adjusted version is 51.6% below the first 1963 sales and at a level similar to the lows we saw during the double-dip recession in the early 1980s, a time when 30-year mortgage rates peaked above 18%. Today’s 30-year rate is around 4%.” – Doug Short

The lack of new home starts and sales may have initially been seen as a positive since there was such a substantial amount of inventory overhang.  However, Americans have continued to form households over that period.  Multi-family starts have risen substantially, but are still a far cry from where they were in the 70s and mid-80s, when the population was much lower. On top of that, multi-family starts historically product less employment than single family starts.  To make matters worse, multi-family starts during the recovery have been highly concentrated at the high end:

The net result is that rents are soaring and home prices are way up, particularly in closed access markets like coastal California where exclusionary zoning makes it extremely difficult to add new units. Residential investment can be expressed in two ways: 1) It goes into starts which create new jobs, keep housing prices relatively stable and create economic growth; or 2) It goes to bid up existing assets, enriching landlords and homeowners while driving up real and imputed rents, creating a net drag on economic growth.  We are solidly in the 2nd column in California and it’s not much of a stretch to see how this leads to the income/wealth inequality so widely decried as a detriment to economic growth.

Conventional wisdom says that secondary housing markets like the better-located portions of the Inland Empire should boom when the coast experiences good job growth, soaring housing prices and quickly rising rents.  However, this time around it’s been strangely quiet as a combination of tight mortgage lending coupled with low FHA conforming loan limits, families waiting longer to have children, and a desire to live closer to employment areas keeps people clustered closer to the coast. The end result is a market defined by pressure: prices and rents continue to climb while creating few jobs through new development, perversely pressuring affordability and  economic growth at the same time.  I can’t imagine that any sane person thinks that the economy can continue to grow with new home sales below 1963 levels. Will 2016 be the year where sales (and for-sale starts) finally take off and pent up demand gets us back to normal again? Or will home prices and rents continue to climb, choking off economic growth, eating into savings and eventually leading to a recession? We’ll see……

By Adam Deermount, Managing Director