The Early Stages of a Downward Spiral

The U.S. economy is in the early stages of a downward spiral that is going to take significant government intervention to avoid double-digit unemployment rates, as occurred in the early 1980s. The stock market has certainly opined on how tough the outlook is for all businesses.

At the ULI Fall Meeting two weeks ago, American economist and former Fed Chairman Paul Volcker mentioned several times that this is the most complicated downturn he has witnessed. In our opinion, the root of the problem is falling home prices, which is leading to massive bank and investment losses, which is shutting down capital flow, which leads to job losses, which leads to more foreclosures and thus falling home prices, etc., etc., etc.

The mission statement for the Treasury includes “promoting economic growth and stability,” and the mission statement for the FDIC includes “maintains the stability and public confidence in the nation’s financial system.” Notice that “stability” is the common thread here. If these two government agencies are to complete their missions, more investment will be needed to encourage home buying, which will have to start with a growing employment base.

Economic Growth…………………………………………………………………..D+
The economic growth indicators continued to erode this month. Real GDP growth dropped sharply in the third quarter, turning negative, to an annual rate of -0.3% from 2.8% in the second quarter. Meanwhile, inflation fell again this month, with the Full CPI now at 4.9% and the Core CPI (all items less food and energy) flat for the third consecutive month at 2.5%. The employment sector continued to weaken, as non-farm payroll job growth remained negative year-over-year for the fifth straight month, with nearly 1.2 million jobs lost in the last 12 months. Mass layoff events – job cuts of more than 50 jobs – have risen 74% year-over-year. The unemployment rate reached 6.5%, which is the highest level since March 1994. Consumer spending continues to decline despite the ramp-up of the holiday season, as the year-over-year change in retail sales turned negative for the first time in nearly 6 years, and the International Council of Shopping Centers reported the weakest October sales since at least 1969.

Leading Indicators………………………………………………………………..D-
Continued declines in the leading indicators suggest that economic instability is likely to remain the norm for the near term. Stocks were pummeled again in October amid global recessionary fears, with year-over-year losses of between 33-40% reported for all four major stock indices we track. Following record volatility in September, stocks continued to see-saw violently through the month of October, resulting in a temporary lock-down of the futures market on October 24th to prevent further panic. The days in November leading up to the presidential election saw a short pre-election rally, but gains were quickly reversed thereafter amid worries about joblessness and recession, sending the market to its biggest two-day slump since 1987. After some improvement during the summer months, home builder stocks fell sharply in October and were down 34% year-over-year. Crude oil prices continued to fall as the economic slowdown reduces demand, despite OPEC’s decision to cut production following a recent emergency meeting. The price of oil fell below the $100-per-barrel mark in mid-September amid heightened turmoil in the financial sector and has since fallen to a monthly average of $76.65 in October. The Leading Economic Index improved slightly from the previous month, but the negative growth rate of -2.5% suggests further weakness in the economy in the near-term. Manufacturing in the U.S. continues to decline, as evidenced by the steep drop in October’s Purchasing Managers Index to its lowest level since the early 1980s, indicating continued contraction not only in the manufacturing sector, but also in the overall economy.

Mortgage Rates…………………………………………………………………….B
Mortgage rates have risen after plummeting in early September following the announcement of the government rescue of Fannie Mae and Freddie Mac. By late September, rates had begun climbing. They reached 6.46% for 30-year fixed mortgages and 5.38% for 1-year adjustable mortgages by October month-end. The Federal Open Market Committee again lowered the Fed Funds target rate from 1.5% to 1% in late October following an emergency 50-basis point cut in the rate earlier in the month. The committee cited severe weakness in the economy as a reason for the rate slash and hinted at more cuts to come. The Mortgage Bankers Association reported a sharp decline in the share of ARM applications, bringing the rate to less than 2% in the last week of October – down from 4% in the last week of September. By comparison, ARM applications constituted more than 35% of total applications at their peak level.

Consumer Behavior………………………………………………………………….D
Consumer confidence continues to weigh heavily on the economy. Consumer confidence fell sharply to 38 in October after hovering at 50-60 points for most of this year and is down 64% from the year-ago level. Both the University of Michigan’s Consumer Sentiment Index and the Consumer Comfort Index also declined this month to near-record lows. While the dollar volume of equity per owned home remains relatively high, the debt percentage of home value (LTV) is at its worst level in history.

Existing Home Market……………………………………………………………….D
The existing home market remains anemic, although several components reported improvements for the month. The annualized existing home sales volume rose to 5.18 million transactions in September – the highest in more than one year – from 4.91 million in August, according to the National Association of Realtors (NAR). The spike in resale activity is largely due to an increase in heavily discounted foreclosure sales. The volume of pending home sales fell in September, but is up nearly 2% year-over-year. The supply of unsold homes shrank for the third straight month to 9.9 months of inventory. Improvements in the resale market were offset by continued declines in home prices, however. While the annualized rate of home price decline slowed in September, the median resale price continues to decrease from the previous month and has fallen nearly 9% year-over-year to $190,600, according to the NAR. The Case-Shiller Price Index also declined, showing an annual decrease in paired sales of more than 15%.

New Home Market……………………………………………………………………F
Conditions in the new home market remained mixed this month, but the overall health of the sector continues to be poor. Builder confidence descended to a new historical low, due largely to heavy declines in expectations for sales in the next 6 months. The median new home price fell for the fifth consecutive month and is down 9% year-over-year to $218,400. Despite falling consumer and builder confidence, the annualized sales volume rose 3% sequentially to 464,000 transactions in September. However, the current volume still represents a 33% year-over-year decline. We believe the increase in sales activity this month was attributed to the rush in home purchases ahead of the elimination of the Down Payment Assistance program on October 1. The rise in new home sales has further reduced inventory, which now stands at 10.4 months of supply.

Housing Supply…………………………………………………………………….F
The overall supply of new housing diminished, pushing housing supply to extremely low levels. While multifamily starts rose slightly from the previous month, single-family starts saw a steep drop, pushing down total starts to 817,000 units. Single-family and multifamily permits also declined, resulting in a 38% year-over-year drop in total permits. The annual volume of new home completions rose in September to 1.1 million units after dropping below 1 million in August, but is down 20% year-over-year. Meanwhile, total housing stock in the third quarter rose sequentially and is up nearly 2% year-over-year. The homeowner vacancy rate was unchanged and remains near a record-high level at 2.8% in the third quarter.

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