- The average rate on the 30-year mortgage has risen above 6.00% in response to the latest hike in the Fed Funds target rate. Freddie Mac’s Primary Mortgage Market Survey pegged the average rate at 6.29% this week.
- The CME’s Fed Watch tool now shows a 73% probability of a 75 bp rate hike and a 27% probability of a 50 bp hike in November. FOMC participants expect the Fed Funds target to rise to about 4.40% by year-end, which is a 125 bp increase from the current level. That could be achieved with increases of 75 bp in November followed by 50 bp in December. Incoming economic data will influence the Committee’s decisions.
- After outperforming the broader market from early April to early August, homebuilding stocks have since underperformed. Since the mid-August highs, my Index has fallen 17.5%, worse that the 13.7% decline in the S&P 500 and the 16.7% decline in the Russell 2000. The Index is still holding at the “possible support” range, but just barely. Like the broader market, homebuilding stocks have now fallen back to their June lows. A break below this level could signal another consequential downward move.
- In spite of the FOMC’s rate hike and the rise in mortgage rates, homebuilding stocks outperformed the broader market last week. My Index declined 2.7%, less than the drops of 4.7% in the S&P 500 and 6.6% in the Russell 2000. About half of the decrease in the Index was due to steeper drops in Beazer Homes USA (BZH) and Hovnanian Enterprises (HOV), both of which are more vulnerable to rising interest rates owing to their higher debt levels. D.R. Horton (DHI) and Lennar Corp. (LEN) were up on the week. NVR and PulteGroup (PHM) slipped about 0.5%. This performance is encouraging but not definitive.
- Last week, KB Home (KBH) reported fiscal 22Q3 diluted EPS of $2.86, up from $1.60 last year and better than Street views of $2.67. Housing revenues increased 25.8%, with unit deliveries up 5.5% and average prices up 19.2%. Deliveries were slightly below implied guidance, due to extended construction times and ongoing supply constraints. Delivery delays will likely continue in 22Q4. The average delivery price and gross margin exceeded expectations. New unit orders fell 50%, as KBH held prices, except in underperforming communities. Order cancellations were up, but below historical averages. The average order price declined 2.4% YOY and 11.6% sequentially, but this was due mostly to a mix shift, including the non-repeat of sales of million-dollar homes in California. KBH has been adhering to its build-to-order approach, focusing on providing the best overall value and features that are important to its customers. Buyers are opting for lower-priced floor plans and fewer options. The company’s high backlog should support its financial performance through mid-fiscal 2023. Going forward, KBH will adjust pricing as necessary to preserve its backlog and achieve minimum absorption rates to optimize its investment returns. The company has slowed new community openings, waiting until models are completed to better support its sales efforts. It has also slowed the pace of land purchases.
- Lennar Corp (LEN) reported fiscal 22Q3 diluted EPS of $5.03 (which included $0.15 of mark-to-market losses on technology investments and other one-time items). That compares with $4.52 in 21Q3, and the consensus estimate of $4.86. Housing revenues increased 30%, with deliveries up 13.5% and average selling price up 14.4%. Both gross margin and operating margin improved. New orders declined 11.7%, but the average order price increased 1.2%. Demand has cooled from the unsustainably high levels of the past two years, but sales are still possible when price and financing cost produce an affordable monthly payment. Lennar is reducing prices and increasing incentives as necessary to attract buyers. It strives to maintain a steady construction pace, so it will adjust prices, incentives and other variables in its product offering market-by-market to ensure that demand matches production. As with KBH, LEN is taking a sharp pencil to land transactions so that it can achieve acceptable returns under current market conditions.
- Key measures of housing sales and production were mostly down once again in August, but there have been a few positive (though modest) surprises. Last week, the Commerce Dept. reported that the seasonally adjusted annualized pace of single-family housing starts increased by 3.4% in August to 935,000 units. The estimate is still subject to revision. If it holds, it would be the first increase since February and only the second this year.
- Existing home sales, as estimated by the National Association of Realtors, slipped by only 0.4% in August (from July) to a seasonally adjusted annualized pace of 4.80 million units.
- Fannie Mae’s consumer-focused House Purchase Sentiment Index (HPSI) decreased by 0.8 points to 62.0 in August, its sixth consecutive monthly decline. Yet, the percentage of consumers saying that now is a bad time to buy declined to 73% from 76%.
- August’s favorable reports on existing sales and the HPSI dovetail with the market commentary from several homebuilders. In August, a surprisingly positive July CPI headline reading raised hopes that the Fed would soon be able to slow the pace of rate increases. That sparked a modest downshifting of the Treasury yield curve and a 50 bp decline in the average 30-year mortgage rate to around 5.00%. The mortgage rate had been as high as 5.80% in June. The decline in mortgage rates brought buyers back into the market. Those builders whose fiscal third quarters ended in July (TOL and HOV) and August (KBH and LEN), said that after a big drop in June, the pace of their sales improved steadily in July and August. They also noted, however, that sales have fallen back in September, as mortgage rates resumed their upward climb. With the recent move in the mortgage rate well above 6%, it seems likely that both existing and new home sales will slow further in October and quite possibly through the end of the year.
- New home sales are down 16.1% YTD through July. August new home sales, which will be reported on Tuesday, may be better than anticipated, but sales for the balance of the year will likely be lower, due to the recent and expected future rise in mortgage rates.
- The NAHB/Wells Fargo Housing Market Index (HMI), a measure of homebuilder sentiment, fell again in September, by three points to 46 and remains below the neutral level of 50.
- With the FOMC dot plot estimates now point to a 4.40% Fed Funds rate by year end and 4.60% by the end of 2023, I am raising my estimate of the potential peak in the 30-year mortgage rate to 7.25% (from 6.75% previously).
- Despite those dot-plot estimates, inflation may fall faster than currently anticipated, which could cause the Fed to slow its rate increases sooner. The market reacted very negatively to the August CPI report which showed a year-over-year increase in inflation of 8.3%, with food up 11.4%, energy up 23.8% and all items less food and energy (the so-called core) up 6.3%. Yet, on a month-to-month basis, the headline CPI (all items) declined 0.04%. This was the second consecutive monthly decline, driven by a 6.2% decline in energy costs. To be sure, there were some notable areas of concern, with food costs rising 0.76% (9.5% annualized) and the core rising 0.51% (6.3% annualized). Shelter costs increased 0.66% (8.2% annualized) and medical costs rose by 0.80% (10.0% annualized).
- Nevertheless, with the prices of most commodities still well below their Spring highs and some continuing to fall, inflation still looks like it will recede in the months ahead. The rise in food costs is worrisome, but the month-to-month increase was the lowest so far this year. The Reuters/Jeffries CRB Index, a broad-based measure of commodity prices, declined 3.7% last week and is now down 18.5% since early June. A wide range of commodities – including coffee, copper, gasoline, gold, crude oil, heating oil, lumber, natural gas, silver, sugar – remain well below their mid-year highs. Last week’s 9.9% in natural gas futures (the near-term contract) is especially noteworthy, because natural gas, which is used in many industrial processes, is a key leading indicator of inflation.
- There are, of course, other drivers of inflation, including supply chain disruptions and wage increases. Ongoing supply chain disruptions are due in part to labor shortages in manufacturing and transportation. Although delivery delays are expected to continue, they have subsided in many parts of the country this year. Labor cost increases could continue for some time, as workers lobby to recover increases in living costs; but if commodity costs continue to recede, there may be less upward pressure on wage rates over time.
- Rising shelter costs have also been a steady contributor to CPI inflation over the past couple of years. I believe, however, that the CPI’s measures of shelter costs (and especially its methodology for determining owners’ equivalent rent (OER)) is flawed and therefore is not indicative of the true impact of rising housing costs on the majority of homeowners. (For example, since less than 10% of the housing stock changes hands in any given year, the majority of the remaining 90% or so of households that either own their home outright or have financed it with fixed rate mortgages do not experience any inflation in housing costs, except perhaps for property taxes and insurance.) Furthermore, since calculations of rental costs and OER incorporate an effective six-month smoothing mechanism, they record price changes with a lag; so the recent mostly anecdotal evidence that for-sale house prices and apartment rental rates have moderated may not show up in the CPI for several months.
- Although the evidence that inflation is receding continues to grow, events could still change the outlook. Chief among these is the war in Ukraine and the impact that it has had and may continue to have on both energy and food prices. The worldwide drought experienced in many parts of the world this summer has led to increases across a range of agricultural commodities, including corn, soybeans and wheat. But so far at least, those increases have been modest, and prices remain well below the Spring highs.
- With this latest 75 bp rise in the Fed Funds rate, the Treasury yield curve has shifted higher and become more inverted. The spread between the 2-year and 10-year Treasury yields has nearly doubled from 27 bp to 51 bp over the past five weeks, indicative of an elevated risk of a hard landing for the economy. Despite worries about the persistent strength of job creation and inflation, the three-month moving average of monthly payroll increases has fallen from 602,000 in February to 378,000 in August. Headline CPI has declined 0.05% over the past two months. Thus, the economy already seems well on its way to slowing. Since monetary policy operates with a lag, the rate increases of the past few months will almost certainly lead to a further slowdown in the months ahead. As a result, the FOMC would be well advised to pause its rate increases before the target rate reaches 4.00%.
- At current levels, the 12 homebuilding stocks that I follow are trading at an average multiple of 3.4 times estimated 2022 consensus earnings and 4.3 times projected 2023 consensus earnings. Earnings estimates may still decline by a modest amount for 22H2 and the full year 2022; while projections for 2023 are still vulnerable to a more consequential decline. However, current valuation levels already discount a more significant decline in earnings.
- Most homebuilders seem reasonably well-positioned to cope with a pullback in housing sales to or near pre-pandemic levels. They are adjusting their go-to-market strategies to preserve their backlogs and sustain sales as much as possible. They are also taking steps to limit their fixed exposures by slowing land purchases and underwriting new land deals at higher hurdle rates. With the contraction in the housing market, selling prices will likely fall back from recent highs. While there may be partial offsets from falling materials costs and further cuts in operating expenses and overheads, it is likely that profit margins will come down. If the economy achieves a soft-landing, this could result in a temporary earnings setback that would reverse when the economy and housing market begins to recover.
- If the FOMC continues to raise interest rates as suggested in its Summary of Economic Projections with the Fed Funds target rate rising to 4.40% by year-end 2022 and 4.60% by year-end 2023, then it is likely that housing sales and production will fall more significantly in the months ahead. In that case, homebuilding stocks will likely follow the housing market and the stock market lower. On the other hand, if inflation is on the verge of receding, as I anticipate, then the FOMC may decide to pause, which could limit the damage to housing and the economy. The next key data points will come on September 30, with the Personal Income and Expenditures report (and its Personal Consumption Expenditures price index, which is the Fed’s preferred measure of inflation)[1]; on October 7, with the September payrolls report, and on October 15, with the September CPI report.
Table 1
Selected Economic and Housing Market Statistics: 2019-2023F
| 2019 | 2020 | 2021 | 2022F | 2023F | |
| Nominal GDP ($B) | 21,373 | 20,894 | 22,996 | 24,146 | 25,353 |
| % Change | 4.1% | -2.2% | 7.0% | 5.0% | 5.0% |
| Real GDP ($B of chained 2012 $) | 19,033 | 18,385 | 19,427 | 19,330 | 19,523 |
| % Change | 2.3% | -3.4% | 5.7% | -0.5% | 1.0% |
| Existing home sales (000s) | 5,340 | 5,640 | 6,120 | 5,233 | 4,814 |
| % Change | 0.0% | 5.6% | 4.1% | -14.5% | -8.0% |
| New home sales (000s) | 681 | 821 | 771 | 649 | 604 |
| % Change | 10.4% | 20.6% | -6.1% | -15.8% | -7.0% |
| Total home sales (000s) | 6,021 | 6,461 | 6,891 | 5,882 | 5,417 |
| % Change | 1.1% | 7.3% | 6.7% | -14.6% | -7.9% |
| Under construction | 520 | 606 | 770 | 811 | 604 |
| SF housing starts | 888 | 991 | 1,127 | 1,032 | 928 |
| % Change | 1.4% | 11.5% | 13.8% | -8.5% | -10.0% |
| UC / SF starts | 0.59 | 0.61 | 0.68 | 0.80 | 0.65 |
| UC / new home sales | 0.76 | 0.74 | 1.00 | 1.25 | 0.95 |
| House prices | |||||
| Existing median ($) | 271,800 | 296,700 | 347,100 | 371,397 | 356,541 |
| % Change | 4.8% | 9.2% | 17.0% | 7.0% | -4.0% |
| New median ($) | 321,500 | 336,900 | 397,100 | 401,071 | 385,028 |
| % Change | -1.5% | 4.8% | 17.9% | 1.0% | -4.0% |
| Case-Shiller National NSA ($) | 212,283 | 234,430 | 278,681 | 301,254 | 289,204 |
| % Change | 3.7% | 10.4% | 18.9% | 8.1% | -4.0% |
Sources: Census Bureau, BEA, S&P, NAR and Lark Research projections.
[1] The PCE price index declined 0.07% in July, consistent with the CPI’s 0.01% decline.
September 26, 2022
Stephen P. Percoco
Lark Research
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