Shane Oliver, Head of Investment Strategy & Chief Economist

The US housing sector turning 1 or 2 Headingthe corner

EDITION 9 16 MARCH 2012

Olivers Insights
Key points
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While Bulletsits too early to call the end of the secular bear market in US shares, there are some signs of light in the US economy, notably in manufacturing, energy production and housing. In particular, after triggering the global nancial crisis, the US housing slump appears to be over and a recovery in prospect. This will help prolong the current US economic recovery, boost household wealth and over time and add to global commodity demand.

quietly bottomed and is now on the rise again thanks to a surge in shale oil production. The US has huge reserves of shale oil and advances in fracking technology (by which shale kilometres below the surface is fractured using explosives, allowing oil to be released and ow to the surface) and oil prices around US$100 per barrel are making it economic for these reserves to be tapped. Some even see the US becoming self sufcient in oil again in the decades ahead.

US housing bottoming
A collapse in the US housing sector was at the core of the subprime mortgage crisis in the US which subsequently morphed into the global nancial crisis. US house prices and housing construction surged into the middle of the last decade as lax lending standards underpinned a huge surge in home ownership. Boom turned to bust, starting around 2006 as housing supply started to surge and it became harder for sub-prime borrowers to renance their loans. Foreclosures rose, made worse in turn by rising unemployment as the whole process fed on itself. The subsequent slump has seen a 34% plunge in house prices. This has seen the volume of private residential investment collapse by about 60% from its peak in the mid 1990s, resulting in a huge drag on US gross domestic product (GDP) growth.

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Introduction
Starting with the bursting of the technology bubble in 2000, the fortunes of the US economy have waned. Since then, the US has seen two recessions with the last being the worst since the 1930s, a rising trend in unemployment, the bursting of a corporate debt bubble with the tech wreck and the bursting of a housing debt bubble with the sub-prime mortgage crisis. So its little wonder the US share market has been spinning its wheels in a secular bear market. Some commentators even talk of a permanent decline for the US. The high level of US public debt, ongoing private sector deleveraging, less business friendly policies, demographic trends and the absence of extreme share market undervaluation suggest the secular bear market in US shares may not be over yet. That said, it would be dangerous to write the US off. Many did this in the 1970s only to see it roar back with a vengeance in the 1980s and 90s. More importantly, there are some signs of light at the end of the tunnel for the US in manufacturing, oil production and housing. This note takes a look at these sectors, focusing on the latter as housing was the original driver of the global nancial crisis.

Why the worst is likely over for US housing

There are good reasons to believe that the US housing market is bottoming and starting to recover. The rst thing to note is that most US housing indicators have stabilised. Home sales have been bouncing along a bottom since 2009. Housing starts and permits to build new houses have been bottoming since late 2009. Furthermore, the National Association of Home Builders conditions index has now broken out on the upside, pointing to a rise in starts ahead. Home builders conditions point to stronger housing starts
2500 2000 1500 1000 500 0 86 88 90 National Assoc of Home Builders' conditions index (RHS) 92 94 96 98 00 02 04 06 08 10 12 US Housing Starts, '000 (LHS) 80 70 60 50 40 30 20 10 0

US manufacturing renaissance
Recently there have been numerous examples of companies setting up manufacturing plants or expanding production in the US over locations in Canada, Mexico, Japan or the emerging world. These include Maserati, Toyota, Honda, Nissan, Kia, Intel, Whirlpool and Caterpillar. In fact for the rst time in over 35 years, annual growth in manufacturing employment is exceeding employment growth elsewhere in the US economy. The key drivers of Americas manufacturing renaissance are restrained unit labour costs in manufacturing (which have been unchanged for the past 30 years), rising wages in emerging countries, the low US dollar (US$) after a decade long slump, and cheap energy prices helped by surging natural gas supply. While its early days yet, Americas manufacturing renaissance has further to go.

Source: Bloomberg, AMP Capital

Surging oil production

US natural gas supply has been surging for years resulting in low prices. More signicantly, a few years ago US oil production

Second, the number of vacant homes is now starting to fall sharply. Over time the equilibrium number of vacant homes has increased in line with the rising population. This is proxied by the long-term trend line in the next chart. It can be seen that the gap between the actual number of vacant homes and its long-term trend is now closing rapidly. Related to this, household formation is likely to rise sharply. Since 2006 it has been running well below that implied by population growth and has collapsed from a record 2 million to around 700,000 last year. This reects tough economic conditions causing young people to stay at home with their parents for longer and is likely to rebound as economic conditions improve. If the number of vacant homes continues to decline at the same rate as the last couple of years and household formation picks up then the overhang of housing will likely be gone by year end.

The US inventory of vacant houses has almost fallen back to its long-term trend
12000 10000 8000 6000 4000 2000 65 70 75 80 85 90 95 00 05 10 Long-term trend Thousands Total vacant houses

Similarly, house price to income and house price to rent ratios have collapsed, pointing to good value in US housing. US house prices back to fair value or cheap
30 25 20 15 10 5 0 -5 -10 -15 % deviation from long-term average US house price to rent ratio

US house price to income ratio 1991 1995 1999 2003 2007 2011

Source: US Census, AMP Capital

Third, the stock of unsold new homes has largely vanished. It is now at its lowest level since the 1950s. This seems more extreme when it is compared with the fact that the US population has more than doubled since then. The stock of unsold single family homes for sale has almost vanished
600 550 500 450 400 350 300 250 200 150 100 65 Thousands

Source: OECD, AMP Capital

The improvement in US house price valuation measures stands in stark contrast to the still very overvalued Australian housing marketbut thats a different story. Note both the US and Australian charts use OECD data for consistency. .... in stark contract to Australian housing which remains very expensive
60 50 40 30 20 10 0 -10 -20 -30 % deviation from long-term average Australian house price to rent ratio

Australian house price to income ratio

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90

95

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Source: Bloomberg, AMP Capital

1991

1995

1999

2003

2007

2011

Fourth, while the US mortgage foreclosure rate remains high, the delinquency rate is slowing as are the number of new foreclosures, pointing to a decline in foreclosures ahead. Falling mortgage delinquencies point to falling foreclosures
11 10 9 8 7 6 5 4 3 % 5 4 % Dwellings in foreclosure (RHS) 3 2 1 Delinquency rate, % (LHS) 98 99 00 01 02 03 04 05 06 07 08 09 10 11 0

Source: OECD, AMP Capital

The bottom line is that the US housing market appears to have bottomed with recovery in both activity and prices likely.

What a recovery in US housing would mean?

A recovery in US housing has several implications.
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First, by reversing a signicant drag on the US economy it should help perpetuate economic recovery. Second, this is likely to be reinforced by a boost to US household wealth as house prices stabilise and recover. Third, residential construction is a key user of raw materials like copper, therefore a recovery in US housing construction should boost global commodity demand.

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Source: Mortgage Bankers Assoc of America, AMP Capital

Finally, housing affordability has reached a record level. While this has not been acted upon given the excess supply of housing and tough economic conditions, we are likely to see greater demand for houses as the excess supply dwindles and economic conditions improve. US housing affordability is at record high
200 180 160 140 120 100 80 60 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12

Concluding comments
While the secular bear market in US shares that began 12 years ago may have further to go, there are a number of positives suggesting there is light at the end of the tunnel. In particular the US housing sector appears to be bottoming. Dr Shane Oliver Head of Investment Strategy and Chief Economist AMP Capital Investors

Source: Bloomberg, AMP Capital

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