Despite mounting signs of a slowing housing market, Goldman Sachs thinks that lower interest rates will boost residential investment throughout the second half of 2019. Both residential investment and housing starts have been decelerating through the first half of this year, but falling mortgage rates and the Federal Reserve’s recent interest rate cut will help to stimulate housing demand, said Goldman’s analysts in a recent note.
Acknowledging that, “homebuilding has been somewhat weaker than we expected, and appears to be confronting a few headwinds that will at least partly persist,” the analysts, led by economist Jan Hatzius, remained optimistic about the sector’s future growth prospects. “Our model points to a healthy rebound to a 4% growth pace of residential investment in 2019H2,” Hatzius wrote.
A rebound in the housing market would help homebuilding stocks maintain their rally through the first half of the year. The SPDR S&P Homebuilders ETF (XHB) is up nearly 27% on the year compared to the S&P 500’s gain of 15%. Individual homebuilder stocks like M/I Homes Inc. (MHO) and LGI Homes Inc. (LGIH) are up more than 70% for the year, while KB Home (KBH) and D.R. Horton Inc. (DHI) are up more than 40%, and PulteGroup Inc. (PHM) is up almost 28%.
What It Means for Investors
Lower mortgage rates will lead the boost in demand for housing, which is the sector of the economy that is most sensitive to interest-rate changes. Since last fall, mortgage rates have fallen 125 bps. The rate on the 30-year fixed mortgage has dropped from a peak of 4.94% in November to 3.60% more recently, according to data from mortgage agency Freddie Mac, per CNBC.
The stimulative effect of lower rates on the demand for housing will come through two separate channels. The obvious channel is that lower mortgage rates make the cost of financing the purchase of a new home cheaper; hence increased demand. The second channel occurs through the lower cost to existing homeowners of refinancing their mortgage at lower rates. The lower costs create a wealth effect that stimulates consumption spending and a subsequent positive feedback mechanism on the housing market.
As of yet, however, lower rates have failed to provide the much-expected boost to housing. Residential investment is experiencing its worst streak since the 2007-2009 Great Recession, having contracted for six straight quarters now. Housing starts dropped 4.0% in July to a seasonally adjusted annual rate of 1.191 million units, and the figures for June were revised downwards. Economists polled by Reuters had been expecting housing starts to increase in July to a pace of 1.257 million units, according to CNBC.
One explanation for the failure of housing demand to respond to lower interest rates is the increasing economic outlook. Indeed, if lower interest rates are the result of a policy move specifically intended to respond to economic uncertainty, then the negative signal that lower rates send may be more powerful than the positive stimulus effect of those lower rates themselves. Homebuilders think that’s a big reason why housing demand hasn’t picked up.
But Goldman has another explanation—response lags. The effects of changes in interest rates are usually not felt immediately, but can take months if not years before they work their effects on economic activity. “[O]ur estimate of the lag time between changes in interest rates and housing activity suggests the bulk of the boost is yet to come,” wrote Hatzius.
There are some positive signs that suggest Goldman’s response-lag hypothesis might be correct. Building permits, which have been weak for most of the year, surged 8.4% to a rate of 1.336 million units in July. That’s the largest gain for permits since June 2017. More positives like that may be in store as the effects of the Federal Reserve’s interest-rate cut at the end of last month slowly work their way through the economy, and more rate cuts are expected before the year is out.
Despite signs of life, Goldman expects a few housing headwinds to linger, including the dilution of the tax incentive for owner-occupied housing, an extremely tight construction labor market, and a rise in land, development, entitling and other regulatory costs. One could add the growing possibility of a recession amid President Trump’s escalating trade war with China.