February 26, 2015

February 2015 Economic Outlook


Sam Khater    |    Economic Trends


Household Growth From Year Earlier Booms
  • Employers have added over 1 million people to their payrolls in the last 3 months; the largest increase in 18 years
  • Oil price drop has done more to increase consumer confidence than five years of economic growth
  • Soaring consumer confidence bodes well for new home sales and residential construction
  • Key oil market home price overvaluation much smaller than 1980s or 2000s and negative impact of oil price drop will be more muted

According to legend, Pythagoras discovered the underlying principles of music theory by listening to the sounds of blacksmith hammers. He noticed when certain hammers were struck simultaneously, their sound would be consonant or dissonant and the combination that caused harmony is the golden ratio of music note intervals. Similarly, the economy has been searching for the residential investment hammers that will produce better economic harmony and bring it to its golden potential but thus far has been missing since the expansion began. However, over the last few months a confluence of forces such as stronger job growth and soaring consumer confidence have coalesced to finally produce conditions for more robust demand for new sales and construction. Will this year be the one that finally brings a stronger rebound in new home sales that spur single-family residential investment? It is shaping up to be the case.

Job growth ended on a high note in 2014, reaching a 2.1 percent increase from the prior year in December – the highest rate of employment growth since March 2006 which was the peak of the last economic cycle. Employers added more than one million jobs the last three months alone, the highest 3 month increase in 18 years. More important, as we have noted over the past few months, the key first-time homebuyer demographic is experiencing surging job growth. The employment growth for 25 to 34 year olds was 2.4 percent, the highest growth rate in 27 years1. The rapid increase in overall employment has led to an average decline of 1.2 percentage points in the unemployment rate the last six months, the largest decline in the unemployment rate since 1985. While the stronger labor market has not yet had a material impact on wage growth, at 5.7 percent the unemployment rate is at a level that will begin to put upward pressure on income growth. In addition, 19 states raised their minimum wage at the beginning of 2015, which will help income growth at the margin, especially on the lower end where it is really needed.

On the demographic front, after seven years of very low household growth, net household growth boomed in the fourth quarter, reaching 1.65 million from a year earlier, up from an average of growth of 561,000 since the recession began in December 2007 (Figure 1). The Q3 to Q4 increase in households was 1.3 million – the highest since 1981. The detail is even more stunning because the number of rental households increased by 2 million, more than double the robust 751,000 average since 2007. To be fair, one needs to interpret the surge with caution because in April 2014, a new sample was implemented through the end of 2015. Typically, prior major sample revisions led to level shifts, so we may not know the full impact of the change for several more quarters.

Consumer Confidence and New Home Sales

The rapidly improving labor market and seemingly stronger household growth is a reflection of soaring consumer sentiment. While sentiment has slowly improved over the last few years driven by improvements in the labor market, the drop in oil prices the last six months has done more to increase consumer confidence than five years of job and economic growth.

Collapse in Oil Prices Has Led to a Surge in Consumer Confidence

The strong link between consumer confidence and oil prices has not just occurred the last six months but over the last two decades (Figure 2). Between 2004 and 2008 there was nearly a one-to-one change in confidence and oil prices, but that relationship broke down in late 2008 and 2009 because consumer outlook was so weak due to the Great Recession during which oil price movements became less relevant. Once the economy began to grow again in 2010 the strong correlation reverted to its old pattern. Over the last six months the striking relationship has really shone as consumer confidence has soared and the now seven month oil price drop has increased confidence about the same amount as five years of job growth.

Surge in Consumer Confidence is a Strong Positive Sign for New Sales

The tight correlation between oil prices and confidence is important due to the linkage between confidence and new home sales, which drives single-family residential investment (Figure 3). Consumer confidence has always had a strong correlation with new home sales. This can especially been seen during the 1980s and 1990s. The correlation delinked during the boom when new sales rose well beyond economic fundamentals; however in the last four years the correlation has reverted back to normal. The recent surge of consumer confidence, in conjunction with lower rates and a drop in FHA MI premium should lead to increased new sales.

Net New Home Orders Rebound

In fact, the Q4 data for builders suggest momentum is already building. Between Q4 2013 and Q4 2014, new residential orders for 7 selected home builders increased 16 percent, up from a 4 percent decline a year ago and the trend continued into January for several builders2(Figure 4). This is stronger than the Census new sales data, which grew 3 percent from a year ago in Q4 and is based on a small sample and has large error ranges. This means that new home sales are expected to increase robustly in 2015. We will track the new sale market and construction closely in 2015 to gauge the impact of the improving economy on residential investment.

The Impact of Oil Prices on Home Prices

The consensus economic forecast is that if oil prices remain at current levels it will add less than one-half of a percentage point of economic growth. The drop in oil prices has caused two major countervailing forces, one for oil producers and one for oil consumers. Producers and residents concentrated in Texas, Louisiana, Alaska and North Dakota (oil states) will be negatively impacted by the drop in oil prices by lowering production and employment and this aspect of the decline is receiving the majority of the headlines. However, it will be more than offset by the positive impacts for consumers outside those states who spend less on energy and have lower inflation and it is showing up in early economic readings in 2015.

At first blush the current drop in oil prices hark back to the very large drop in the mid-1980s that spurred the large home price declines in key oil markets such as Texas, Oklahoma and Louisiana. However, today’s housing market valuations in the key oil markets are very different relative to the past. House prices in the three largest metros that have the highest concentration of oil and gas extraction (Houston, Oklahoma City and New Orleans) combined are only 5 percent overvalued relative to income fundamentals, compared to being 45 percent overvalued during the late 1970s and 14 percent overvalued in the mid-2000s. During the 1970s cycle, valuations in the three markets eventually fell from being 45 percent overvalued in 1979 to 12 percent undervalued 15 years later. During the mid-2000s cycle, the three markets fell from being 14 percent overvalued in mid-2005 to 3 percent under valued in 2011.

Key Oil Markets Much Less Overvalued Than Prior Cycles

Examining the three markets in detail reveals a more nuanced picture. At its peak Houston was overvalued by 26 percent in November 1984 and by 20 percent in November 2005, but it was overvalued by only 16 percent as of December 2014 (Figure 5). Oklahoma City, OK peak valuation was in October 1979 when homes were overvalued relative to incomes by 74 percent. During the last decade Oklahoma City was only overvalued by 6 percent at its cycle peak in September 2007, which is why they did not have a housing bust when the recession began and as of last December, Oklahoma City was undervalued by 3 percent. New Orleans, LA was overvalued by 53 percent in October 1979 and was overvalued by 17 percent in August 2005, the same month Katrina impacted the city and as a result, price growth significantly slowed prior to the recession. In December 2014, New Orleans was only overvalued by 4 percent.

Assuming oil prices remain low, the negative impact on home prices will likely be much more muted in New Orleans and Oklahoma City than in the past since prices in the two markets are currently more in line with income driven fundamentals. Houston is much more at risk than the other two markets since it is overvalued by 16 percent. That does not mean prices will fall by 16 percent, especially given the very strong demographic in-migration, tight unsold inventories and low mortgage rates. However, it most likely will mean that Houston will have very low home price growth as the market corrects. Going forward, we will track the impact of the oil price drop on markets with substantial oil employment by tracking the inventories, sales, prices and eventually performance vis-à-vis the rest of the nation.

[1] 12 month average of year ago change in 25 to 34 employment.

[2] LEHC & Kris Hudson, Home Builders Reporting Stronger Sales in January in Wall Street Journal, Feb 4th, 2015.

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