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Macro View

Housing Starts fell in August to a seasonally adjusted annual rate of 571,000 from 601,000 in July, a decrease of 5.0%. However, the July numbers were revised lower from 604,000, so it is possible to see the decrease as 34,000, or 5.5%. The number was also slightly below the expected level of 575,000.

Relative to a year ago, housing starts are down 5.8%. Quite frankly, a year ago was also a pretty lousy time for the homebuilders, so the drop is off a pretty easy comp.

Given the extremely depressed state of the housing industry, the decline is not good news. It does, however, mean less inventory is the pipeline, so there is sort of a silver lining in the dark cloud. That is helpful for the longer-term health of the industry, but does not help economic growth or job creation now.

If one looks at only single-family houses, the picture was also discouraging, but not quite as bad.  Single-family starts fell to 417,000 from 423,000 in July, a drop of 1.4%, and down 2.3% from a year ago. The June numbers were revised down by 2,000, so one could see it as a decline of 8,000 or 1.9%. The volatile multi-family (Apartment, Condo and Co-op) sector fell by 12.4% to an annual rate of 148,000. Year over year, multi-family starts are down 10.3%.

Still a Major Drag

The level of housing starts is just plain awful. The extremely weak rate of new home construction is a major drag on the economy. It is the principal reason that this recovery feels so anemic.

We still face an inventory glut, so a weak homebuilding industry is a key part of the repair process for the housing market. The inventory glut is concentrated in the used home segment of the market, and that is also where the “shadow inventory” resides. New home inventories are actually near historic lows in absolute terms. Used homes are pretty good substitutes for new homes, so that is a bit of a distinction without a difference.

Housing Starts peaked in June of 2006 at an annual rate of 2.273 million. We are thus 74.9% off of the peak levels.

Lower starts, however, will only bring down inventory levels as long as new home sales do not also come down. The level of housing starts has been very depressed for almost three years now, and the overall inventory situation (new and used) is still very bad relative to the sales rates. That means downward pressure on prices. We will find out about the level of used home sales (and very importantly, inventories) tomorrow and New Home Sales next week.

Housing Starts an Economic Building Block

It is hard to overstate just how important housing starts are to the economy. Yes, at this point, residential investment has declined to the point where it looks almost insignificant -- just 2.23% of GDP in the second quarter, down from 6.34% of GDP at the height of the housing bubble. However, historically, residential investment -- of which new home construction is the largest part -- has always been the main locomotive in pulling the economy out of recessions.

Take a good hard look at the first graph below (from this source http://www.calculatedriskblog.com/) and the relationship between when the lines bottom and the light blue recession bars. If you want to know why this recovery seems so anemic, look no further than this graph.

Even the 2001 recession, which was not caused by a housing downturn, saw a sharp acceleration in housing starts as the recession came to an end. Of course, since starts were jumping but were not starting from a depressed level, that boom later became known as the housing bubble that put us in this mess to begin with. Every other recession was preceded by a sharp fall in housing starts, every other recovery saw housing starts lead the way. 



This is no coincidence. Each new home built generates a huge amount of economic activity. It put construction workers back to work, and construction workers have been particularly hard hit in the Great Recession. They account for over 31.8% of the total private sector jobs decline since the start of the downturn. That is despite being less than 6% of the total workforce when the recession started.

That is just the direct construction jobs, but lower building activity also means fewer jobs in the factories that produce building materials, which are counted as manufacturing jobs. Clearly jobs in mortgage finance are also affected by the housing slowdown. They are not included in that almost one out of three jobs lost figure.

If they and the construction workers could go back to work, they would have more money to spend, perhaps even go out to eat, thus creating jobs for cooks, waitresses and busboys. Housing starts are not just about profits and jobs at D.R. Horton (DHI - Analyst Report) and the other homebuilders, but about jobs and profits at firms as diverse as Plum Creek Timber (PCL - Analyst Report), Fortune Brands (FO) and Berkshire Hathaway (BRK.B - Analyst Report). Indirectly, Wal-Mart (WMT - Analyst Report), Darden Restaurants (DRI - Analyst Report) and every other firm that depends on middle and working class discretionary income.



Why is housing so central, as opposed to other industries? Why does it hold the key to the economy booming or busting?  Because it is exquisitely sensitive to interest rates, or at least it was, before the avalanche of houses in foreclosure simply swamped the housing market. The key reason that the Fed tries to lower interest rates when the economy weakens, is to jump start residential investment.

This time around, even record-low mortgage interest rates don’t seem to be moving the needle. The simple fact is that during the housing bubble we built far too many homes, and we now have a glut of empty homes around the country. Most estimates put the excess vacancies at between 1.1 to 1.4 million (including rental units).

The next graph (also from http://www.calculatedriskblog.com/) shows the total (homeowner and rental) vacancy rate over time, relative to housing starts. While it is off its peak, it is still far above normal. In such a situation, it seems economic folly to simply build more houses and add to the glut.

But if we don’t build houses, the economy remains stuck in a rut. From a strict “allocation of resources” point of view, we would want to see slow housing starts until the vacancy rate fell back to more normal levels (say under 4.0%). Unfortunately the graph only goes through the end of 2010. However, based on other data it looks like the vacancy rate has continued to fall so far this year, particularly in the apartment sector.



Thus, one can argue that in the long term, low housing starts are a good thing, as it means fewer new homes adding to the glut. That, however, is extremely cold comfort to the millions of construction workers without jobs. It is also going to be very difficult to create a sustained growing economy if home building continues to be a drag.

Results by Region

For the month, regionally the results were extremely mixed. The Northeast was the weakest by a large margin, with total starts plunging 29.1% on the month, and down 15.3% year over year. The strongest was the Midwest, with a rise of 2.6% on the month but off 25.2% year over year. The West was also relatively strong, with a 2.2% rise from July but down 1.4% from last year.

The South, which is by far the largest of the four regions, accounting for 51.1% of all starts for the month, was down 3.3% for the month, but up 1.7% year over year. It is possible that the starts in the Northeast were affected by Hurricane Irene, but it is by far the smallest, and thus the least significant of the four regions.

Building Permits

Looking forward, we might see a little bit of relief, but not enough to really move the needle. The best leading indicator of housing starts are Building Permits. There the news was a bit better, at least from a near-term economic growth point of view. (Or worse from a long-term repair of the housing market point of view).

For the month, total permits rose 3.2% to an annual rate of 620,000 and were up 7.8% year over year. That was nicely above the consensus expectations for a 575,000 rate. July was revised up from a 597,000 rate to 601,000. Single-family permits were up 2.5% on the month, 2.0% year over year. Multi-family (5 or more units) permits rose 0.6% on the month and are up 19.5% year over year.

The multi-family permit rate is well above the start rate, so we can probably look forward to a rebound in the multi-family sector in September. The single-family permit rate is slightly below the start rates, so look for more stagnation in September.

Regionally, the West was the strongest for the month, with permits up 11.3% on the month and up 16.5% year over year. The South was the only region to post a decline, falling 1.3% on the month, but up 10.0% year over year. The Midwest saw a 6.3% increase on the month and is up 4.1% year over year. The Northeast saw a 3.3% rise in permits for the month, but is down 11.4% year over year. Weather is not a big factor for Permits, but it can be for starts.

The Ambiguity Over the Fall in Starts

There is a certain level of ambiguity about if a fall in starts is good news or bad. We need less supply to help the market clear, but in the meantime, the economy is going to be stuck in limbo unless we can find another locomotive to help pull us forward. The one we have always relied on in the past is clearly derailed.

Additional government spending on infrastructure would be the logical solution. After all, we have huge needs to rebuild out crumbling infrastructure. Better infrastructure would enhance our long term economic competitiveness. The government would not be competing for resources with the private sector, it would be competing with idleness.

With rock bottom interest rates, the cost of financing the infrastructure rebuild would be extremely low. The AJA proposed by PrtObama has some of this spending in it, mostly focused on school construction and rehabilitation, but the main thrust of the AJA is a tax cut on the first $106,800 of earned income. 

However, in the current political environment, Congress is not going to pass the AJA, or anything like it. The “Super Committee” more likely to slash existing infrastructure spending than increase it. More likely, the Super Committee comes to an impasse, and the automatic $1.2 billion in spending cuts over 10 years will go into effect.

President Obama just promised that he will veto any package they come up with that does not raise taxes on the highest earners, while Speaker Boehner has vowed that there will be no tax increases at all in the package (although he seems fine with letting the current 2% cut in the payroll tax expire).

Household Formation

Eventually, the combination of a rising population, and higher household formation will absorb the excess inventory, and we will be able to once again increase housing construction. Household formation is "economist speak" for kids moving out of their parents houses and getting a place of their own. To do so takes a job, and one that pays enough to support having your own place.

In the past, residential construction itself provided a lot of those jobs. That produced an upward spiral. This time around, the jobs have to be created in other parts of the economy to increase the household formation rate, and absorb the excess inventory, which makes the process slower.

This process should probably hit the rental market first, and we are starting to see that. Most of the decline in the vacancy rate shown above has come from the rental side of the housing market. After all, kids moving out of Mom’s basement are more likely to first move into a rental apartment than to buy a house.

The decline in the rental vacancy rate is thus a positive omen for the future. However, with the unemployment rate for those 20 to 24 years old, the prime age for moving out on your own, running at 14.8% in August. That is going to be a slow process. The unemployment rate for those 25 to 34 years old is also higher than that for the country as a whole at 9.5%. That is the prime age for buying your first house.

The day will come when housing is once again a big positive contributor to economic growth. It is not really sustainable over the long term to have total housing starts running at substantially lower levels than we saw in the 1960’s. Back then the population of the country was around 200 million; now it is north of 310 million.

That day, however, is not today nor in the near future. It is possible that it might happen in 2012, but I would not be counting those chickens yet. For the time being, the best we can really hope for is that it stops being a brake on the economy.

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