How To Predict A Recession

Home For Sale Real Estate Sign and House

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If you want to predict a recession, look no further than the housing market. The cycles in the housing market have predicted every recession over the last 80 years, with few exceptions.

In this article, we’re going to look at how you can predict recessions or substantial downturns in the economy by carefully studying the ebbs and flows of the housing sector.

Throughout this article, I am going to make frequent references to one of my favorite papers on forecasting recessions by Edward Leamer, titled “Housing IS The Business Cycle.”

Rather than focusing on lagging economic data points like employment and inflation, Leamer argues that the Federal Reserve should monitor the housing sector when conducting monetary policy, and therefore, they can be early to business cycle turning points rather than late.

By focusing on lagging data points, the Fed makes booms bigger and busts worst, always making the wrong move at the wrong time. This is one major reason why the Fed is triggering a major housing deceleration that could make the 2022 slowdown worse and even recessionary.

Let’s start by looking at why the housing sector should be the main focus of anyone’s analysis of the economy.

The housing sector is classified as a leading economic indicator which means that the housing sector moves BEFORE the broader economy. The housing sector leads the economy into recession and lifts the economy out of recession.

Why does the housing sector lead? Several reasons.

First is that the housing sector is extremely sensitive to changes in interest rates, so it responds very quickly to changes in monetary policy. Services consumption, like dining at a restaurant, really doesn’t change if interest rates are 3% or 6%, but the demand for a new home radically changes as interest rates move up and down.

Second is that the purchase of a home and the maintenance of a home are the largest line items in the household budget, so any weakness in the economy will cause a reluctance to trade up for a bigger home.

Lastly, there are dozens of knock-on effects of purchasing a new home, including furnishing that home with new appliances, furniture, and other household items, which is reflected as a rise in retail sales.

So a boom in housing today means a rise in retail sales tomorrow. Conversely, if no one is buying a new home, then manufacturers of kitchen appliances, for example, will notice a build-up of inventory.

The overall economy is made up of several sectors, including consumption, investment, government spending, and net exports.

Housing is a sub-set of “investment” called “residential fixed investment.”

Surprisingly, even though the housing sector IS the business cycle, as Leamer notes in his paper, the housing sector only makes up 3%-6% of total GDP!

Housing % of GDP

BEA, EPB Macro Research

How is it that a fraction of the economy can drive the entire business cycle?!

The chart above shows the housing sector as a % of the total economy. You can clearly see that a weakening housing sector has foreshadowed a recession almost every time since the 1940s!

Leamer writes, “residential investment is subtracting from GDP growth before the recession starts but starts to contribute more than normal in the second or third quarter of the recession.”

No other sector of the economy has such a reliable track record of leading the economy into and out of recession.

Since World War II, only two recessions were NOT preceded by major downturns in the housing sector, 1953 and 2001.

1953 was a recession was caused by massive swings in defensive spending around the Korean War.

Government % of GDP

BEA, EPB Macro Research

The chart below from Ed Leamer’s paper shows the % of weakness coming from each sector of the economy in the year leading up to each recession.

The top panel shows that in nearly every recession except 1953 and 2001, housing was the major driver of weakness in the year before the recession.

Weakness Before Recessions

NBER, Leamer

The next most predictive sector of the economy is the spending on big-ticket durable goods, which is why if we combined these two sectors, housing and durable goods, we have a near foolproof gauge of future economic activity.

If there’s clear weakness in housing or durable goods, the broader economy will slow in the year ahead.

Any other sector besides housing and durable goods offers almost no insight into the economy in the months and quarters ahead, so you can virtually ignore the rest. What are housing and durable goods telling you? That’s all you need to know.

Housing & Goods % of GDP

BEA, EPB Macro Research

We’re now going to look at the housing sector today to show why housing is suggesting the 2022 downturn will get WORSE in the coming months. Based on everything we just learned, the economy won’t bottom until the housing sector bottoms, so without a clear inflection higher in housing, there’s little hope the broader economy will improve.

Leamer makes it clear that housing is a VOLUME cycle, not a price cycle. Too many people are focused on home prices rather than the volume of transactions in the housing market.

Like growth leads inflation, VOLUME leads price.

A downturn in housing volumes today means a reduction in prices tomorrow. VOLUME is the focus.

Why is it a volume cycle? Let’s hear what Leamer has to say:

“[O]ne very big clue is that housing has a volume cycle, not a price cycle. Home prices are very sticky downward, and faced with a decline in demand, it is the volume of sales that adjusts, not the prices. With the decline in sales volume comes a like decline in jobs in construction, finance, and real estate brokerages.”

Thus volumes matter for real GDP accounting, not prices.

Let’s start by looking at the volume of new home sales and the volume of existing home sales. A new home is a new construction while an existing home is already built.

The volume of new home sales is completely crashing and has not yet turned up…at all.

New Home Sales

Census Bureau, EPB Macro Research

New home sales have crashed 43% from their peak! One of the largest declines in volume over the last 60 years. A recession occurred each time new home sales volumes fell this much.

Existing home sales are not much better, down almost 25% from the peak.

Existing Home Sales

NAR, EPB Macro Research

Now, many people will say volumes are declining because of supply.

First of all, that doesn’t matter. As Leamer notes, less volume means less production, less employment, lower commissions and less economic activity, regardless of the reason.

Even still, that narrative about supply is only true in the existing home sales market. Right now, many existing homeowners have locked in low mortgage rates and thus WILL NOT sell out of fear of losing that low rate. So that supply isn’t hitting the market and the month’s supply of existing home sales is only 3, a very tight market.

Months Supply Homes

NAR, Census Bureau, EPB Macro Research

But new homes don’t have an existing owner with a low mortgage rate, so sales are drying up, and the month’s supply of new inventory is exploding, up to 9, the highest level since the financial crisis.

If we look at the pending home sales index, a leading indicator of existing home sales, we see further declines in store.

Pending Home Sales

NAR, EPB Macro Research

The sentiment among home builders is crashing as price cuts are inevitable with a month’s supply figure rising to 9.

Housing Market Index

NAHB, EPB Macro Research

So there’s virtually no housing data point that you can point to right now in terms of volumes that shows a bottom. In fact, almost all of the housing data points are getting worse each month, and since we now know that housing is a LEADING indicator, that means there’s a very strong chance that deeper declines in the broader economy are coming, and coming for up to a year.

The housing sector is at its worst in the year before the recession and in the first quarter of a true recession. By the third quarter of a recession, housing starts to flip higher.

So the fact that we have not seen a bottom in ANY of the major housing data points means we are still at the beginning of this economic downturn, not near the middle, and certainly not near the end.

The first sign that this economic downturn is starting to give way to a new upturn will be positive data in the volumes of housing activity.

Even in the most recent Q2 GDP report, we saw significant weakness in the two key leading sectors, housing and goods. The focus was on the 2nd consecutive contraction, but we’re seeing even more pronounced weakness in the key sectors that matter.

Cyclical GDP

BEA, EPB Macro Research

The Fed is still tightening monetary policy, which will further pressure the housing market, leading to more downside in the broader economy in the quarters ahead.

Always remember that HOUSING IS THE BUSINESS CYCLE, and with the housing sector still on its knees, a sustained upturn is not in the cards.

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