Tuesday, November 1, 2005

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Dr. Doom vs. the soft landing

As long as this blog has been in existence, Morgan Stanley's Stephen Roach has been pessimistic about the U.S. economy. His latest missive is in today's Financial Times:

If the world's dominant deficit economy - the US - goes even deeper into deficit at the same time that the world's leading surplus economies start to absorb their domestic saving, the noose will tighten on America's external financing pressures. This raises the distinct possibility that these pressures will have to be vented in world financial markets in the form of a classic current account adjustment - complete with a weaker dollar and higher US interest rates. As long as the rest of the world was in an excess saving position, a big repricing of dollar-denominated assets could be avoided. But now, with surplus economies beginning the long march of absorbing their excess saving, it could well become all the tougher for the US to avoid this treacherous endgame.

Sure, this is all theory, leaving unanswered the key question of what it will take to spark the adjustments implied by this theory. There are several possible event risks, or shocks, that I believe would be capable of triggering the rebalancing. They include an energy shock, an outbreak of US protectionism, the bursting of the US housing bubble, a US inflation problem and the uncertainty that always arises during the transition to a new Federal Reserve Board chairman. All of these potential risks have two things in common - they are not a stretch and they could shake the confidence factor that underpins overseas investor appetite for ­dollar-denominated assets.

In the end, the history of economic crises is clear on one important thing: the longer any economy holds off in facing its imbalances, the greater the possibility of a hard landing. In my view, an unbalanced world has waited far too long to face up to the heavy lifting of global rebalancing. I would reluctantly conclude that there is now about a 40 per cent probability of a hard landing at some point in the next 12 months.

I'm a bit more sanguine than Roach. The U.S. has already absorbed several energy shocks in the last year, and the reaction by financial markets to Greenspan's successor has been pretty smooth. I'm just as worried as Roach about US protectionism, but it's not clear to me that the situation is going to worsen in the next twelve months, and the Doha round is still moving forward -- albeit very slowly.

[Yeah, but what about the housing market?--ed.] Mary Umberger writes in today's Chicago Tribune that the National Association of Realtors sees a soft landing rather than a hard one:

America's historic real estate boom is cresting, and the rate at which home prices appreciate should begin to slow significantly next year, according to the chief economic forecaster for the National Association of Realtors.

It was the closest statement yet to an admission by the real estate industry that the bull market for housing may have run its course.

"It's the peak of the boom," David Lereah said at the Chicago-based trade group's annual meeting, which ended here Monday. "But we're looking at a soft landing next year. I can't guarantee that there won't be some hard landings in some markets, where prices will actually decline. In fact, there will probably be two or three over the next two years that do pop."

....In many markets--though not in Chicago--there has been widespread speculation that the boom could turn into an unsustainable bubble that might eventually pop, causing prices to actually fall.

Lereah did not see that happening on a national scale, but a real estate market at the peak of its boom doesn't continue to skyrocket.

The NAR's prediction represents an acknowledgement that this could be the end of a joy ride that has allowed many in the industry to prosper. To make that statement at the real estate industry's convention--an annual celebration of its role in driving the economy--represented a break from the usual mood.

With average 30-year mortgage rates expected to reach 6.7 percent by the end of 2006, Lereah's forecast on Friday predicted that:

- Existing-home sales will decline 3.5 percent next year, to about 6.9 million from this year's projected 7.1 million;

- New-home sales will fall 4.5 percent;

- Home price growth should slow significantly--with this year's median 12.4 percent appreciation slowing to 5.3 percent in 2006....

[chief economist for National City Bank in Cleveland Richard] DeKaser said the NAR prediction of a "modest cooling" is a fair description, though rosier than his own analysis of existing-home sales dropping 7 percent and new-home sales declining by 12 percent.

"A downturn the likes of what the NAR is predicting would be almost ideal and welcome," DeKaser said. "It's not implausible, just a tad more optimistic than I would be expecting."

Real estate agents at the convention did not focus all their attention on the possible end of the boom. They still found good news to focus on.

"Real estate is going to be good forever because of the echo boom generation [born beginning in 1982]," J. Lennox Scott, a leading Seattle-area broker, told a roomful of conventioneers. "They're going to be streaming into the first-time buyer market: 75 million of them."

I'm not saying the chances of a hard landing are zero -- let's just say I'm twice as optimistic as Roach.

UPDATE: Kash at Angry Bear is more pessimistic -- and he has some persuasive reasons. The real question, to me, is not whether the economi

posted by Dan on 11.01.05 at 11:45 AM


Growth, growth, growth, growth, growth, growth, growth.

posted by: Mark Buehner on 11.01.05 at 11:45 AM [permalink]

The Realtors association predicts a soft landing rather than a hard one ? What a shocker !!

I predict a hard landing for the housing industry in many markets expecially in California.

posted by: erg on 11.01.05 at 11:45 AM [permalink]

The New York real estate market is definitely reaching a peak as it seems that there is far more inventory on the market now than in recent history and fewer people out there to snap up properties with all-cash offers.

That being said, Wall Street's bonus season is shaping up to be a good one and all the local real estate prognosticators are still talking up the market saying a bunch of new demand will be created.

For what it's worth, in my opinion, just because you may get a good bonus for one year doesn't mean you want to move your entire family into a new place.

Then again, it's not like Manhattan is getting any bigger...

posted by: Jay Drezner on 11.01.05 at 11:45 AM [permalink]

1)What replaces housing to drive GNP growth?
2)Who panics if liquidity dries up?
3)Can local government survive without continual property tax increases?
4)How is the FED going to open unsecured lines of credit to people?

posted by: Huggy on 11.01.05 at 11:45 AM [permalink]

*... let's just say I'm twice as optimistic as Roach.

Do the math: 0*2 = 0 Maybe Roach (and I) aren't quite at "0." But we are, or at least I am, pretty close to it. Where does that put you?

I really wish there might be at least one pony buried in the pile of manure that sits in front of us. But I'm very, very skeptical. We've been 'kiting' the system for far too long now, methinks.

posted by: dave iverson on 11.01.05 at 11:45 AM [permalink]

Once again, massive overreacting. The economy is huming along at almost 4% growth despite a big drag from energy and rising interest rates. Housing is not driving all of that, its simply been leading the way. Its not like the economy cant survive without a booming housing market. The real estate crash in the late 80s occurred during a booming economy- and note there were double digit interest rates in that period. We would have to double interest rates to get back to that atmosphere.
People always need houses, it's speculators that take the hit in a bear real estate market, and even then its never been a collapse anything like we see in the stock markets.
Take it for what it is, the end of an incredible run. Meanwhile the rest of the economy is roaring along, the stockmarket is undervalued, and the dollar is having a good year. Must everything be a looming armageddon?

posted by: Mark Buehner on 11.01.05 at 11:45 AM [permalink]

With Krugman behind a firewall, the doomies need a more accessible financial guru to say the end is nigh.

posted by: Tom Holsinger on 11.01.05 at 11:45 AM [permalink]

I am less concerned about Manhattan than about California. Manhattan at least has some of the income required to sustain these prices. Southern California is driven by the real estate industry and is obscenely overpriced relative to income. Northern California still hasn't recovered job wise from the dotcom crash. I think the possibility of a soft landing for California and a few other markets is getting dimmer and dimmer.

No recovery we've had in the past has been driven as much by real estate as this recovery. In the past, interest rates this low would have led to a huge investment in productive, profitable, innovative enterprises. Now it seems like all that money is going to build new houses. At least in the dot-com era, while a lot of money was wasted, a lot went to truly innovative companies like Google and Amazon (Google started before the dot-com crash).

As for real estate crashes hurting only speculators, anyone who uses an exotic mortgage (IO, for instance) is a speculator, since they are relying on appreciation to bail them out.

I personally think a real estate crash especially in California, would be good for the economy. It would mean that speculators would be shaken out of the market, it would mean that capital would go to truly productive endeavors. Finally, it would remove the moral hazard we have now where it pays to be as irresponsible as possible when buying a house.

posted by: erg on 11.01.05 at 11:45 AM [permalink]

I don't understand why the NAR is constantly quoted in these types of articles - why would the author expect the fox to be the expert on chicken coop protection?

More importantly, though, why don't housing industry articles mention the fact that hard landings in the housing market and historically common. There is a persistent belief that the worst that can happen is 0% growth. Going back four centuries to Holland, or more recently to Hong Kong or Japan, there are countless examples of major (25-50%+) drops in real home prices.

posted by: cure on 11.01.05 at 11:45 AM [permalink]

Anecdotal evidence to be sure.

Have any of you gone shopping at a Mall during
the last few weekends? Did you have trouble
finding a close-in parking space? See lots of
shoppers carrying multiple bags? Have to wait
in line at the Starbucks or Caribou Coffee kiosk?
Prices seemed more than reasonable to us. Lots
of nostagia on sale at Restoration Hardware.
[Madlibs anyone?]

I'd have to say that things are booming here
in the Midwest. And this is more than seven
(7!) weeks before Christmas.

posted by: Ted on 11.01.05 at 11:45 AM [permalink]

Do the real estate market analyses take into account the impact of foreign investors, also immigrant investors who are recycling their profits from China, India, Brazil etc into residential real estate in Manhattan, Florida, California?

Just speculation (no pun intended) here, but I'd not be surprised if more than a third of the speculative real estate investment on the coasts is coming from Asian and Latin American flight capital, as well as profits from immigrants' US-based business ventures that are parked in expensive coastal apartments for young Sunil or Ming or Mauricio.

If so, then this is a powerful force at the margin for asset price appreciation in the more overheated markets such as Miami and Silicon Valley. Ironically, this capital is less skittish about US economic prospects than American capital, given the extremely high risk premium, not to mention tax (and in some cases legal) exposure presented by these investors' own home countries. Until we see a proper and detailed estimation of the size and nature of this source of real estate investment, it would be unwise to predict a crash in the coastal markets that attract flight capital.

posted by: thibaud on 11.01.05 at 11:45 AM [permalink]

Dan -- last I checked, the Doha round said basically zero on the set of issues that will drive protection in the US -- namely, China, its booming exports, its move up the value chain into new areas (autoparts being one obvious one) and how the world trading system is silent on currency issues (And rato thinks the imf should be too), so concerns that china's intervention in the fx market constitutes a de facto export cannot be addressed in the trade context.

in other words, Doha is about opening up still relatively closed sectors; the real protectionist threat comes from closing up already (mostly) open sectors as Chinese/ Indian/ other exports in those areas heat up.

what's changed in the last 12 months. schumer-Graham, Cnooc, etc. What's likely in the next twelve months: Competitive elections in the upper midwest; lots of talk of serious dislocations in the auto sector and some potential slowdown in overall growth (b/c of less real estate stimulus), which makes jobs more scarce and makes those with jobs less willing to give them up.

on rising risks of a protectionist backlash, I am with Roach. I cannot see anyone up for election in Michigan or Ohio or many other places voting against schumer -graham in an election year ...

posted by: brad setser on 11.01.05 at 11:45 AM [permalink]

Real estate crashes can be pretty severe. 20 to 30% is not uncommon. And unlike stock market crashes they tend to inflict themselves slowly.

50% of new jobs are connectd to real estate so there is a big potential problem there.

I really don't know were the myth that our fireign lenders are always true comes from. A Japanese pull out in the late seventies led to a stock market fall and a few years under Clinton rapidly knocked down the dollar by 20%.

The dolar will be trusted as long as it's trusted. It has lost much of that trust in the past.

posted by: don on 11.01.05 at 11:45 AM [permalink]

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