Are the gravy days over for real estate? According to the Federal Reserve, the answer is YES! Real estate is cyclical, so a recession was bound to happen sooner or later – and new metrics from the Fed indicate that it’s already looming on the horizon. Even worse, during past recessions, the Fed was able to cut interest rates by five to eight percentage points in order to restimulate the economy – but the current rate is only 2.5%, which means the Fed can only cut rates by 2.5 percentage points before we hit zero again.
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One of the most historically reliable predictors of US Recessions has been inverted yield curves – and the three-month/ten-year curve has been inverted since May 2019. The three-month/ten-year curve was at -49 basis points at the end of August. This is close to the 2007 extreme of -60 basis points, which is the most inverted reading in almost two decades. Not only is the yield curve flashing red, so is a new recession indicator released by the Federal Reserve in July 2018. The paper was titled “The Near-Term Forward Spread as a Leading Indicator: A Less Distorted Mirror.” Although it covers a shorter history (22 years), the chart below shows this has been a clear warning signal in advance of the last three recessions.
Haver Analytics constructed a recession probability model using this yield spread data, and the model spiked to a reading of almost 90% recently.
Recession Looming with Unemployment So Low?
How could a recession be on the horizon with the U.S. unemployment rate (3.7%) at a 50 year low?
What most people don’t realize is that the unemployment rate is a lagging economic indicator – and not a leading indicator like the yield curve. As the chart below shows, the unemployment rate has always been near its trough when recessions start – and near their peak when recessions end.
In short, we should not use lagging indicators to time real estate markets and you can’t forecast economic turning points using lagging economic indicators either.
Is a Downward Mean Reversion For U.S. Housing Prices on the Horizon?
From the standpoint of practical economics, there may be only three principles that have genuine value
in the real world – everything else is theory, commentary, or BS:
- The law of supply and demand;
- There is no free lunch;
- Everything tends to return to normal.
The illustration below plots three key financial metrics from 1985 to 2019: (1) the Case-Shiller National Home Price Index; (2) the Consumer Price Index; and (3) the Average Hourly Earnings of Production and Non-Supervisory Employees in the Private Sector.
As you can see from the chart, when housing prices rise to levels that are above average hourly earnings and consumer prices, they don’t stay there forever. Instead, home prices will eventually correct “back to normal” in order to bring them back into alignment with hourly earnings and price inflation metrics. There are fundamental reasons for this phenomenon – but not to over-complicate the message, it’s just the way the world works.
Like rubber bands, housing prices only get stretched so far before they snap back to normal. This occurred after the 1980’s boom in housing prices and after the 2000-2006 housing bubble as well. Home prices hit bottom in March 2012. Did the next seven years produce a 2nd bubble? Based upon the elevated valuations, housing prices now reside at above hourly earnings and the rate of inflation, another major bust might be looming.
What should investors do with their money in this market environment?
They should recognize that interest rates are likely to go lower and bond prices are likely to rise as the Fed continues to cut rates and perception of future economic weakness intensifies. Gold should also perform well. One reason is the nearly perfect correlation gold has had with the increasing amount of negative debt in the world – which has now grown to $17 Trillion. Why invest in gold that produces no cash flow? Or invest in bonds the carry record low or even negative yields? Because they’re both likely to appreciate in value.
Even the General Public is Now Worried about Recession
The financial pros have had recession worries ever since the yield curve inverted in May 2019. Now the general public is worried too – as the chart below shows. Google data shows that searches for “recession” spiked to their highest level in August since November 2009, which was just a few months after the NBER retroactively reported the Great Recession had officially ended – even though it didn’t feel that way at the time.
Recession searches peaked in January 2008, just after the start of the last recession – which may be precisely where we are now. In a July survey by the National Association of Realtors (NAR), 36% of all prospective home buyers said they expect a recession to start in 2020 – up from 30% a few months ago. Not only that, but 56% of today’s home buyers said they would hold off buying a home if the economy worsens.
Even with mortgage rates at near-record lows, recession concerns may start dominating the thoughts of home buyers (and all Americans frankly) on a growing basis. If people think a recession is right around the corner, an economic downturn could become self-fulfilling: Americans would reduce their spending and investing, which in turn would cause the economy and markets to contract, which in turn would cause employers to start laying people off – all of which would perpetuate a self-reinforcing cycle.
What are your thoughts on this data? Do you have strategies in place in case another recession does indeed happen? Sound off in the comments below and tell us what you think.
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