Existing home sales, mortgage delinquencies, and MBA mortgage foreclosures data released Thursday were disappointing. The data continue to suggest that we are undergoing a very slow, unbalanced, and tenuous economic recovery. Wealthier Americans are clearly doing much better due to their stock gains, but the middle class is still struggling with high unemployment, weak income growth, inadequate retirement savings, and housing price declines. All one needs to do is take a look at recent earnings in the retail sector – Sak’s, Coach and Tiffany are blowing it out while Wal-Mart, Target, Kohl’s, etc, continue to struggle. We believe the only sustainable recovery is a more balanced recovery.
I have said many times that the housing market is THE key to a sustainable recovery. The double dip in housing prices is highly likely, in my opinion, to cause a slowdown in consumer spending, especially since the double dip has been accompanied by much higher gas prices. Unfortunately, I don’t see a way around further meaningful declines in home prices. Banks and government agencies have tightened lending requirements, and agencies are still buying or guaranteeing some 90% of mortgages. Recent bank regulatory changes and the need for the government to eventually extricate itself from the market will ensure tight credit conditions into the future. At the same time, about 28% of mortgages are underwater – a figure that will rise as prices continue to fall. We are likely to see increasing numbers of strategic defaults, a situation whereby an underwater homeowner decides it simply is not worth it to continue making mortgage payments. And the cycle will continue.
Increasingly, it appears that stock investors want to overlook what is going on in the housing market. Most believe that better job growth will eventually stabilize the housing market, but we don’t think it will be that easy. The problems in housing are not simply an issue of employment. The real issues are that 1) we have undergone a fundamental and dramatic change in the way homeownership is financed in this country, and 2) there is a huge backlog of foreclosures and other inventory (ie, supply far exceeds demand). These two issues almost ensure that housing prices will go lower in the future (absent some new and exceedingly expensive government program). If you add higher mortgages rates, the decline in housing is likely to be more pronounced.
Equity investors are ignoring the reality that there is a ceiling on the rate of economic growth we can expect in a best-case scenario. Because the Fed must extricate itself from unprecedented monetary policy, better economic indicators will be met with higher interest rates (and likely higher commodity costs). Sharply higher interest rates will hinder economic growth and cause further housing price depreciation. Therefore, I think the stock market is still in a situation whereby bad news is good news. As long as the economic indicators are weak enough to ensure continued Fed commitment, investors are likely to find stocks attractive (the risk trade). Once the Fed starts to get more serious about tightening (in reaction to better economic data), investors would be wise to question the sustainability of economic growth.
We have been in this goldilocks scenario now for many months – the recovery is not too hot, but not too cold. Throughout this period, investors have favored more speculative stocks that benefit from the Fed’s efforts to reinflate the economy. High-quality, blue chip companies that offer greater stability and downside protection have been left for dead. More recently, we have begun to see a rotation into quality. We would expect this rotation to continue, and our portfolios are set up to benefit from these rotations.