The Economy's Housing Problem

Weak third-quarter GDP numbers came courtesy of the housing slump. Is a real estate-led recession far behind?

by Marc Hogan

Anyone trying to judge the state of the housing sector could be excused for feeling a bit…befuddled. On Oct. 20, Goldman Sachs (GS) issued a report suggesting the worst of the housing downturn could be over, and former Federal Reserve Chairman Alan Greenspan reiterated remarks of his own to a similar effect on Oct. 26 (see BusinessWeek.com, 10/23/06, "Is Housing Out of the Woods?"). Encouraging words, to say the least.

But while analysts and economic eminences see a trough, data reports point to more gloom ahead. In the third quarter, the biggest drop in homebuilding investment since 1991 slowed economic growth to its worst pace in more than three years, an Oct. 27 report showed. New home sales rose in September, but the median price of a new home fell by nearly 10% in the biggest one-year drop since 1970, according to the Census Bureau on Oct. 26 (see BusinessWeek.com, 10/27/06, "The Housing Fire Sale"). And on Oct. 25, the release of September existing home sales slightly missed Wall Street expectations.

It's enough to leave homeowners across the country understandably perplexed (see BusinessWeek, 11/6/06, "Boom! Bust! Boom?"). Should they believe the ex-Fed "Maestro," or the numbers? While the housing slowdown may not wind up crippling the economy the way some pundits feared, many analysts say its effects aren't finished just yet.

How Long a Slump?

"The velocity of the slowdown [in housing] is going to moderate," says Jeff Kleintop, chief investment strategist at PNC Wealth Management (PNC). "But we are still a number of quarters away from a true bottom."

The cooling housing market has already taken a slice out of the economy. Gross domestic product (GDP) expanded at a pace of 1.6% in the third quarter, down from a 2.6% pace in the second quarter, according to the Commerce Dept.'s advance report. Residential investment tumbled at a 17.4% one-year pace from a year earlier, trimming 1.1% from GDP growth. Fed Chairman Ben Bernanke has predicted softening housing would probably subtract 1% from economic expansion in the second half of 2006, and possibly 2007.

Experts are divided over how long the housing weakness will continue and what its effect will be on the overall economy. Troubled homebuilder stocks like D.R. Horton (DHI), Lennar (LEN), Pulte Homes (PHM), and KB Home (KBH) have perked up since their midsummer lows. As for the decline in new home sale prices, "it remains to be seen" what this development implies for consumer spending, according to Thomas Stolper, global markets economist at Goldman Sachs. "The market for now seems to be giving greater attention to the boost to real disposable income from falling gas prices," Stolper says in an Oct. 27 note to clients.

Impact Could Be Wide

Some analysts expect economic growth to start increasing again, until the Fed is forced to raise interest rates yet again sometime next year to rein in inflation. "After the housing construction adjustment has worked through, we look for growth to rise back above potential," says John Ryding, chief U.S. economist at Bear Stearns, in an Oct. 27 dispatch.

On the downside, a drop in mortgage applications for new home purchases may illustrate the depth of the housing decline.