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S&P's chief strategist says the slump probably won't tilt the economy into recession, thanks to a proactive Fed
From Standard & Poor's Equity ResearchIn the past few weeks, news and forecasts surrounding the housing decline—which began in 2005 and is projected by S&P Economics to bottom out during the first half of 2008—appear to have shaken investors awake and generated a renewed worry. At a recent meeting of S&P's Investment Policy Committee, someone said these investors must have awakened from a coma and are only now pressing the panic button multiple times.
Maybe the consensus expected the decline to be a lot worse than it will likely be. David Wyss, S&P's chief economist, has been forecasting for nearly a year that the slump in housing would subtract 1% from U.S. gross domestic product in 2007 and 2008. What's more, Wyss thinks the median price for homes across the U.S. will decline 11% from the peak in 2005 to the projected trough during the first half of 2008, and that—as we are less than halfway there—things will get worse before they get better.
What could be generating increased agitation among investors, in our opinion (besides the 10.2% plunge in September's U.S. housing starts to a 1.191 million pace, the lowest level in 14 years), is history, which has demonstrated a high correlation between declines in residential construction and recessions. I was alerted to this fact by my friend Jim Stack of InvesTech Research in Whitefish, Mont., and was alarmed to see that every recession since 1960 has been accompanied by a year-over-year decline in residential construction, which includes new home construction and home improvements.
During the current housing cycle downturn, S&P and Global Insight, an economic forecasting service, sees the year-over-year decline in residential construction bottoming in the first quarter of 2008 at –20.8%, and becoming positive once again in the second quarter of 2009. Obviously, with such a high correlation between construction declines and recessions, no wonder investors worry about recession and question the validity of our stated 33% risk of recession in 2008—equal to the risk percentage held by former Fed Chairman Alan Greenspan. But we think we will escape recession, despite weak housing, as we did twice since 1960.
Lessons from the Past
The reverse of this proposition is less alarming because even though all recessions have been accompanied by construction declines, not all construction declines resulted in recessions. Twice the U.S. experienced year-over-year declines in residential construction—1967 and 1995—but did not slip into recession. In 1995, the reason could have been that the housing decline was the second shallowest of all 10, posting a 7.5% drop-off during the second quarter of 1995. The construction decline was also fairly short, lasting only four quarters, as opposed to the decline of 1973-1974, which lasted nine straight quarters, eight of which featured double-digit declines. (The housing recession of 1980-1982 saw 14 months of declines, but was separated by one positive quarter.)
Another reason the 1995 housing slump may not have triggered a recession, in our opinion, was that the Federal Reserve acted fairly quickly to reverse the effects of the seven Fed funds rate increases from February, 1994, through April, 1995, that raised rates from 3% to 6%. The Fed reversed course five months later and cut rates from July 1995 through January, 1996, bringing the Fed funds rate down to 5.25%. Also, U.S. real (i.e., unadjusted for inflation) GDP slowed to a 2% year-over-year gain in the December, 1995, quarter and was surrounded by 2.5% gains in the September, 1995, and March, 1996, quarters.
The housing slump from the fourth quarter of 1964 through the first quarter of 1967, which saw a 22.9% year-over-year decline in residential construction, but did not lead to a U.S. recession, was also incorrectly anticipated by the S&P 500 as it slipped into a bear market mode from February, 1966, until October, 1967, that shaved 22% off of the S&P 500's value. One reason could be that the economy again slowed, but did not enter into a recession. In March, 1966, the U.S. economy peaked at an 8.5% year-over-year increase in real GDP, and bottomed in June, 1967, at a 2.4% rate of growth. It fell into recession two-and-a-half years later. Fed policy was on hold in 1966, after policymakers gradually raised the discount rate from 3% in August, 1960, to 4.5% in December, 1965.
No Recession in the Cards
S&P Economics is also not predicting a recession this time around—due to the breadth of the overall economy, a weakening dollar's attractiveness to foreign investors, and its positive impact on export demand, as well as the aggressiveness of the Federal Reserve and Treasury Department to get ahead of a recession curve. Indeed, we see the dollar continuing to weaken in the months ahead as the Fed cuts short-term rates at least once, if not twice, more before the January, 2008, FOMC meeting. We think a lower dollar will help boost growth in exports, which we see rising 9.5% in 2008, following a 7.3% advance this year, helping to offset a decline in consumer spending growth to 2.2% in 2008 from our estimate of 3% growth in 2007. These cuts should also help profits rebound.
Still Cautious on Housing-Related Groups
Just because we don't see the U.S. economy slipping into recession doesn't mean we think housing-related subindustries deserve positive fundamental outlooks, nor do S&P equity analysts have an abundance of buy recommendations on stocks in these groups. In fact, none of the six housing-related subindustries in the S&P 1500 (which account for only 1.3% of the entire market value of the broad U.S. benchmark) have a positive fundamental outlook. Four carry negative outlooks by S&P equity analysts, while the remaining three have neutral outlooks.
Home Furnishings: Specifically, S&P equity analyst Kenneth Leon has a negative fundamental outlook on the home-furnishings subindustry. This group has experienced weak demand from lower customer spending, minimal pricing power, and low net margins. Foreign providers benefit from lower labor costs and government subsidies. U.S. home-furnishings companies have tried to remain competitive by investing capital more efficiently and creating new furnishing groupings that have more appeal for today's lifestyles.
Leon expects increased efficiency to help companies consolidate production into fewer domestic manufacturing facilities, particularly as outsourcing to low-cost countries is becoming an increasingly important factor in production. Near term, he expects companies to preserve or build cash by divesting less attractive brands and divisions, lowering operating costs to widen margins, and refinancing or reducing debt outstanding.
Home Improvement Retail: S&P's fundamental outlook for the home improvement retail subindustry is neutral. Michael Souers, S&P's equity analyst covering this group, projects new housing starts to decline an additional 16.6% in 2008, following a projected fall of 25.2% this year and a 12.6% slump in 2006. Despite this negative trend and a slowing economy, he believes the group has some favorable drivers. For one, future hurricanes notwithstanding, we think the rebuilding efforts from Hurricane Katrina bode well for home improvement retailers for the next several years.
Also, S&P believes the aging of homes, coupled with the retirement of many baby boomers, provides a solid demographic driver and should lead to continued home-improvement expenditures. Lastly, remodeling will likely remain a focus for consumers regardless of the state of the housing market, as homes are generally viewed as investments by homeowners.
Homebuilding: Ken Leon also has a negative fundamental outlook for the homebuilding group. For 2007, he sees the typical homebuilder's earnings per share (EPS) to be at least 75% lower than in the peak year of 2005, following average annual profit growth of 30% to 40% in 2000-2005. The National Association of Homebuilding's chief economist sees no recovery until the 2008 third quarter.
With credit tightening negatively affecting the mortgage market, new housing starts may dip lower before bottoming out, in our opinion. Homebuilders' focus has shifted to sales incentive programs, liquidity, and bank refinancing to endure the current downturn. With no sign of near-term improvement, Leon thinks it may take a few quarters before homesites owned by builders are reduced, and projects that the equilibrium between supply and demand may not be realized until the second half of 2008.
Home-Furnishing Retail: Michael Souers' fundamental outlook for the home-furnishing retail subindustry is negative. He thinks home furnishing retailers will be hit even harder than most retailers as consumers likely will be hesitant to buy big-ticket furniture items. The home-furnishing retail industry is intensely competitive, with retailers looking for ways to broaden product offerings as they add square footage to their stores.
General merchandise stores such as Target (TGT) and Wal-Mart (WMT) are contributing to this, in our view, and have been offering a greater amount of home-furnishing items at discount prices. As a result, heavy discounting by retailers trying to meet sales forecasts is putting a strain on margins, and Souers expects continued promotional activity through 2007 and well into 2008 as companies look to unload excess inventory.
Household Appliances: Ken Leon's fundamental outlook for the household appliances subindustry is neutral. He expects modest top-line growth over the next 12 months—driven by emerging markets—to partly offset a slowdown in the U.S. market. He thinks household appliance companies have done a good job of managing costs in a challenging environment. However he believes the opportunity for future margin expansion is limited after industry consolidation.
In our view, the U.S. consumer is fairly stretched, partially due to relatively higher energy costs and interest rates, which could put a damper on appliance spending. Furthermore, Leon believes a decline in new housing starts through 2008 will hurt demand for appliances, although home remodeling, which has pent-up demand, could spur upscale appliance spending. Although Leon thinks sales of appliances for new homes may slow further, lower interest rate trends may enable households to replace older or broken appliances.
Housewares & Specialties: Equity analyst Loran Braverman has a neutral fundamental outlook on the housewares subindustry. The group has experienced mixed results, with some companies benefiting from new product introductions and others being pressured by inexpensive, imported goods and inventory reductions at some retailers. Rising raw material and packaging costs have negatively affected virtually all companies. Sales growth has been modest, with innovation in new products partially offsetting slow category growth in a mature industry. She believes the rise in energy prices and interest rates has also dampened consumer spending. With a partial mix of cyclical business lines, she thinks this industry should generally move in tandem with the economy.
So there you have it. Even though, in our opinion, the housing slump and sharp rise in oil prices have increased the odds of a recession, S&P Economics believes we will avert economic disaster primarily because of the aggressiveness of the Federal Reserve, with its expected continuing rate-cutting and liquidity infusion efforts. We also believe the weakness in the U.S. dollar will aid U.S. exporters, and the restatement of August's employment data, as well as strength in September's results, will help consumers feel less anxious about their jobs and lessen the effect on consumer confidence.
Industry Momentum List Update
Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of sub-industries in the S&P 1500), along with a stock with the highest S&P STARS (tie goes to the highest market value).
S&P STARS Rank
Auto Parts & Equipment
Johnson Controls (JCI)
Lyondell Chemical (LYO)
Apple Inc. (AAPL)
Construction & Engineering
Jacobs Engineering (JEC)
Construction & Farm Machinery
Trinity Industries (TRN)
Diversified Metals & Mining
Freeport-McMoRan Copper (FCX)
Apollo Group (APOL)
Fertilizers & Agr. Chem.
Air Products (APD)
Oil & Gas Equip. & Svcs.
Tires & Rubber
Goodyear Tire (GT)
Source: Standard & Poor's Equity Research