Contractors work on townhouses under construction at the PulteGroup Inc. Metro housing development in Milpitas, California, U.S., on Thursday, Oct. 25, 2018. PulteGroup Chief Executive Officer Ryan Marshall said that the housing recovery will continue because the economy is strong and the inventory of available homes remains tight. Photographer: David Paul Morris/Bloomberg
Higher construction costs could hit the profits of US homebuilders © Bloomberg

The US housing market was at the heart of the financial crisis that rippled through the global economy a decade ago. Today, emerging cracks in a property recovery are darkening the outlook for housing-related stocks — and possibly further afield.

US house prices kept deflating until 2012, but since then they have climbed more than 50 per cent, propelled by a slowly-healing economy, falling unemployment and interest rates at record lows. That buoyed home-builder stocks, with the Dow Jones Home Construction index, a $47bn-in-market-capitalisation benchmark, delivering almost twice the return of the broader US stock market over the five years to 2017.

But the bloom came off last year, as the index fell more than 40 per cent from peak to trough. While homebuilder stocks have enjoyed a welcome bounce over the past couple of months, they are still down 32 per cent from the top. Concerns over the sector — and what the deterioration means for the broader US economy — continue to swirl.

“The psychology in the housing market has altered,” says Michelle Meyer, head of US economics for Bank of America Merrill Lynch. “That could be very forceful in dictating future volumes in home sales.”

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Indeed, the number of US homes sold fell to a three-year low in December, according to data released last week by the National Association of Realtors. The tumble, the second-sharpest month-on-month drop in home purchases since prices began to recover in 2012, may not have halted the recovery in housing stocks, but raises important questions over whether rising US interest rates are now biting into the real economy.

The Federal Reserve lifted rates four times last year, nudging the cost of new mortgages higher, keeping would-be buyers at bay. The central bank has now turned more cautious, and analysts expect an easing in mortgage rates since November to coax back nervous purchasers in the crucial spring selling season that begins next month.

Yet the long-term prospects for the sector remain more challenging. In addition to interest rates, more structural headwinds — including affordability after the dramatic rise in prices, unexpected demographic changes and the rising cost of construction — have dimmed the outlook for homebuilders.

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High prices have deterred younger buyers while older owners are staying in family homes, bucking expectations they will sell up for a smaller place in a warmer climate.

“Baby-boomers are working longer and millennials are taking longer to move into a single-family home,” says Susan Maklari, an analyst with Credit Suisse in New York. Meanwhile, last year’s market ructions deterred wealthier buyers with assets tied up in stocks and bonds, she argues.

The other end of the spectrum has fared no better. Higher construction costs mean the homebuilders that have cut prices to lure buyers at the low-end of the market will have a hit to their profits.

“Ultimately, they’ll have to make some difficult decisions around pricing,” says Michael Dahl, housing analyst for RBC Capital Markets. “You might see more activity come back but it will be at the expense of margins for homebuilders.”

Mr Dahl believes the sector’s earnings have peaked, and predicts that valuations will drop again in coming months. The industry itself is also growing more concerned, with homebuilders’ confidence near the lowest levels since May 2015, according to the National Association of Home Builders.

The spring selling season — the busiest time of the year for home sales — will be a crucial test that will probably inject volatility to the sector, whether or not sales volumes impress. Meanwhile, there are a few bright spots.

Companies specialising in home repairs and remodelling, for example, could gain from still-rising house prices and a dearth of buying activity. Analysts expect owners who enjoyed the twin benefits of low mortgage rates and rapid price growth will refinance their homes to fund improvements.

“A lot of people out there will say to themselves ‘we’ll tap into the equity of this home and redo the kitchen or the bathroom’. That’s an alternative to going out and buying that new home,” Ms Maklari says.

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However, the broader concern is that the softening housing market and the slide in homebuilders’ stock prices could be a sign of big trouble ahead.

The Dow Jones Home Construction index and sales volumes both started to slide in 2005, before actual house prices began to weaken in 2006. A broader economic downturn took hold a year later.

The recent housing weakness could be a sign that the US economy is more sensitive to interest rates than previously thought, some analysts say. Such fears come as concerns over a slowdown are already elevated.

The International Monetary Fund predicts that the pace of US economic growth will slow a little from 2.9 per cent in 2018 to 2.5 per cent this year, but some investors and analysts fret that the next downturn could be much closer.

“Let’s not forget that [former Fed chair Ben] Bernanke said there was no recession coming in 2008,” says Chris Rupkey, chief financial economist at MUFG in New York. “Housing was the canary in the coal mine and it pulled the economy straight down.”

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