Housing Deep Dive: Q1 2023
The construction cycle in residential housing is the most important cycle in the economy.
The residential construction sector is often referred to as residential fixed investment, and although this sector only makes up 3%-6% of the total economy, the leading and high multiplier nature of residential construction makes it extremely influential despite its small size.
Whenever there is a big decline in the residential construction sector, a recession or sizable economic downturn in the broader economy usually follows.
This chart plots the 2-year rate of change of the housing sector as a share of GDP.
The latest value, in Q4 of 2022, tells us that the residential construction sector was contributing 1% less to overall economic activity compared to the last two years.
When the housing impulse in the economy is this negative, it’s highly common to already be in a recession.
There is also an apparent relationship between the depth of the housing downturn and the severity of the recession, with the 1974 recession, early 1980s double recession, and 2008 recession representing recessions with large negative contributions from housing.
We can learn more about the importance of the housing or residential construction sector in the paper “Housing IS the Business Cycle” by Edward Leamer. Many people dismiss this paper because of the overly reductionist conclusion in the title, but that is not the correct takeaway.
Of course, the housing sector is not foolproof as an indicator of economic activity, but if you could only choose one sector to follow, you’d empirically have the most success on a leading basis, tracking the residential construction cycle.
Fortunately, we don’t only have to pick one sector, and we can add the manufacturing cycle and other parts of the economy to round out the areas that the housing sector may be lacking and the paper helps us do that by analyzing the performance of various sectors entering into recessionary periods.
The housing sector, while not enough in isolation, is important enough that it warrants its own breakdown to understand all the drivers and what the most recent data is telling us about this current downturn.
Construction Spending
Remember that we’re very focused on the level of construction activity in the housing market, not the price of homes. Price is a lagging indicator.
This chart shows the total level of residential construction spending in the economy.
Residential construction spending peaked in May 2022.
Residential construction spending has three major components: new single-family construction, new multi-family construction, and remodeling or residential improvements to existing homes.
This chart shows the level of new construction spending on the left and remodeling spending on the right.
New construction spending peaked in June, while remodeling spending peaked in July.
The downturn in new construction is much deeper than remodeling.
If we separate new construction into single-family and multi-family, we can see that the only segment of residential construction spending that is really declining is new single-family.
New multi-family construction spending is still exploding, and remodeling spending is barely off its high, in a clear bubble after the pandemic.
Building permits are the most reliable leading indicator of residential construction spending. Permits come before construction begins.
While total residential construction spending peaked in May of 2022, building permits peaked in March of 2022.
There was a similar lead time between permits and construction spending in the 2006 cycle.
The downturn in building permits is also falling most heavily on single-family. Single-family construction spending peaked in May 2022, and permits peaked in February.
Multi-family permits are more volatile and didn’t start turning lower until July 2022.
So aggregate building permits peaked in March 2022, and aggregate construction spending peaked in May 2022.
Single-family permits turned down in February 2022, and single-family construction spending turned down in May 2022.
Multi-family permits turned lower almost six months after single-family. Over the next 1-2 quarters, we should then see the peak in multi-family construction spending.
What’s also important is that we haven’t seen a bottom in aggregate permits so there’s nothing suggesting that the total level of residential construction spending will turn higher in the next 3-4 months.
In other words, we don’t have good reason to believe housing will add positively to economic activity in Q1 or Q2, and with the economy already either in, or on the cusp of recessionary territory, that’s a big vulnerability.
Units Under Construction
Construction spending is reported in nominal dollars, and the price of many items used in residential construction skyrocketed in recent years.
We can also track the number of units under construction to remove the effect of prices and get a cleaner read on the level of actual construction activity.
In the 2006 housing peak, building permits topped out in September 2005 and then the number of units under construction peaked about 5-6 months later in Q1 of 2006.
Although we saw the peak in building permits more than six months ago, we have not yet seen the decline in the number of housing units under construction. Prices are coming down, which is driving the dollar value of spending down, but the number of units under construction is at an all-time high.
The story is the same, however. The number of single-family housing units under construction is declining, having topped out over the summer.
The number of multi-family units or apartments under construction is still exploding.
It’s worth pointing out that the number of multi-family units under construction is not as reliable of a leading indicator as single-family construction and 2008 is a good example. The number of multi-family units under construction was increasing into the middle of the crisis.
The reason for this is that it takes a lot longer to build a multi-family building compared to a single-family, so the financing and approvals for a project that breaks ground in 2008 could come many quarters earlier.
So what’s happening is that the rise in mortgage rates and terrible housing affordability is taking a major toll on new single-family construction, but multi-family construction is not really impacted by the 30-year fixed mortgage, and many of these projects were planned over a year ago.
Construction Employment
Now that we’ve seen a downturn in multi-family permits, we know that there will be a peak in multi-family units and total multi-family construction spending in next quarter or two.
Once the downturn in single-family construction is met with a downturn in multi-family construction, then construction employment will follow. This is likely going to be a story for the spring and early summer of 2023.
This is not at all inconsistent with a recession beginning late in Q4 or early in Q1.
The number of construction employees did not decline in advance of the 1970 recession, rose into the first few months of the 1974 recession, and did not decline in advance of the 1980 recession.
Construction employment has peaked before the start of the recession in recent cycles, but it’s not at all inconsistent to have a recession form before there has been a material decline in construction employment.
This is another way to stress that we have to remain focused on the more leading indicators and cannot make determinations about what is going to happen by looking at coincident indicators.
Coincident indicators don’t tell us anything about what’s going to happen. They only define the current trend.
The level of permits, construction spending, and units under construction will tell us about construction employment.
So we know that the level of building permits generally leads the level of construction for new and multi-family units.
We also can’t forget about remodeling because that is not really tied to mortgage rates.
In the Ed Leamer paper, he shows how mortgage rates, the yield curve, and the real Fed Funds rate are the best leading indicators of housing starts and construction spending.
Changes in mortgage rates are only one factor that impacts residential construction spending because two of the three categories, multi-family construction, and residential remodeling, are not impacted by mortgage rates.
The combination of mortgage rates, the real Fed Funds rate, the yield curve, and the state of monetary policy, all taken together, are the best leading indicator of building permits and then construction spending because we get a read on all three sectors.
Mortgage rates and affordability most closely impact new single-family construction, the real Fed Funds rate and the level of monetary tightness impact multi-family construction, and the yield curve leads broader economic activity and discretionary consumption like residential remodeling.
Let’s walk through the leading indicators of each segment, contextualize the movement in building permits and then make our conclusions about the construction cycle, which inform our conclusions about the broader economy.
—
This is a shortened version of the Semi-Annual Housing Deep Dive Report, published to members of the EPB Gold Tier.
The EPB Gold Membership delivers a total of 68 videos per year including Weekly Economic Updates, Monthly Cyclical Trends Updates and more. You also get access to the EPB Member’s community which allows you to interact with me (Eric) and other top macro investors.
