Competing Forces in the U.S. Housing Market

Ken Johnson, CFA Investment Strategy Analyst Luis Alvarado Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS Competing Forces in the U.S. Housing Market April 10, 2018 Key takeaways» Pressures on housing affordability (due to rising home prices, subdued income growth, and increasing interest rates) remain high in some places. As a result, some are questioning whether the housing market can continue to contribute to economic growth as it has done in the recent past.» There is historical evidence that confirms housing demand is sensitive to movements in interest rates. Yet, our research shows that there is no direct relationship between rising mortgage rates and increasing home prices. What it may mean for investors» We are relatively cautious about the U.S. housing sector, but we do not believe that it is overextended yet. It is easy to understand how higher mortgage rates may create concern for consumers and markets alike; however, we remain convinced that current evidence doesn t support weakness in the housing sector. With spring just around the corner, we believe that this is an appropriate time to assess some key factors that currently are affecting the U.S. housing market. Over the past year, the housing market has improved and continued to contribute to economic growth; however, some headwinds are beginning to surface. Pressures on affordability (due to rising home prices, subdued income growth, and increasing interest rates) remain high in some places. As a result, some are questioning whether the housing market can continue to contribute to U.S. economic growth as it has done in the recent past. In this first of a series on housing, we focus on the effect that rising mortgage interest rates have on home prices and sales. Why do mortgage rates rise? Interest rates have been rising. This includes not only the fed funds rate the rate that banks charge other banks when they lend them money overnight but also mortgage rates. 2018 Wells Fargo Investment Institute. All rights reserved. Page 1 of 7

Mortgage rates generally track the 10-year U.S. Treasury yield, as Chart 1 illustrates. Two prominent factors influencing the 10-year Treasury yield and mortgage rates are inflation expectations and the U.S. fiscal deficit. One way we measure inflation expectations is using the five-year forward breakeven index, which measures expected inflation over the five-year period beginning five years from now. This indicator has shown relatively low inflation expectations in the range of 1.81% to 2.26% over the past 12 months, with an average value of 2.0%. Chart 1. Thirty-year mortgage rates track 10-year Treasury yields closely 20 18 16 14 Interest rates (%) 12 10 8 6 4 2 0 '72 '74 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Freddie Mac 30-Year mortgage rates Ten-year U.S. Treasury yield Source: Bloomberg, as of March 31, 2018. Monthly data from March 31, 1972 to March 31, 2018. Another factor that is currently influencing the 10-year Treasury yield is the rising U.S. fiscal deficit. We discussed this in detail in our Paying America s Bills Report released last summer. 1 One of the report s main points was that investors could demand higher rates if they become insecure about the United States ability to repay its debt. We believe the United States leading global economic position and the dollar s position as the world s primary reserve currency can support this country s current debt levels. Furthermore, if debt were to rise significantly, we believe that the government has other tools, such as reducing entitlement spending, to help get expenses back in check. Today, neither inflation nor the U.S. fiscal deficit appear to be overly concerning to bond buyers, and we anticipate only a modest increase in interest rates this year. The average spread over the past 46 years between the 10-year Treasury yield and 30-year mortgage rates has been roughly 1.6%. If we assumed that this spread would remain constant, and added it to our year-end 2018 midpoint 10-year Treasury yield forecast of 3.0% that would approximate a mortgage rate of 4.6% by year-end. That is not far from today s 30-year mortgage rate of 4.4%. 1 Wells Fargo Investment Institute, Paying America s Bills, July 2017. 2018 Wells Fargo Investment Institute. All rights reserved. Page 2 of 7

Rising home prices Who is to blame or thank? According to CoreLogic, U.S. home prices increased 6.2% in January 2018 from the January 2017 level, and they are forecasted to increase by another 4.8% by January 2019. While these price increases erode housing affordability, our research shows that there is no direct relationship between rising mortgage rates and increasing home prices. When rates rise, the monthly cost (mortgage payment) for a new home also rises, which discourages consumers from purchasing homes (i.e., demand falls). At the same time, homebuilders can find it more costly to finance new construction, which may constrain the inventory of new homes (i.e. supply falls). All things being equal, if both demand and supply decline simultaneously, home prices are unaffected. The increase in home values today is still heavily influenced by demand and supply dynamics. The U.S. unemployment rate has dipped to levels not seen since before the 2008 recession, incomes are moving higher (although at a slower pace), and consumer confidence continues to hover around its all-time highs all key factors for an increased appetite for homes. However, new home construction has been sluggish as builders struggle to find qualified workers and undeveloped land in desired locations. This combination of pent-up demand and low inventory levels has been driving overall home prices higher, with some regions seeing sharper increases than others. We will expand more on the regional dynamics of the U.S. housing market in part two of our series. The ups and downs of rates and home sales Mortgage rates seem to have a negative relationship with home sales. Generally, in periods of rising mortgage rates, new home sales have declined, and in periods of falling mortgage rates, they have increased. Chart 2: New home sales are sensitive to mortgage rates 1450 20 New home ssles (Thousands) 1250 1050 850 650 450 18 16 14 12 10 8 6 4 Interest rates (%) 250 2 '72 '74 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 New home sales (LHS) Freddie Mac 30-Year mortgage rates (RHS) Source: Bloomberg, as of March 31, 2018. Monthly data from January 31, 1972 to March 31, 2018. Yellow boxes encompass periods of negative relationship between new home sales and mortgage rates. 2018 Wells Fargo Investment Institute. All rights reserved. Page 3 of 7

However, our intent is to measure the magnitude of change (elasticity) of housing demand in relation to an upward movement in mortgage rates over different periods of time. Elasticity, in simple terms, is equivalent to the percentage change in demand in this case, new home sales, divided by the percentage change in the mortgage interest rate. Applying a simple linear regression over different periods, we determined that as mortgage rates increased, new home sales decreased (Table 1). Table 1: As mortgage rates increased new home sales decreased Rising mortgage rate periods Dates If mortgage rates increased by 10%, new home sales decreased by: 1/31/1973 4/30/1975 2.1% 11/30/1977 4/30/1982 6.5% 3/31/1994 3/31/1995 2.1% 9/30/2005 10/31/2006 0.1% 5/31/2013 5/31/2014 1.5% 11/30/2016 3/31/2018 0.5% Average 2.1% Sources: Bloomberg, Wells Fargo Investment Institute, as of March 31, 2018. Simple linear regression equation determined as: [Ln (new homes sales) = 2.97 0.214 * Ln (mortgage rates)]. This regression equation implies that if interest rates increased by 10%, new home sales decreased by 2.1% on average (all other things being equal). Monthly data from January 31, 1973 to March 31, 2018. Ln= natural log of a number. It s easy to understand how higher mortgage rates may create concern for consumers and markets alike; however, we remain convinced that the evidence doesn t support weakness in the housing sector. The average mortgage interest rate was 4.4% on March 31, 2018. If the rate were to increase by 10% to 4.88%, we would expect a 2.1% average decline in new home sales (all other things being equal). This effect seems to be very minimal, and we don t believe that it would derail the momentum in home sales supported by strong demand. Investment implications Historically, housing has contributed between 15 and 18% of U.S. economic growth (with roughly 3-5% coming from physical residential investment). According to the National Association of Home Builders Market Index, market conditions for the sale of new homes are at some of their best levels since the late 1990s. As Chart 3 shows, the lift in housing construction, represented by housing starts, should help to support economic growth. From an equity investor s perspective, we believe that two sectors can benefit in this current housing market: Financials and Consumer Discretionary. 2018 Wells Fargo Investment Institute. All rights reserved. Page 4 of 7

Chart 3: Housing starts support GDP growth 20 2500 U.S. GDP gross domestic residential investment (YoY%) 15 10 5 0-5 -10-15 -20-25 -30 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17 2000 1500 1000 500 0 Housing starts (Thousands) U.S. GDP gross domestic residential investment (YoY%) Housing starts Source: Bloomberg, as of December 31, 2017. Mortgage loans often make up a large part of banks credit portfolios, and as mortgage rates increase, banks profitability tends to increase. Mortgage supply has been slow to increase since the financial crisis. Yet recently, we have observed positive mortgageloan growth on companies balance sheets. Consumer Discretionary companies could benefit indirectly from a stronger housing market, by way of the wealth effect (which describes the psychological phenomenon by which consumers increase spending habits due to their perceived wealth). Typically, as home values increase, consumers feel wealthier and this translates to their willingness to purchase more goods and services. We believe that the U.S. housing market likely will continue to improve and contribute to the overall economy. In addition, while mortgage rates are likely to rise as the economy improves, we do not expect the increase to be large enough to reduce the pace of home sales. Furthermore, we do not expect gradually rising interest rates to directly affect the value of homes. \ 2018 Wells Fargo Investment Institute. All rights reserved. Page 5 of 7

Economic Calendar Date Report Estimate Previous 4/10/2018 NFIB Small Business Optimism 107 107.6 4/10/2018 PPI Final Demand MoM 0.10% 0.20% 4/10/2018 PPI Ex Food and Energy MoM 0.20% 0.20% 4/10/2018 PPI Ex Food, Energy, Trade MoM 0.20% 0.40% 4/10/2018 PPI Final Demand YoY 2.90% 2.80% 4/10/2018 PPI Ex Food and Energy YoY 2.60% 2.50% 4/10/2018 PPI Ex Food, Energy, Trade YoY -- 2.70% 4/10/2018 Wholesale Trade Sales MoM 0.10% -1.10% 4/10/2018 Wholesale Inventories MoM 0.80% 1.10% 4/11/2018 MBA Mortgage Applications -- -3.30% 4/11/2018 CPI MoM 0.00% 0.20% 4/11/2018 CPI Ex Food and Energy MoM 0.20% 0.20% 4/11/2018 CPI YoY 2.40% 2.20% 4/11/2018 CPI Ex Food and Energy YoY 2.10% 1.80% 4/11/2018 CPI Index NSA 249.576 248.991 4/11/2018 CPI Core Index SA 256.2 255.751 4/11/2018 Real Avg Weekly Earnings YoY -- 0.60% 4/11/2018 Real Avg Hourly Earning YoY -- 0.40% 4/11/2018 Monthly Budget Statement -$186.0b -$215.2b 4/11/2018 FOMC Meeting Minutes -- -- 4/12/2018 Import Price Index MoM 0.10% 0.40% 4/12/2018 Initial Jobless Claims 230k 242k 4/12/2018 Import Price Index ex Petroleum MoM 0.20% 0.50% 4/12/2018 Import Price Index YoY 3.80% 3.50% 4/12/2018 Continuing Claims 1843k 1808k 4/12/2018 Export Price Index MoM 0.10% 0.20% 4/12/2018 Export Price Index YoY -- 3.30% 4/12/2018 Bloomberg April United States Economic Survey 4/12/2018 Bloomberg Consumer Comfort -- 57.2 4/13/2018 JOLTS Job Openings 6065 6312 4/13/2018 U. of Mich. Sentiment 100.4 101.4 4/13/2018 U. of Mich. Current Conditions -- 121.2 4/13/2018 U. of Mich. Expectations -- 88.8 4/13/2018 U. of Mich. 1 Yr Inflation -- 2.80% 4/13/2018 U. of Mich. 5-10 Yr Inflation -- 2.50% 4/16/2018 Retail Sales Advance MoM 0.30% -0.10% 4/16/2018 Empire Manufacturing 19.6 22.5 4/16/2018 Retail Sales Ex Auto MoM 0.20% 0.20% 4/16/2018 Retail Sales Ex Auto and Gas -- 0.30% 4/16/2018 Retail Sales Control Group -- 0.10% 4/16/2018 Business Inventories 0.60% 0.60% 4/16/2018 NAHB Housing Market Index 70 70 4/16/2018 Total Net TIC Flows -- $119.7b 4/16/2018 Net Long-term TIC Flows -- $62.1b Source: Bloomberg, as of April 9, 2018. 2018 Wells Fargo Investment Institute. All rights reserved. Page 6 of 7

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