No bubble in housing?

The Federal Reserve Bank of New York put out a report last week stating that there is no bubble in the US housing market.

Home prices in the US have been rising strongly since the mid-1990s. Many economists think that the housing market is a bubble and that home prices are vulnerable to a collapse that could in turn adversely affect consumer spending and hurt the US economy, especially if the Federal Reserve Board raises interest rates.

However, the Federal Reserve Bank of New York report, written by Jonathan McCarthy, a senior economist, and Richard W. Peach, a vice president at the bank, has a different take. It concludes that the rise in home prices is largely attributable to strong market fundamentals. "Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates," it states.

To arrive at this conclusion, the authors used a constant-quality new home price index that takes into account the physical and locational characteristics of homes, rather than the more commonly-used index tracked by the Office of Federal Housing Enterprise Oversight. This is to adjust for improvements in quality over time.

Using the constant-quality new home price index, the authors show, using both cash flow affordability and an asset valuation model, that "given the steep decline in interest rates, home prices do not appear to be at unusually high levels".

The authors also think that home prices are not likely to plunge even if fundamentals deteriorate as home prices are less volatile than those for other assets, such as equities.

Not everyone agrees with the report's conclusion.

Ian Morris, chief US economist at HSBC, thinks a bubble exists and prices are likely to deflate gradually over a few years, triggered by interest rate rises. "This bubble-psychology has manifested itself in very rich valuations," he wrote in a report released on Friday titled "The U.S. Housing Bubble -- The case for a home-brewed hangover".

"Expectations of future house price appreciation are spectacularly, and unrealistically, high," he wrote.

Morris has doubts about the use of the quality-adjusted home price index. He thinks the existing stock of housing does not show the same improvement in quality as new homes.

Mark Weisbrot, co-director of the Center for Economic and Policy Research in Washington, DC, also thinks that there is a housing bubble. In his article "Greenspan Should Respond to Housing Bubble" on 24 June, he urges the Federal Reserve chairman Alan Greenspan to emulate Mervyn King, Governor of the Bank of England, who had sounded the warning in the UK that "the chances of falls in house prices are greater than they were".

"The bigger the housing bubble grows, the greater will be its negative impact on the economy when it bursts," writes Weisbrot.

"The Fed Chairman is supposed to be the country's most fearless economic watchdog, appointed to be independent of political pressures, willing to speak the truth and take the heat for 'pulling the punch bowl away just as the party is getting started.' If he won't warn the public of dangerous bubbles in asset prices, who will?"

Those who are familiar with Greenspan's thinking would know that he would probably not acknowledge a bubble even if it were staring at him in the face. Back in 2002, in defending his failure to act earlier to deflate the stock market bubble of the late 1990s, he had said that "it was very difficult to definitively identify a bubble until after the fact -- that is, when its bursting confirmed its existence".

Back in the late 1990s, Greenspan would have been concerned that any tightening action taken to deflate the stock bubble could also harm the economy. Unfortunately, the problem today could be worse. With American households more heavily indebted than ever, a housing bubble may be needed just to keep the US economy going.

As Richard Russell wrote in the Dow Theory Letters earlier this month: "I believe the Fed's fighting the global forces of DEFLATION. I think that Greenspan is afraid that the American consumer is 'tapped out.' And that consumers are very close to cutting back on their spending. The Fed's defense against a 'disastrous' consumer cut-back is to keep asset inflation going."

On 30 June, the Federal Reserve meets to discuss its next move in monetary policy. With near-unanimity among economists that the Federal Reserve will begin its tightening cycle at the meeting, we will soon know whether there is a housing bubble.

Singapore's growth rate: 7 percent but slowing

The forecast for Singapore's growth in gross domestic product has been revised upward, with the purchasing managers' index (PMI) continuing to indicate expansion in manufacturing. However, there are also indications that the pace of expansion may slow in the coming months.

According to the latest survey of private-sector forecasters published by the Monetary Authority of Singapore (MAS) on 3 June, Singapore's gross domestic product will grow by 7 percent this year. This compares with a median forecast of 5.5 percent in the previous survey in March.

On 17 May, the Ministry of Trade and Industry had raised its forecast for Singapore's economic growth to between 5.5 and 7.5 percent, up from 3.5 to 5.5 percent earlier.

The PMI reported by the Singapore Institute of Purchasing & Materials Management (SIPMM) also indicates good growth ahead, with a reading of 55.7 for May, up half a point from the previous month. It was the twelfth consecutive month that the PMI has been above 50, the threshold for indicating an expansion in manufacturing.

And just for good measure, on Friday, the US Labor Department reported that the economy added 248,000 jobs in May. Job gains in April and March were revised upward to 346,000 and 353,000 respectively.

However, the jobs data is widely acknowledged as a lagging economic indicator. Among the leading indicators is growth in new orders. Here, the picture is less rosy.

Among the sub-indices reported by the SIPMM last month, the electronics new orders sub-index fell 4.4 points from the previous month to 55. The electronics new export orders contributed the bulk of the fall, down 6.2 points from the previous month to 54.4.

In the US, the Commerce Department also reported last week that new orders at US factories fell 1.7 percent in April.

The forecasters surveyed by the MAS also expected a slowdown. Their median forecast was for the Singapore economy to peak at 10.3 percent growth year-on-year in the second quarter, before falling to 6.1 and 4.6 percent in the third and fourth quarters respectively.

Further downside to economic growth this year, however, may be limited. According to the MAS report, higher oil prices, hikes in US interest rates and a slowdown in the China economy have all been factored into the forecasts. None of these -- and not even terrorist attacks, in fact -- were anticipated "to derail domestic growth prospects".

The forecasters were also relatively optimistic for next year. The median forecast for 2005 was 5.0 percent. This was higher than the forecast of 4.5 percent in the previous survey.

Some economists think a slowdown is inevitable. Much of this year's growth has been powered by monetary and fiscal stimulus in the US, that is, low interest rates and tax cuts. With interest rates expected to head higher from here onward, the huge levels of debt held by households and businesses in the US will become serious headwinds for further economic growth.

On the other hand, many economists are hoping that if jobs can continue to be created in the US at the pace of the past few months, the purchasing power of American consumers can be maintained and the economic expansion will become self-sustaining. As William G. Cheney, chief economist at MFC Global Investment Management said: "You create that many jobs and people go out and spend the money and it feeds on itself."

And some of that money will ultimately make its way to Singapore and feed its economic growth as well.

It's still a bull market

The Standard and Poor's 500 closed at 1,121.20 yesterday, 3.2 percent below its peak this year of 1,157.76 in February, but well off its recent low of 1,084.10 on 17 May. Up till last week, when the S&P 500 gained 2.5 percent, the US stock market had been on an almost continual decline since early April, weighed down by concerns over impending interest rate hikes and increases in oil prices. These concerns, however, may be overdone.

Theoretically, interest rate hikes should have little impact on the stock market if they reflect an improving economy. In fact, the latter by itself should actually augur well for stocks. Of course, valuations are negatively affected by higher interest rates. The two factors tend to cancel each other.

Furthermore, the latest data show that inflation remains low even as the US economy continues to grow. In April, consumer spending was up 0.3 percent and incomes rose 0.6 percent, but the core personal consumption expenditures index was up only 0.1 percent or 1.4 percent year-on-year.

Employment data, which had been so strong in March and April and which had fuelled much of the fears for an interest rate hike, have not been as strong recently. On 27 May, the US Labor Department reported that the number of people filing for first-time unemployment insurance claims for the previous week was 344,000. This was down from the revised 347,000 reading on initial filings for the week before, but higher than the 335,000 expected by economists surveyed by Briefing.com. Also, the four-week moving average for claims rose by 1,500 to 335,500.

Overall, these data indicate that there may not be a need for the Federal Reserve to raise interest rates as aggressively as analysts had thought.

As for oil, crude oil futures surged past US$42 a barrel on 1 June after the killing of 22 people last weekend in Khobar, Saudi Arabia raised concern that attacks by Islamic militants might disrupt shipments.

However, the impact of oil prices on the economy is not as great as what it was in the 1970s, as pointed out in an article in The Business Times on 24 May titled "Markets in for rough ride as Opec defers output decision".

"The growth of service industries, combined with higher productivity levels, has reduced the energy intensity of OECD economies dramatically," said UK information group Oxford Analytica. "The amount of oil the OECD uses to produce one dollar of real GDP halved between 1973 and 2002. The International Energy Agency estimates that the oil import bill for the OECD region last year was worth only about one per cent of the region's GDP."

US Council of Economic Advisors chairman Gregory Mankiw also said that while oil prices may be a "headwind for the US economy", they do not pose a significant threat to recovery.

In any case, much of the increase in oil price is the result of China's surging demand. Efforts by the Chinese government to cool its economy may curb that demand. Already, China's State Development Reform Commission has reported that prices of steel products and non-ferrous metals are sliding. "The government's bid to rein in raw material prices is kicking in," DBS Hong Kong economist Chris Leung told Bloomberg.

Many analysts also think that the bull market is intact, based on another article titled "It's still a bull market, say Wall St analysts" on 24 May in The Business Times. According to the article, investors have over-reacted and the sell-off on Wall Street has gone "too far".

Ryan & Beck investment strategist Joe Battipaglia thinks that investors are overreacting on the negative side in the face of an improving jobs market and the prospect of rising interest rates. "I think once investors take a deep breath and look at what's going on, the market will start climbing again," he argued.

Chuck Hill of Thompson/First Call is similarly optimistic. "Early in the year, people were worried that from the first quarter on, profit growth would slow once we started coming up on tougher year-over-year comparisons, but just the opposite is happening. The profit picture looks great through the end of the year," he said.

Peter Halesworth, president of Libertas International, attributes the downturn not to a negative shift in market fundamentals but to "a messy sector rotation. Investors simply waited too long to shift their positions and now they're being caught in a short squeeze". Investors had been too complacent, assuming that the liquidity drive would continue indefinitely.

He foresees a gradual, if choppy, trend up over the summer for the stock market, followed by a stronger bullish move in the fall, although that could be delayed until after the presidential elections.

The latest economic indicators released yesterday support his forecast. The Institute for Supply Management's index of national factory activity rose to 62.8 last month from 62.4 in April. The US Commerce Department reported that construction spending rose 1.3 percent in April to a seasonally-adjusted annual US$970.4 billion, the third consecutive record high.

So yes, it is probably still a bull market, although the ride may be a little rough for the next few weeks or months.