A return to 60/40 balance? [PODCAST]
This strategy fell out of favor, but it may be poised for a return.
This strategy fell out of favor, but it may be poised for a return.
Do high mortgage rates mean trouble is brewing, or will high demand continue to drive prices? Bottom line, we do not foresee a significant correction in home prices, but we do think investors would be well served to understand market conditions.
Are recent headlines that suggest trouble is brewing in the U.S. housing market fear mongering? Coming up, we answer that question and many more.
From Thrivent Asset Management, welcome to Advisor’s Market360TM. A podcast for you, the driven financial advisor.
Recent headlines about the U.S. housing market suggest trouble is brewing. Last month CNN ran a story titled “Why the housing market is going from tough to terrible”, and earlier this month Bloomberg published a thoughtful piece titled, “The U.S. housing market has become an impossible mess”. But so far, the reality seems to be that the volume of transactions has withered, and that’s about it.
A lot of the handwringing may be the result of the actions of the Federal Reserve, or Fed. Its series of interest rate hikes are central to housing and very visible in mortgages. The housing market is the most directly and immediately impacted sector when the Fed starts hiking. So, it stands to follow that a drop in prices would indeed make sense given that already high prices have become even more unaffordable with higher interest rates. But the situation is more complicated — mostly because demand for housing is unusually high, and the supply of housing is extremely low.
Bottom line, we do not foresee the makings of a significant correction in home prices, but we do think investors would be well served to better understand how and why the housing market has changed, as well as the opportunities an active investor may have to capitalize on these changes through the bond markets.
As already mentioned, we don’t believe housing prices will fall. In fact, history shows us that home prices hardly ever fall. Country-wide declines in U.S. home prices are rare. In the last 50 years, a nation-wide correction has only happened twice — in the 1980s after the Great Inflation caused interest rates to surge to levels roughly twice what they are now, and in 2007, when a collapse in median home prices famously ignited the Global Financial Crisis.
Keep in mind that regional or highly localized corrections are more frequent but are more driven by highly idiosyncratic factors.
While the recent surge in inflation and interest rates may evoke fears of the 1980s, inflation has been falling since last summer, and the Fed is likely near the end of its 16-month campaign to slow the economy. Yet, all median home prices have done is stabilize — albeit at levels roughly 40% higher than in January 2020 — before the pandemic, inflation, and higher rates.
Falling home sales tend to foreshadow price declines, and existing home sales have plummeted since early last year — when the Fed was preparing for its first interest rate hike — to the lowest level since the Global Financial Crisis. New home sales, in sharp contrast, have climbed over much of this year and are currently above their pre-pandemic levels. Why the difference?
There are many nuances, but the primary factor is that many existing homeowners were able to lock in record low mortgage rates when Treasury yields were a mere 0.5%. To sell their home now, and buy another, would mean a substantial jump in financing costs — a strong incentive to shelve their plans.
Another factor is the ability of new home builders to support potential buyers by offering direct support for financing their home. This could be an offer to cover closing costs or even contributing capital to “buy down” the interest rate, creating a lower monthly payment for the buyer for the life of the loan.
Today’s housing market is less affordable than at any time since 1984. Monthly principal and interest payments are up 94% in just the last two years, according to Intercontinental Exchange, and a typical household would have to spend 41% of their income to make their monthly mortgages payments, up from an average of 25% over the last 35 years.
Higher mortgage rates, while clearly a problem, are not the only problem. In the 1980s, when affordability last reached similar lows, the average home price was around 3.5 times the median household income. Today that figure is closer to six times the median household income. Simply put, incomes have not kept pace with the steady rise in home prices since the Global Financial Crisis and certainly not since the surge in prices after the pandemic.
However, it is perfectly reasonable for home prices to have outpaced income when financing costs were falling. Surging prices simply brought the market back to an equilibrium — with mortgage costs low, families could afford to pay higher prices. But when those higher prices meet a nearly 40-year high in mortgage rates, affordability collapses and something has to give.
Perhaps the biggest factor keeping housing prices stable is that there are simply not enough homes in America.
Part of the problem has been a matter of space: Whether a simple shortage of available land and/or increased restrictions on using that land, finding places to profitably build new homes has become more difficult in recent decades.
But the larger problem has been a dramatic reduction in the number of new homes built after the Global Financial Crisis. While it is understandable that both builders and consumers would want to take a step back from investing in housing, for almost a decade the completion of single-family homes was almost half its long-term average. And while new construction has steadily risen from the lows of 2011, it has only recently risen above its long-term averages. It will take time for the country to generate enough supply to make up for the lost decade in home construction.
Meanwhile, the U.S. has been relatively unique in the developed world in seeing steady population growth, both from domestic births and immigration. Furthermore, demand for housing is growing more acute as the millennial generation enters home-buying age.
More recently, COVID-19 changed the demand side of the equation for many families. Working from home meant less burdensome commutes, making suburban or even rural living more palpable. And, working from home, together with — for a while at least — educating your kids at home, fueled a demand for more living space. The result was a rise in the perceived value of owning a home, at a time when the availability of single-family homes was in short supply.
Another driver of the housing shortage is that an increasing percentage of America’s homes that have been bought for use as second homes or for investment purposes. A recent study by the National Association of Realtors estimated that 13 percent of the entire stock of American homes are owned by institutions or investment vehicles looking for rental income. According to the nonprofit news outlet Stateline, nearly 25% of all single-family homes sold in 2021 were bought by investors, up from 15% to 16% annually since 2012.
Bottom line, America has a housing shortage, with the absolute number of homes available to purchase at a nearly 25-year low. The U.S. housing agency Freddie Mac estimated back in 2020 that the country was short about 3.8 million housing units. While that number has stabilized since then, a substantial shortage is likely to remain for some time.
If the shortage of homes is the problem, are lower prices the answer? In a word, no. Not only will lower prices not address the shortage of homes, but the shortage itself is likely to put something of a pricing floor — pun intended — on the housing market. Put differently, rising prices over the last decade can be seen as a perfectly rational response to a shortage of supply and an increase in demand.
As we look into 2024, a modest correction in home prices wouldn’t surprise us, but stable or even rising prices wouldn’t surprise us either as long as the economy doesn’t slow into a recession. We believe the economic outlook is key, as weak economies can often force homeowners’ hands, as a loss of income or rising borrowing costs prove too great a burden.
The Global Financial Crisis of 2007 has left scars on the psyches of many. But rest assured that 2023 is not 2007. The underlying problem in the Global Financial Crisis was excess leverage. People, companies, and banks had borrowed so much that a small change in the value of their assets or the cost of borrowing had systemic effects.
But the aggregate consumer is nowhere near as leveraged today as they were in 2007, and neither is the financial system. Bank balance sheets are generally much stronger than they were in 2007, in part due to lessons learned in the Global Financial Crisis and have improved as banks took steps to prepare for higher interest rates and a potential recession.
However, in the broadest terms, we believe current home prices are largely a function of low supply, coupled with high demand, and it will take a significant change in either one of those variables to cause the market to reset at significantly lower prices. More likely, in our view, home prices cool, maybe correct modestly, and the housing market muddles through until falling interest rates lower borrowing costs, improving affordability.
So what are the investment opportunities in mortgages? The residential mortgage-backed securities that are part of so many benchmark bond indexes are guaranteed by the issuing Federal agencies, such as Fannie Mae or Freddie Mac, so they carry the same credit rating as the U.S. Government. As such, we are not worried about credit default risk in traditional bond benchmarks whatever the outcome of the current housing affordability problem.
However, many of these same securities have seen a drop in prices as banks have sold them in an attempt to improve the quality of their balance sheets. Remember, mortgages are long-maturity assets while banks fund themselves with short-maturity cash deposits. In our view, these securities may have upside relative to other benchmark bond asset classes as supply and demand for them normalizes.
Similarly, mortgages which do not conform to the agencies’ standards for guarantees —so called “non-conforming” mortgages — may also offer attractive valuations. Today, the due diligence, credit enhancement, loss protection, and third-party oversight provided by many of these securities may provide compelling valuations, especially considering yields offered are often well in excess of that provided by similarly rated corporate bonds.
Finally, the prevailing mortgage rate is currently unusually high relative to government bond yields, suggesting it may have been driven higher by uncertainty about how high Treasuries could go, not how high they are. The difference between the prevailing 30-year mortgage rate and the benchmark 10-year U.S. Treasury rate is nearly 3%. This excess yield over Treasuries that consumers must pay to get a mortgage is near the 25-year high.
History shows us that the only times this excess yield reached these extreme levels it didn’t stay there for long, returning to the long-term average within a year or so. It seems likely to us that today’s mortgage rates are pricing in a great deal of uncertainty, and rates could come down as much as a full 1% without Treasury yields falling or the Fed cutting rates.
While falling mortgage rates would be good news for consumers and likely provide a boost to the housing market, active bond investors can take advantage of the potential for such a move. For example, some mortgage-based securities separate the interest paid into one security and the principal repaid into another. If mortgage rates do fall, recent borrowers are likely to refinance quickly, potentially creating an outsized return in principle-only securities.
It looks to us — despite the fears of a “terrible” and “impossible mess” — that the best course of action for the Fed, existing homeowners, and want-to-be homeowners, is to wait. If inflation continues to fall at its current pace, lower rates could come as early as next year, boosting affordability and injecting some life back into the housing market.
While we wait, we encourage investors to take a closer look at the mortgage-related bond markets for opportunities to benefit from unusually high mortgage rates and the potential gains realizable as yields fall.
We hope you found this special report on the house market beneficial. A special thanks to Steve Lowe, Thrivent’s Chief Investment Strategist, and J.P. Gagne, Senior Portfolio Manager, for their insights. More episodes of Advisor’s Market360TM are available wherever you get your podcasts. Email us at podcast at thriventfunds.com with your feedback, questions, and topic suggestions for future episodes. And as always, you can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.
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All information and representations herein are as of November 17, 2023, unless otherwise noted.
Past performance is not necessarily indicative of future results.
Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC is a member of FINRA and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.