Fidelity: Home is where the supply shortage is
How much further can the US housing market rally run? Ultralow interest rates and a strong consumer balance sheet are fueling recent US home price gains, boosting broader growth in the world’s biggest economy and, more recently, making rising inflation stickier.
Now, as the US Federal Reserve eyes a cycle of interest rate hikes, will the prospect of pricier mortgages threaten to crash the party? Not necessarily, judging by the supply and demand fundamentals of the housing market. In fact, as this week’s Chart Room shows, home supply in the US is running as low as it has ever been.
Partly thanks to the pandemic, supply chain constraints and labour shortages have contributed to record backlogs and bottlenecks in housing construction across America. As a result, the nationwide existing home sales inventory plunged to about 910,000 in December, representing a record-low 1.8 months’ supply, down from levels above three months before the pandemic, according to data compiled by the National Association of Realtors. New home inventory is even tighter at around 0.65 months’ worth of supply.
Focusing on fundamentals
Such dire shortages should offer strong near-term support for the home market, even as the Fed starts raising interest rates. Of course, past performance isn’t a reliable indicator of future results. But looking back at previous tightening cycles, the existing home inventory started from a much higher base. For example, in the 2004 to 2006 period, there were 2.1 to 3.7 million homes for sale, equivalent to 3.8 to 6.8 months’ supply.
While the Fed taking the punch bowl away is a negative for housing, rate hikes of 75-100 basis points would not necessarily kill the current up cycle. The current household balance sheet is an important offset. For instance, despite home price gains during the pandemic, consumers have not struggled to qualify for mortgages, with debt-to-income ratios and credit scores staying in healthy territories.
The key question remains around affordability in a rising rate environment. Currently, an average homebuyer’s mortgage payment accounts for about 25 per cent of gross household income, and the affordability ratio could rise to 27.5 per cent following rate hikes of 75 basis points in total, assuming zero wage growth. That would still be lower than levels of above 30 per cent seen in the 1990s and in 2007.
Looking further into the supply and demand set-up, new home starts have been trending below their long-term average of about one million starts a year for a decade. While they are beginning to rise above the historic mean, it will probably take at least a few years of above average starts to close the accumulated deficit. On the demand side, encouragingly, millennials are getting in the household formation age. In each of the next five years, some four million millennials will be turning 30, higher than an annual average of 3.3 million passing this age milestone over the last five years.
While tighter monetary policy will be a headwind for US housing, structural supports appear to be converging around fundamentals. Short supply, strong household balance sheets and demographic tailwinds should combine to underpin the home market beyond the near term. Therefore, despite expected rate hikes, it’s too early to call an end to the current up cycle.