Click here for recent Market Insight reports on our US Homebuilders theme →

March 6, 2020

MRP Adds Long US Homebuilders as a Theme

Summary: The US housing market may be about to experience its strongest spring season since before the financial crisis. Cheap mortgages, warm weather, rising wages, and declining materials costs have helped to create an environment where affordability and supply are improving at the same time. That combination makes for a potent cocktail that could lead to a rip-roaring market, benefitting homebuilders.

Related ETFs: iShares U.S. Home Construction ETF (ITB), SPDR S&P Homebuilders ETF (XHB)

The market for U.S. homes is driven by three principal engines: mortgage loan interest rates, home prices and available inventory. Right now, all three are doing their best to entice more buyers into the market or encourage builders to bring more supply into the market.

Improved Affordability

New research published by HSH, an online consumer destination for mortgage information and rate shopping, reveals that housing affordability has improved in most metro areas. In 49 of the 50 major metropolitan areas reviewed by HSH, the income needed to purchase a median-priced home decreased in the fourth quarter of 2019, compared to the same period a year earlier. That is mostly due to lower mortgage rates offsetting gains in home prices.

It is worth noting that affordability may look even better today. The current rate on a 30-year fixed rate mortgage is 3.29%, the lowest level since 2016 and about 55 basis points below where it was at the time HSH was crunching its numbers for Q4 2019. What’s more, mortgage rates usually follow the direction of the 10-year Treasury note’s yield, which dropped to a history low of 0.82 this week. That's at least 100 basis points lower than at the start of 2020. 

Meanwhile, wage growth is finally picking up, a decade after the Great Recession ended. The January jobs report showed the U.S. economy added 255,000 jobs, exceeding expectations in a strong economy. The employment-to-population ratio rose to 61.2%, its highest level since November 2008. Average hourly earnings rose 3.1% YoY, marking 18 consecutive months of wage gains above 3%. Americans at the bottom of the labor market are doing especially well. In the past year the wages of those without a high-school diploma have risen by nearly 10%.

The extra buying power resulting from higher wages and lower mortgage rates should fuel purchases in the coming months and give homebuilders an incentive to start work on new houses.

Strong Demand

US pending home sales surged in January, rising the most in nine years. The index was 5.2% higher than in December and 6.7% higher than in January 2019. While pending home sales do not represent a completed transaction, they do outline an agreement where contracts have been signed. The index is therefore be a decent indicator of future housing trends, which in this case is supportive of a new housing boom.

Sales of new single-family homes, which account for nearly 12.5% of total housing sales, jumped 7.9% in January to a seasonally adjusted annual rate of 764,000 units, the highest level since July 2007. On a year-over-year basis, new home sales rose 18.6%. In the case of previously-owned homes, sales dipped slightly in January compared to December due to tight supplies. January’s sales, however, were nearly 10% higher than the same month last year.

The uptick in activity has even compelled JPMorgan Chase, the nation’s biggest lender, to shift resources internally to handle a sharp increase in its volume of mortgage loan applications.

Also consider the fact that millennials - the largest generation in American history - are finally coming into the single family housing market and represesent a source of pent-up demand.

Rising Supply

Since the last recession, the US housing market has been constrained by under-building of new homes and under-investment in existing homes. The number of available homes nationwide tumbled 11% in January from a year earlier, the biggest decline since 2013, according to online real estate brokerage firm Redfin.

Nevertheless, recent data pertaining to construction looks encouraging. There were 324,000 new homes on the market in January, up 0.3% from December, per CNBC. Furthermore, home building permits rose to the highest level in 13 years, and the stock of homes under construction in January was the highest since February 2007. These are positive indicators for greater production in the months ahead, and those new supplies could help to ease the shortage of homes that has constrained sales.

Two factors could incentivize home builders to build more. The first is that home price gains are accelerating, after slowing down last year. The median new house price surged 14% to a record $348,200 in January from a year ago. The second factor is that the cost of residential construction materials like lumber and steel have fallen since 2018. Data on Trading Economics shows that, while lumber prices are 5% higher than a year ago, they are still 35% lower than in May 2018. Similarly, steel’s price is 10% lower than this time last year and 29% lower than in September 2018. Higher home prices and lower materials costs should boost profits for homebuilders.

Some Caveats

Clearly, things are looking up for the US housing sector. However, the turmoil created by fears of a coronavirus pandemic could destabilize home builder confidence and the vital investment required to increase supplies.

As it is, the US yield curve is already inverted, with the 3-month Treasury bill holding a higher yield than the 10-year Treasury note. Economists at the Fed call the 3-month/10-year inversion the "best summary measure" of economic downturn, perhaps because a yield curve inversion has preceded every recession of the last 50 years within approximately 6-24 months. Because homebuilding is, essentially, a play on the overall U.S. economy, a recession would curb appetite for home ownership, causing the housing market’s rally to come to a standstill even if rates fall further.

There also a risk that loan costs could climb quickly, once the coronavirus outbreak is contained, or that house prices may rise too fast, eroding the benefits of low mortgage rates to the point of harming sales.

For now, however, there are plenty of tailwinds to support the housing market's forward momentum.


New MRP Theme: Long US Homebuilders

MRP believes US housing could embark on a fresh bull run in 2020. There is strong demographic-driven demand from millennials entering the market for the first time, and the sharp plunge in mortgage rates combined with rising wages have improved affordabitity for that cohort. Moreover, the cost of construction materials like lumber and steel has fallen significantly since 2018, which should help the bottom line of the builder community.

Given these tailwinds, we are compelled to add Long US Homebuilders to MRP's list of active investment themes and will monitor the theme through the iShares U.S. Home Construction ETF (ITB). 

Homebuilders lagged the broad equity markets during the two-year period that ended on December 31, 2019. Over that period, ITB delivered flat returns while SPY rose 17.92%. This year, however, ITB is outperforming SPY, and we expect that trend to continue in the months ahead.

Investors who would like their exposure to also include a retail component such as the home improvement segment may want to look at the SPDR S&P Homebuilders ETF (XHB) instead of the ITB which focuses primarily on home construction companies.

US Homebuilders vs S&P 500