Doug Duncan: Housing Market Fundamentals Won’t Change Much in 2018


One of the key characteristics of the U.S. housing market in 2017 was that it was highly constrained by a lack of supply – especially for detached, single-family homes. This, in turn, drove prices artificially high and kept many potential first-time home buyers on the sidelines. This alone resulted in very unique and challenging set of housing market fundamentals – basically, a sluggish housing market in an otherwise growing and improving economy.

Although builders are expected to bring more inventory online in 2018, it won’t be enough to meet the strong, pent-up demand from millennial buyers, who are now starting to see their incomes rise. With a lack of skilled labor and a lack of available land upon which to build, especially in the growing urban centers, construction firms this year will be hard-pressed to bring enough homes into the pipeline to make any meaningful difference.

As a result, housing market fundamentals in 2018 probably won’t be much different than they were in 2017, says Doug Duncan, chief economist for Fannie Mae, who recently provided MortgageOrb with a “preview” of the government-sponsored enterprise’s soon-to-be-released housing market forecast.

Reflecting on 2017, Duncan says it “went pretty much the way we expected,” in terms of the forecast, which is put together by Fannie Mae’s Economic & Strategic Research Group, which in 2016 won a NABE Outlook Award for the report’s accuracy.

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“We were very close to the actuals in our January 2017 forecast – so, there were no big surprises for us,” Duncan says. “We saw multifamily activity slow, later in the year, because the pipeline of product is pretty full. So that was expected. At the same time, we saw continued supply issues, particularly in entry-level, single-family, detached housing – so that turned out to be true.”

“We saw some growth in terms of the increase in housing starts – they were up about 8% for the year,” he says. “And the increase in new home sales was just under 11%. This is very close to what we expected at the beginning of the year.”

Duncan says the reason housing starts turned out to be slightly lower than what was expected was “due to what builders have been saying all along: it’s been hard to get skilled labor and it’s been hard to find land to develop in areas where the employment is growing.”

In addition, “the impact of local regulations [on new home construction] are making it more costly,” he says. “So, building new housing has been a real challenge.”

Meanwhile, demand for new housing has been growing, particularly among millennials, who now represent the largest home buyer demographic. Duncan says that demand will only continue to grow, as we head into 2018, especially if the U.S. economy continues to improve and real wages begin to rise.

“They’ve got jobs, they’ve got growing incomes, they are getting married, they’re having babies, and they are buying houses,” Duncan says of the millennials. “So that demand side factor is growing faster than the supply. And that is leading to strong price appreciation. That turned out to be true… we saw price appreciation of five to six percent in 2017.”

As far as interest rates go, Duncan pointed out that Fannie Mae got it right in terms of forecasting three rate hikes for 2017. However, what the company failed to predict was the impact that the new administration’s policies would have on small business fixed investment. This increase in small business fixed investment, Duncan says, came mainly “in response to the decline in the issuance of new regulations.”

“It was a significant decline, with the new administration coming in,” he says, adding that the drop-off is clearly shown in the federal register. “And there was even the outright repeal of some regulation. That sprung significant confidence, especially in small business – and they increased investment as a result. So, that became a driver for growth, in the second and third quarter, of better than three percent, annualized. And that was about five to six tenths percent stronger than what we had forecast for either of those quarters.”

Duncan says although it appears the overall economic growth “fell back a bit” in the fourth quarter – perhaps due to uncertainty as to whether the GOP tax plan would go through – “the actuals for real GDP growth [for 2017] are likely to be about four tenths percent stronger than what we had forecast at the beginning of the year.”

“But if I’m going to be wrong, I’d rather be wrong in that direction than the other,” he adds.

Duncan says he expects the drop-off in regulatory issuance to continue in 2018 – but there is a question as to wether that will continue to lead to increased business fixed investment.

“So the question is, going into next year, now that there is a tax cut in place – that represents more of a reform on the business side than it does on the personal side – how will that impact the business environment for 2018?” he asks rhetorically. “We would not expect to see a resurgence in regulation – in fact, we expect to see continued attempts to make the business environment more productive.

“And that’s really what we’re looking for in 2018 – is will the level of fixed business investment hold?” he says. “And, if so, will that start to show up in productivity gains?”

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Duncan points out that the December jobs report from the Bureau of Labor Statistics shows that there has been very little change in income growth and wage growth during the past 12 months. The key to increasing wages, he says, is increased productivity.

“The most recent numbers on productivity have shown some beginnings of improvement,” he says. “And that’s normally the relationship that you have: When business fixed investment picks up; subsequent to that, productivity starts to pick up; and subsequent to that, real incomes start to pick up.”

“But frankly, none of that is inflationary,” he adds. “If that’s the sequence of things that happen, then the gain in productivity and real income means that unit labor costs don’t change, and that’s a reason for the Fed to remain on the sidelines, or at least stay patient, as growth picks up.”

Duncan says that because there is a strong chance that small business fixed investment will pick up in 2018 – which, in turn, should increase productivity and increase wages – “our forecast for next year will be a bit stronger.”

But with the new tax code changes, the job of forecasting what housing will do over the next 12 months will be a little more challenging than last time around.

“The best thing you can do in macroeconomics is give a range of outcomes,” Duncan says. “Because there are millions upon millions of decisions that are made in a dynamic economy – and sorting through all those things is, frankly, an impossible task.”

“So how difficult is it? Well, there are a couple of big factors that you need to make some decisions about,” he says. “One is, this is now the third longest economic expansion that we’ve ever had. So, it suggests that we’re late in an economic cycle – that is, if you don’t believe that the business cycle has been repealed. And I don’t believe that the business cycle has been repealed. So, how do you factor in a tax cut when unemployment is already around 4% – which most economists feel is pretty full employment – and with the Fed tightening and the growth curve getting flatter? That will be part of the discussion [when we put together our forecast].

“You also see housing accelerating – which is not typical late in an ecnomic cycle,” Duncan adds. “Housing usually tends to slow as the Fed tightens – but that’s not the case – because we have this supply problem. So, none of housing’s behavior in this cycle has been normal, relative to the past ten housing cycles. So, how do you factor that in?”

Adding to the complexity, he says, is that with the new tax code, “the tax implications are different on the business side than they are on the household side.”

“Clearly, on the business side, there are more attributes of reform – which should actually strengthen the business sector over time,” Duncan says. “On the personal side it’s more about tax cuts from the stimulative perspective, rather than reform perspective. Most households will see an increase in after-tax income because incomes will grow a little bit in 2018 and also because their tax burden will decline somewhat. Of course, that will depend on a set of factors, including where you live, whether or not you are a homeowner, what tax bracket you fall into – so there’s definitely distributional differences.

“So, the question for 2018 is, will the business side grow enough to increase incomes, which, when combined with that reduction in household taxes, generates a significant extension of this economic expansion? That’s kind of the decision that you need to make.”

Another factor, Duncan says, is the fact that this has been one of the longest and weakest economic expansions in U.S. history.

“In fact, it is the weakest expansion post WWII,” he says. “So when you make these changes late in a cycle – even though unemployment is low – if it is a weak cycle, how does it differ from when you made changes during a shorter but stronger expansion?”

Duncan says for now, Fannie Mae is forecasting just two rate hikes for 2018, as opposed to the four that have been indicated by the Fed, “and if things continue the way they are, then we expect the next one to come in March.”

“But we have a little bit of a different view of the Fed than others do – and that’s partly because of our view of what we feel [Jerome] Powell will do when [Janet] Yellen steps down and he becomes chair,” he adds. “I think, from our perspective, he certainly wants to prevent any significant discontinuities in public perception of his policy – during the transition – but that doesn’t mean that he’s not his own man, in terms of what he thinks. Most of his votes have been made without comment – and in support of the chair. So we will see over time how patient he is willing to be.

“The other thing is that are a few outgoing [Fed board] governors – we already have one new governor and we’re going to get a couple more new governors – and they’re probably will have a different view of monetary policy,” Duncan continues. “And that could have some impact on how the Fed acts. That said, our view is that they are likely to be patient and tolerant of some pick up in wage gains, especially if they are driven by gains in productivity.”

As far as the housing market is concerned, Duncan says the supply issues “will continue in 2018.”

“And, as long as employment continues to grow, and incomes continue to grow, the millennials will be pushing the demand side of the curve,” he says.

“But unless there is a significant acceleration in new home construction, you’ll see the same fundamentals in place in 2018 that we saw in 2017,” he says.

“We don’t believe that we’ll see a significant change in interest rates either,” he concludes.

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