Housing Froth

In this week’s review, we take an in-depth look at the property market. It’s no secret that Covid turbocharged the global housing market: homeowners – flush with cash from government support programs – had more dough to spend and lower mortgage rates to pay as central banks slashed interest rates. What’s more, the pandemic popularized remote work and sent homebuyers on the hunt for bigger spaces. But the market has started to cool as higher interest rates and red-hot inflation dent housing affordability. So the big question is, which housing markets are the frothiest and could experience the biggest corrections – and how would this impact the global economy?

Macro

The global housing market, which was supercharged by Covid, is finally showing signs of weakness as higher interest rates and red-hot inflation dent housing affordability. The big question now on investors’ minds is which housing markets are the frothiest and could experience the biggest corrections?

Helping us assess that is a handy scoreboard (shown below) by Bloomberg Economics that combines five gauges of property risk. The house price-to-rent and the price-to-income ratios judge sustainability and affordability, house price growth (in real and nominal terms) measures price momentum, and credit growth assesses risk. Excess growth in household credit, after all, can be a sign of trouble ahead, just like in the US before the subprime mortgage crisis.

Bloomberg calculates an overall score for each country by averaging each of its five ratios’ z-scores – a measure of how far a country’s ratio is from the mean. The countries that come out on top with the bubbliest housing markets – making them particularly vulnerable to big corrections – are New Zealand, Czech Republic, Australia, Canada, and Portugal.

But the analysis also shows that the frothiness is pretty widespread: 19 OECD countries have combined price-to-rent and home price-to-income ratios that are higher today than they were ahead of the 2008 financial crisis – an indication that prices have moved out of line with fundamentals and are becoming unsustainable. What’s more, the IMF global house price index, which covers 57 countries, is well above its prior peak in 2008.

This matters because a potential bursting of the global housing bubble would hit the global economy in a few ways. First, a sharp decline in house prices could significantly reduce wealth and lead to a contraction in consumer spending. Second, a stagnation or slump in property construction and sales would directly hit global growth since these activities are huge multipliers of economic activity around the world. Third, a declining property market would hit bank lending as the risk of bad loans increases, choking the flow of credit that economies thrive on. These risks are even more serious for the countries that top Bloomberg’s scoreboard.

To be sure, even if prices do drop, analysts see a repeat of the 2008 housing crash as unlikely. First, there are still too few houses available right now. Housing supply has become more inelastic, with increased demand leading to higher prices rather than more construction. In the near term, an ongoing shortage of labor and materials is likely to prevent a large increase in supply that would normally depress prices.

Second, the housing market is healthier than it was in 2008. Lending standards are much stricter, homeowners have healthier balance sheets, and far fewer of them have rate-sensitive variable mortgage rates. What’s more, the recent spike in prices has more to do with a pandemic-era demand boost than pure speculation.

Third, structurally, the demand for housing is still strong. More millennials are in their prime home-buying years, and permanent shifts in working conditions – such as hybrid work arrangements – have been positive for prices. What’s more, real estate is a pretty good hedge against inflation – and that’s something that’s not that easy to find. If that’s not enough to convince prospective buyers to buy, it’s probably enough to prevent some current homeowners from selling.

Stocks

Buckle up: Tesla investors had a lot to digest this week. First, the EV maker released an update over the weekend that showed its global vehicle deliveries fell last quarter from the previous one – the first time that’s happened in over two years. The firm delivered around 255,000 cars during the quarter that ended in June – fewer than expected and down by nearly 60,000 from the previous quarter. The decline was mainly driven by Tesla’s Shanghai factory, which was impacted by Covid-related lockdowns across the city that lasted for weeks.

Second, Tesla is planning to pause production at its plants in both Shanghai and Germany for several weeks according to a new report out on Monday. Third, new data out on Tuesday showed China’s BYD, which is backed by Warren Buffett, overtook Tesla as the world’s biggest EV maker by sales. Only a handful of BYD’s factories are based in regions that suffered from China’s most severe lockdowns. That enabled it to sell 641,000 EVs in the first six months of this year – up more than 300% from the same time in 2021, and 14% more than Tesla managed in the same period.

But here’s the thing, not all EVs are the same. Tesla only sells “BEVs” – that is, battery EVs that are purely powered by electricity. BYD, on the other hand, sells BEVs and plenty of “PHEVs” – that is, plug-in hybrid electric vehicles. PHEVs have a battery plus a regular gasoline-powered engine for longer journeys, but are still considered “zero emission” under China’s sales rules. In other words, PHEVs get the benefit of less range anxiety but just as much subsidy support in China, the world’s biggest car market. That – combined with BYD’s fewer factory problems in the country – could help explain how BYD overtook Tesla.

Commodities

In another blow to consumers already struggling with surging costs of virtually everything, power prices in Europe hit new records this week. German power for next year, the European benchmark, touched a record €350 per megawatt-hour on Thursday as fears rise about a looming gas shortage after Russia cut its energy supplies to Europe’s biggest economy.

Germany’s energy crisis already took a turn for the worse last month after the government raised the country’s gas risk level to the “alarm” phase, one step below the final “emergency” stage which would involve gas rationing. This table shows how Germany’s gas risk levels work.

Germany, which still relies on Russia for more than a third of its gas, enacted the initial “early warning” phase in March after Russia’s demands for payment in rubles prompted Germany to brace for a potential cut in supply. That cut came last month after Gazprom slashed shipments through the key Nord Stream pipeline by 60%. The move prompted Germany to raise the gas risk level to the “alarm” phase.

Fast forward to today, and Russia is poised to shut the Nord Stream pipeline for maintenance on the 11th of July for ten days. But several German officials fear that Russia could use the planned maintenance works to turn off the taps for good, leaving Europe’s biggest economy without its main source of gas. That would most certainly trigger the third and highest “emergency” level, which would involve state control over gas distribution and outright gas rationing.

Such a scenario would be devastating for the German economy. The graph below shows the German central bank’s estimate of the potential losses to the economy due to production cutbacks in the case of natural gas rationing. According to the estimates, Germany could see an 8.6% hit to economic output in the first quarter of 2023 that would plunge it into one of its worst recessions in recent history.

Next week

Second-quarter earnings season officially gets underway in the US next week. As usual, financials will kick things off with some big names reporting on Thursday and Friday like JPMorgan, Citigroup, Morgan Stanley, and Wells Fargo. Investors will be paying particular attention to the financial giants’ economic outlooks and whether they think the US economy is indeed headed for a recession. Elsewhere, the UK will report June GDP data on Wednesday. This will be followed by China the next day reporting its second-quarter GDP.