The risk of a US economic recession has been consistently on the rise since July. Moody's Economy.com posted the probability of a recession occurring in the US within the next six months at 15.3% in July.
The latest report now places the probability of a recession within the next six months at 47.3%, an astounding 209% increase.
The initial rise in the probability occurred with the first public announcements that defaults of sub-prime mortgages were going to negatively impact bonds being held by a number of Wall Street financial institutions. The fear of a recession was temporarily reduced when the Fed acted quickly to pump liquidity into the system by both reducing the discount rate, the rate Fed charges on its short-term loans to creditworthy banks, and the federal funds target rate by 50bps. However, any optimism that the threat of a recession had been significantly reduced was short lived; the probability of a recession began to climb again as it became evident that more firms, both in the US and globally, were going to be negatively impacted by what is now dubbed ‘sub-prime contagion'.
At this point in the business cycle, it is clear that if the US economy is going to fall into a recession, it will be driven there by the current downturn in the US housing market and a subsequent reduction in the availability of credit and an increase in its cost to both consumers and businesses. This type of recession scenario is precipitated by financial market tightening emanating from the US mortgage-backed securities market.
A major concern is if the deterioration in credit quality extends to prime mortgage loans investors, who, concerned about hidden risk, might pull back from all types of mortgage-backed securities. This could cause credit to the mortgage market to dry up and exacerbate the current decline in the housing market, resulting in a legitimate housing market crash. A crash of this magnitude might result in housing starts dropping as much as 50% from their early 2006 peak, and home prices, as measured by the National Association of Realtors median sale price, falling more than 25% peak to trough, before turning around in 2009. This decline in home prices could lead to an outright decline in real consumer spending in the first half of 2008 due to consumers being unable to use the mortgage equity in their homes and the impact of a negative wealth effect.
If these assumptions becoming reality are truly enough to lead the US economy into a recession, then it is easy to understand why the probability is now hovering near 50%. Recent data appear to support the possibility of the above assumptions occurring. Recent data on the US housing market indicate that the decline in the market is showing no signs of slowing. September sales of existing US homes were down 21% from the same month a year earlier, while the median price of a home was down 5.1%. The inventory of available homes is now near 11 months. Housing starts for October were down 46% from their peak in 2006. A November survey of senior loan officers at commercial banks indicates that 19.2% are tightening lending standards for commercial borrowers, while 40.8% are tightening lending standards for prime mortgage borrowers.
Offsetting these rather bleak indicators is the strong US employment situation and excellent condition of corporate balance sheets. This has kept US consumer spending growth positive, albeit at a lower trajectory, and has allowed business to continue to invest in plant and equipment. It will be necessary to closely watch economic indicators in the coming months to determine if the negative pressure applied by the declining housing market and problems in the credit market will eventually overwhelm the offsetting positive forces in the economy.
There is currently a great deal of speculation surrounding the impact of a US recession elsewhere. The increase in globalisation of economies in North America, Europe and Asia suggests that global growth might be less impacted by a US recession than has occurred previously. A downside to this globalisation has been the announcement by global banks of exposure to the same types of mortgage-backed bonds that may well push the US economy into a recession. In addition, any drop in US consumer spending will lead to a decrease in demand for imported goods and services.
If the US economy does fall into a recession, national US property fundamentals are positioned well to absorb the downturn. The four core property types, office, industrial, retail and multi-family, are all at equilibrium vacancy rate levels. In addition, there does not appear to be an extraordinary imbalance between projected demand and the amount of new supply currently under construction. The office market is the sector that would be most impacted by an economic recession. Office market fundamentals will be negatively impacted on both the supply and demand side. Demand for office space is projected to decline due to reductions at firms that serve the residential real estate market. In addition, the credit crash will lead to reductions in employment at a number of financial services firms. Industrial fundamentals are projected to hold up well under the recession scenario.
Domestic consumption will fall due to its dependence on the housing market, but this decrease in activity will be offset by consistent levels of exports. Given that a recession is likely to be the result of a reduction in personal consumption, the retail sector would likely exhibit a significant downturn. The downturn would be offset by the relatively strong fundamentals that currently exist but falling retail sales will put negative pressure on retail rent growth.
Finally, the impact on the multi-family sector of a recession brought on by a housing crash produces what could be confusing results. The housing crash and subsequent credit market turmoil will likely lead to an increase in demand for rental housing. This is expected due to homeowners being forced out of their homes and the increased difficulty in obtaining a home loan for prospective buyers. This relatively positive outlook needs to be viewed with some scepticism. It is quite possible that many multi-family markets will struggle with rising competition from for-rent condos and single-family homes.
Investor demand for US real estate has exhibited a clear slowdown in September and October. This can be attributed to both buyers who are now unable to attain debt capital at levels and/or prices that allow them to complete transactions, and to buyers and sellers who are taking a step back to assess the direction US real estate prices may be heading. Preliminary reports covering this time period indicate that prices may indeed be softening. Any actual decline in property values, however, is not uniform across all markets and property types.
Demand for well-leased properties in top markets remains strong and prices in these locations have held firm. Investors appear to be less interested in properties in secondary markets that are not as well leased. In the case of a recession, this trend is likely to be amplified as investors will seek out more stable income streams in markets where values will be at less risk to significant declines. A drop in expected returns from investments in US real estate may also lead to investors accelerating their ongoing expansion into global real estate investment.
Andrew Warren is managing director, research at Principal Real Estate Investors
