Where Is The US Housing Market Heading?

The construction cycle in residential housing is the most important cycle in the economy.

The residential construction sector is often referred to as residential fixed investment, and although this sector only makes up 3%-6% of the total economy, the leading and high multiplier nature of residential construction makes it extremely influential despite its small size.

Whenever there is a big decline in the residential construction sector, a recession or sizable economic downturn in the broader economy usually follows.

This chart plots the 2-year rate of change of the housing sector as a share of GDP.

The latest value, in Q4 of 2022, tells us that the residential construction sector was contributing 1% less to overall economic activity compared to the last two years.

When the housing impulse in the economy is this negative, it’s highly common to already be in a recession.

There is also an apparent relationship between the depth of the housing downturn and the severity of the recession, with the 1974 recession, early 1980s double recession, and 2008 recession representing recessions with large negative contributions from housing.

We can learn more about the importance of the housing or residential construction sector in the paper “Housing IS the Business Cycle” by Edward Leamer. Many people dismiss this paper because of the overly reductionist conclusion in the title, but that is not the correct takeaway.

Of course, the housing sector is not foolproof as an indicator of economic activity, but if you could only choose one sector to follow, you’d empirically have the most success on a leading basis, tracking the residential construction cycle.

Fortunately, we don’t only have to pick one sector, and we can add the manufacturing cycle and other parts of the economy to round out the areas that the housing sector may be lacking and the paper helps us do that by analyzing the performance of various sectors entering into recessionary periods.

The housing sector, while not enough in isolation, is important enough that it warrants its own breakdown to understand all the drivers and what the most recent data is telling us about this current downturn.

Remember that we’re very focused on the level of construction activity in the housing market, not the price of homes. Price is a lagging indicator.

This chart shows the total level of residential construction spending in the economy.

Residential construction spending peaked in May 2022.

Residential construction spending has three major components: new single-family construction, new multi-family construction, and remodeling or residential improvements to existing homes.

This chart shows the level of new construction spending on the left and remodeling spending on the right.

New construction spending peaked in June, while remodeling spending peaked in July.

The downturn in new construction is much deeper than remodeling.

If we separate new construction into single-family and multi-family, we can see that the only segment of residential construction spending that is really declining is new single-family.

New multi-family construction spending is still exploding, and remodeling spending is barely off its high, in a clear bubble after the pandemic.

Building permits are the most reliable leading indicator of residential construction spending. Permits come before construction begins.

While total residential construction spending peaked in May of 2022, building permits peaked in March of 2022.

There was a similar lead time between permits and construction spending in the 2006 cycle.

The downturn in building permits is also falling most heavily on single-family. Single-family construction spending peaked in May 2022, and permits peaked in February.

Multi-family permits are more volatile and didn’t start turning lower until July 2022.

So aggregate building permits peaked in March 2022, and aggregate construction spending peaked in May 2022.

Single-family permits turned down in February 2022, and single-family construction spending turned down in May 2022.

Multi-family permits turned lower almost six months after single-family. Over the next 1-2 quarters, we should then see the peak in multi-family construction spending.

What’s also important is that we haven’t seen a bottom in aggregate permits so there’s nothing suggesting that the total level of residential construction spending will turn higher in the next 3-4 months.

In other words, we don’t have good reason to believe housing will add positively to economic activity in Q1 or Q2, and with the economy already either in on the cusp of recessionary territory, that’s a big vulnerability.