In this week’s edition of “Three on Thursday,” we examine recent trends in the U.S. housing market. On Tuesday, new data on home prices were released: the Case-Shiller Index rose 0.2% in July, up 5.0% from the previous year and reaching an all-time high. Similarly, the FHFA Index increased by 0.1% in July, up 4.6% year-over-year, also hitting record highs. In spite of continued price increases, could we be seeing early signs of a shift towards more affordability? 

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Implications:  The unchanged reading on new orders for durable goods in August beat even the most optimistic forecast from any economics group on Bloomberg, as a concentrated decline in aircraft orders was offset by broad-based growth elsewhere.  Transportation orders can swing wildly from month to month as aircraft orders tend to come in chunks rather than steadily over time.  That was the case again in August, as commercial aircraft orders fell 7.5% after soaring in July.  Excluding the transportation sector, orders for durable goods rose 0.5% versus a consensus expected +0.1%.  Electrical equipment led non-transportation orders higher, rising 1.9% in August, while fabricated metal products (+0.6%) and machinery (+0.5%) also increased.  Although orders activity came in solid for the month, other data in the report point to dark clouds on the horizon.  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – inched up only 0.1% in August following a 0.4% decline in July. If unchanged in September, this measure would decline at a 1.8% annualized rate in Q3 versus the Q2 average.  That would be the third quarter in the last four where core shipments have declined, a clear sign that all is not well on the economic front. Meanwhile, overall orders for durable goods are failing to keep pace with inflation, up 1.5% in the last twelve months and, excluding transportation, up just 1.0%.  While GDP readings continue to run positive, we expect a rocky path forward as the economy feels the lagged effects of the Federal Reserve’s tightening of monetary policy.  In employment news this morning, initial jobless claims inched 1,000 lower last week to 218,000.  Meanwhile, continuing claims rose 13,000 to 1.834 million.  These figures are consistent with continued job growth in September.

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Implications:   The final reading for real GDP growth in the second quarter remained unchanged from last month’s estimate, holding at a 3.0% annual rate. However, the underlying components showed a slightly weaker mix. Downward revisions in consumer spending (primarily non-durables), business investment (equipment & software), and net exports were balanced by upward revisions in inventories and government spending.  For a more accurate measure of sustainable growth, we focus on "core" GDP, which includes consumer spending, business fixed investment, and home building, but excludes the more volatile categories like government purchases, inventories, and international trade. "Core" GDP grew at a 2.7% annual rate in Q2,  below the prior estimate of 2.9%. The Bureau of Economic Analysis (BEA) also released its comprehensive annual update, revising data from the past five years. It now shows that average real GDP growth from Q2 2020 through 2023 was 5.5%, compared to the previously reported 5.1%. Additionally, the second look at economy-wide corporate profits for Q2 revealed a significant upward revision, with profits rising 3.6% from Q1 (compared to the 1.7% initially reported) and up 10.8% year-over-year. Since Federal Reserve profits are included in this data – and the Fed has been posting losses – we focus on corporate profits excluding the Fed, which are up 9.0% year-over-year. Using pre-tax profits, our Capitalized Profits Model suggests stocks remain overvalued. However, using after-tax profits suggests stocks are near fair value.  We also received a second look at Q2 Real Gross Domestic Income (GDI), an alternative measure of economic activity, which was revised higher to a 3.4% annual growth rate and is now up 3.5% from a year ago. As for inflation, it remains stubborn. GDP inflation was unchanged at 2.5% annually in Q2, and GDP prices have risen 2.6% over the past year. Meanwhile, nominal GDP (real growth plus inflation) increased at a 5.6% annual rate in Q2 and is up 5.7% year-over-year.

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Implications:  New home sales took a breather in August, pulling back modestly following the largest monthly gain in nearly two years. The big question for the housing market is whether the Federal Reserve cutting rates will be enough to start a new upward trend in sales, or if buyers will continue to delay purchases in anticipation of even lower rates in the future.  Thirty-year fixed mortgage rates have fallen roughly 100bps over the past couple months, but new home sales are still roughly where they were in 2019 before COVID.  Given that new home sales are a timelier barometer of the housing market because they are calculated when contracts are signed while existing homes are only counted after the sale is closed, it doesn’t look like lower rates have had a huge impact yet. That said, affordability has been improving across the board for potential buyers, with the median sales price of new homes down 8.6% from the peak in 2022. It does look like a small part of this decline reflects a lower price per square foot as developers cut prices.  The Census Bureau reports that from 2022 to 2023 (the most recent data available) the median price per square foot for single family homes sold fell 1.1%. While that decline is modest, it represents a stark reversal from the 45% gain from 2019 to 2022.  That said, most of the drop in median prices is likely due to the mix of homes on the market including more lower priced options as developers complete smaller properties. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes is up over 200% versus the bottom in 2022. This contrasts with the market for existing homes which continues to struggle with an inventory problem, often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic.  The combination of more affordable financing, lower prices, and the abundance of inventories giving potential buyers a wider array of options will help fuel a rebound in new home sales.  In other recent housing news, home prices continued to rise in July. The Case-Shiller index rose 0.2% and is up 5.0% from a year ago. The FHFA index increased 0.1% and is up 4.6% from a year ago.  In the manufacturing sector, the Richmond Fed index fell to -21 in September from -19 in August, highlighting weakness in that sector.   Finally, the Federal Reserve released monthly figures on M2, showing it up 0.6% in August (the largest monthly gain since 2021) but still up only 2.0% in the past year.  The faster gain in August signals that the Fed needs to be cautious with rate cuts if it wants to prevent a resurgence of inflation in 2025-26.

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With only one week left in the fiscal year, it looks like the budget deficit for the federal government for Fiscal Year 2024 is going to come in at about $1.9 trillion, which is 6.7% of GDP.

To put this in historical perspective, we know of no other year in US history where in the absence of a major full-mobilization war (like World War I or II) or a major recession and its immediate aftermath when the budget deficit was so large.  Some may point out that the budget gap was this large in FY 2012, a few years after the Financial Panic and Great Recession of 2008-09.  However, the unemployment rate averaged 8.3% that year, more than double the average jobless rate of 4.0% this year.  In other words, the economy in 2012 was still far from a full GDP and job-market recovery.

You may not remember, but Democrats hammered Ronald Reagan for deficits in the 1980s.  Well, looking back the largest deficit we ever had under Reagan was in 1982, when the unemployment rate was 10% and we were fully funding the Pentagon at the height of the Cold War.

In other words, there is simply no excuse for running a deficit this large given the lack of a major war and the absence of a recession.

And yet here we are.  What’s amazing is how much the budget situation has changed in only the past five years.  When looking at the budget it’s important to compare apples-to-apples, so we like to use the budget at the same point in the business cycle.  In 2019 the economy was at a pre-COVID peak and 2024 is, so far, a peak business-cycle year as well.  (It remains to be seen if 2025 is an even higher peak, in which case we will be happy to make a 2019 versus 2025 comparison a year from now).

Five years ago, in FY 2019, the deficit was 4.6% of GDP, so with this year at 6.7% it is 2.1 percentage points higher.  Is it higher because of less revenue?  Not at all.  In the past five years revenue as a share of GDP has risen to 17.2% from 16.3%.   They were $3.5 trillion in 2019, this year they are $4.9 trillion, $1.4 trillion higher.

Instead, the problem with the growing deficit is on the spending side.  And while many just chalk it up to Social Security and Medicare because of our aging population, this just isn’t true. There are three major factors: (1) net interest on the federal debt, (2) “other” mandatory spending, and (3) major health care programs, such as Medicare (for senior citizens) and Medicaid (for those with lower incomes).

The growth in the net interest on the federal debt has been astounding and we plan to write more about the major political and policy implications of that change in the months ahead.  Back in 2019, net interest was 1.8% of GDP; this year it will clock in at 3.1% of GDP, the highest share since 1995.

Meanwhile, “other” spending is up because the Biden Administration has been busy finding ways to forgive as many student loans as it can legally get away with (as well as ways that may end up being illegal, like with policy changes announced in 2022 and later overturned by the Supreme Court).  When loans are forgiven, the Department of Education calculates present value of less future repayments, and factors that into the current budget year.  As a result, “other” spending, which was 2.7% of GDP in 2019 is 3.8% this year.

Then there are the health care programs, which cost 5.3% of GDP five years ago, but 5.8% this year, with Medicaid growing much faster than Medicare.  With population aging and barring major reforms to these programs, this share should only grow in the decade ahead.

The bottom line is that the US faces big structural budget challenges in the years ahead, particularly on the spending side.  With low interest rates in the past fifteen years, we had the chance to avert our eyes from the problem, but we are soon to run out of time.  No matter who we elect in November, we expect getting our fiscal house in order to eventually become a major policy theme of the next Administration as well as those beyond.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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In today’s fast-paced world, it’s easy to be overwhelmed by daily news cycles, which often focus on crises and challenges. But when we zoom out and take a long-term view, it’s clear that global living standards have improved dramatically over the past several decades. While no metric can capture this perfectly, three key indicators — life expectancy, poverty rates, and literacy — show that, overall, we are living in a healthier, wealthier, and more educated world than ever before. 

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The Fed began the process of rate cuts today, and they came out not with a whimper, but with a bang, cutting rates by 0.5% (50 basis points). Following the June meeting, Fed members forecast it would be appropriate to cut rates once – by 25 basis points (bps) – in 2024. Three months on, they have already surpassed those expectations, and forecast further cuts before the year is through.  

So what has changed?  Today’s statement saw a number of alterations from the August meeting.  Beyond the language surrounding today’s rate cut, the Fed tempered language around the labor market and were intentional in highlighting that they view the balance of risks between inflation and employment as now roughly equal.  Meanwhile the committee has gained “greater confidence” that inflation is moving steadily toward its 2.0% inflation target, justifying today’s actions.  It’s notable that there was a dissent in today’s vote – the first vote against a Fed action since 2005 – as Fed Board Governor Michelle Bowman preferred to cut rates today by 25 bps.  That said, all nineteen voting members – including Bowman – forecast that rates should be cut to at least today’s level by year end.

Today’s statement was accompanied by updated economic projections from Fed members (the so-called “Dot Plots”) which were consistent with rate cuts.  The unemployment rate is now expected to end the year at 4.4% (in June Fed members were forecasting 4.0%), while PCE inflation expectations have fallen from 2.6% on a year-ago basis down to 2.3%.   Weaker employment growth and a faster moderation in inflation add to a more robust reaction from the Fed.

When looking at the pace of anticipated rate cuts moving forward, today’s accelerated start looks like a front-loading of cuts that were previously expected.  Fed members signaled expectations for 50 bps of further cuts before this year is through, likely 25 bps at each of their two remaining meetings.  For 2025, the Fed anticipates a total of 100 bps of cuts, the same number of cuts they signaled back in June.  In 2026, the June forecast for another 100 bps of cuts is now down to 50bps.  So more now, less later.  On net, the Fed is signaling a steady pace of cuts from here, barring any substantive shift in the data.  

During the press conference, Powell was peppered with questions related to the concerns over a slowing labor market, the Fed falling behind the curve, and what the Fed would need to see to be convinced 50 bp+ cuts should continue at future meetings.  While Powell responded by reinforcing the Fed’s data dependence and downplayed current labor market conditions as anything to be concerned about, we remain concerned that the Fed – and the markets – are watching the wrong data.  

The money supply remains the most important indicator on the path forward. The M2 measure of money has been rising at a gradual pace after falling into contraction territory for much of 2022-23, and how M2 growth progresses from here will dictate if the Fed has room for further rate cuts or sees a re-acceleration of inflation as was seen when the Fed declared a premature victory on inflation back in the 1970’s.  If M2 growth remains modest, both inflation and economic growth will slow, but the Fed will have room to continue cuts. If, however, rate cuts lead to a rapid rise in M2 growth, the Fed has shown an active neglect of the warning signs that would have preempted this inflation debacle to begin with.  We will continue to watch – and report – on the money supply, and the ongoing ramifications it has on the economy as a whole.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Don’t get too excited about the jump in housing starts in August. Although they rebounded for the month, they remain below the pace of 2021-2023.  The good news for future homebuyers is that builders have been focusing their efforts on completing projects already in progress.  Completions jumped 9.2% in August to a 1.788 million annual rate, the highest pace since the run-up before the Great Financial Crisis.  With strong completion activity and tepid growth in starts, the total number of homes under construction continues to fall, now down 10.1% since the start of 2024.  That type of decline is usually associated with a housing bust or recession.  The lack of new construction is why home prices have remained elevated while rents are still heading up in much of the country: we are building too few homes while lax enforcement of immigration laws mean rapid population growth.  The home building sector seems strangely slow given our population growth and the ongoing need to scrap older homes due to disasters or for knockdowns. We think government rules and regulations are likely the major hurdle for builders in much of the country, but home construction might also be facing headwinds from a low unemployment rate (which makes it hard to find workers) as well as relatively high mortgage rates.  That said, there are some tailwinds for housing construction, as well.  Many owners of existing homes are hesitant to sell and give up their fixed sub-3% mortgage rates, so many prospective buyers will need new builds.  In addition, Millennials are now the largest living generation in the US and have begun to enter the housing market in force, which represents a demographic tailwind for activity.  Finally, the widely anticipated commencement of the Federal Reserve’s easing cycle will begin this afternoon at the FOMC meeting. As rate cuts arrive, mortgage rates should trend lower as well, helping put a floor under housing later in 2024.   Putting it together, we don’t see housing as a major driver of economic growth in the near term, but we’re not expecting a housing bust like the 2000s on the way, either.

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Implications:  Industrial production surprised to the upside in August, coming in higher than even the most optimistic forecast from any economics group. That said, data from previous months were revised down and when included brought August’s gain to a modest 0.2%. Meanwhile, the details in today’s report weren’t quite as strong as the headline either.  Manufacturing was the biggest source of strength in August, rising 0.9%.  However, the volatile auto sector was largely responsible, with activity jumping 9.8%. Notably that was the largest monthly gain since 2021 and follows an 8.9% decline last month. Non-auto manufacturing (which we think of as a “core” version of industrial production) posted a more modest gain of 0.3% in August. The production of high-tech equipment led the way in this “core” measure, rising 1.8% in August, likely the result of investment in AI as well as the reshoring of semiconductor production.  High-tech manufacturing is up at a 12.9% annualized rate in the past six months and 9.1% in the past year, the fastest for any major category. The mining sector was also a source of strength in August, increasing 0.8%.  Broad-based gains in the production of oil and gas, the drilling of new wells, and the extraction of other minerals all contributed.  Finally, the utilities sector (which is volatile and largely dependent on weather) was the only category that posted a decline in August, falling 0.1%. In other news this morning on the housing front, the NAHB Housing Index, a measure of homebuilder sentiment, rose to 41 in September from 39 in August. The small gain was the first in six months as developers anticipate the beginning of Fed rate cuts during tomorrow’s FOMC meeting. A reading below 50 signals a greater number of builders view conditions as poor versus good.

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Implications:   Retail sales rose unexpectedly in August, eking out a 0.1% gain  (+0.2% including revisions to prior months) versus a consensus expected decline of 0.2%. Despite the upward surprise, sales have been weak of late, and point to a softening economy that is starting to feel the lagged effects of tighter monetary policy.  Looking at the details of the report, August’s gain was driven by a 1.4% increase at nonstore retailers (think internet and mail-order) which helped mask declining sales across the majority of categories.  Overall, just five out of thirteen major categories rose in August.  Auto sales ticked down 0.1%.  Meanwhile, gas stations declined 1.2% as gas prices fell in August.  Stripping these out along with the other often-volatile category for building materials, “core” sales rose 0.2% in August.  These sales – which are crucial for estimating GDP – would be up at a respectable 4.4% annualized rate in the third quarter if unchanged in September.  But much of that increase is due to one category; online purchases at nonstore retailers are up at a 13.5% annualized rate in the last three months.  Things are not looking as good when looking at the service side of the economy.  Sales at restaurants and bars – the only glimpse we get at services in the retail sales report – were unchanged in August and up 2.7% in the last year.  It looks like tighter monetary policy is finally starting to weigh on this sector, with sales up at just 0.9% and 1.5% annualized rates in the last three and six months, respectively, lagging overall sales.  Meanwhile, overall sales are up 2.1% in the last twelve months, which has not kept up with inflation; “real” (inflation-adjusted) retail sales are down 0.4% in the last year and have remained stagnant for three years since peaking in April 2021.  This is consistent with our view of a slowing US economy that is starting to feel the lagged impacts from a drop in the M2 measure of the money supply from early 2022 through late 2023.

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