House of horrors: Prices Falling in 8 of 16 Measured Countries; Is the US Undervalued?

The Economist is frequently a mixed bag. Here is an article on the global housing market that pretty much hits the right spot. Please consider House of horrors, part 2

The bursting of the global housing bubble is only halfway through.

MANY of the world’s financial and economic woes since 2008 began with the bursting of the biggest bubble in history. Never before had house prices risen so fast, for so long, in so many countries. Yet the bust has been much less widespread than the boom. Home prices tumbled by 34% in America from 2006 to their low point earlier this year; in Ireland they plunged by an even more painful 45% from their peak in 2007; and prices have fallen by around 15% in Spain and Denmark. But in most other countries they have dipped by less than 10%, as in Britain and Italy. In some countries, such as Australia, Canada and Sweden, prices wobbled but then surged to new highs. As a result, many property markets are still looking uncomfortably overvalued.

The latest update of The Economist’s global house-price indicators shows that prices are now falling in eight of the 16 countries in the table, compared with five in late 2010.

Home Price Indicators

To assess the risks of a further slump, we track two measures of valuation. The first is the price-to-income ratio, a gauge of affordability. The second is the price-to-rent ratio, which is a bit like the price-to-earnings ratio used to value companies. Just as the value of a share should reflect future profits that a company is expected to earn, house prices should reflect the expected benefits from home ownership: namely the rents earned by property investors (or those saved by owner-occupiers). If both of these measures are well above their long-term average, which we have calculated since 1975 for most countries, this could signal that property is overvalued.

Based on the average of the two measures, home prices are overvalued by about 25% or more in Australia, Belgium, Canada, France, New Zealand, Britain, the Netherlands, Spain and Sweden (see table). Indeed, in the first four of those countries housing looks more overvalued than it was in America at the peak of its bubble. Despite their collapse, Irish home prices are still slightly above “fair” value—partly because they were incredibly overvalued at their peak, and partly because incomes and rents have fallen sharply. In contrast, homes in America, Japan and Germany are all significantly undervalued. In the late 1990s the average house price in Germany was twice that in France; now it is 20% cheaper.

This raises two questions. First, since American homes now look cheap, are prices set to rebound? Average house prices are 8% undervalued relative to rents, and 22% undervalued relative to income (see chart). Prices may have reached a floor, but this is no guarantee of an imminent bounce. In Britain and Sweden in the mid-1990s, prices undershot fair value by around 35%. Prices in Britain did not really start to rise for almost four years after they bottomed.

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Jingle mail

American prices fell sharply, even though homes were less overvalued than they were in many other countries, because high-risk mortgages and a surge in unemployment caused distressed sales. In most other countries, lenders avoided the worst excesses of subprime lending, and unemployment rose by less, so there were fewer forced sales dragging prices down. America is also unusual in having non-recourse mortgages that let borrowers walk away with no liability.

An optimist could therefore argue that our gauges overstate the extent to which house prices are overvalued, and that if markets are only a bit too expensive they can adjust gradually without a sharp fall. It is important to remember, however, that lower interest rates and rising populations were used to justify higher prices in America and Ireland before their bubbles burst so spectacularly.

Another concern is that Australia, Britain, Canada, the Netherlands, New Zealand, Spain and Sweden all have even higher household-debt burdens in relation to income than America did at the peak of its bubble. Overvalued prices and large debts leave households vulnerable to a rise in unemployment or higher mortgage rates. A credit crunch or recession could cause house prices to tumble in many more countries.

Implications

That analysis is about as good as mainstream media gets. However, The Economist fails to address the global implications.

What happens if home prices plunge (and they will) in Australia, Belgium, Canada, France, New Zealand, Britain, the Netherlands, Spain and Sweden?

How will those central banks react?

Except for France which has no direct control, I will tell you how. Central banks will cut interest rates and/or launch various quantitative easing programs.

All other things being equal, that is net US dollar supportive.

Moreover, if prices and transaction volumes collapse in China (and they will), what will that do to the demand for commodities? In turn, what would falling demand for commodities in China do to the economies of Canada and Australia?

The Economist asks "Since American homes now look cheap, are prices set to rebound?"

That is a good question.

The Economist answers (correctly) "Average house prices are 8% undervalued relative to rents, and 22% undervalued relative to income (see chart). Prices may have reached a floor, but this is no guarantee of an imminent bounce."

However, The Economist fails to discuss the possibility that US rents are artificially high due to people seeking rental properties after being foreclosed on.

Moreover, income statistics are very skewed. Most of the gains in income are on the "high end", not people in financial trouble.

Still, as I said, this article is about as balanced as one can expect from mainstream media. It provides much opportunity for further commentary (both positive and negative) from bloggers.

The Economist correctly states "The bursting of the global housing bubble is only halfway through."

However, it's the non-discussed ramifications that are important.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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