Will China really save the world? September 8, 2006 The Office of Federal Housing Enterprise Oversight (OFHEO) was created as an independent entity within the Department of Housing and Urban Development, a department of the Government of the United States. OFHEO's primary mission is to oversee the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) -- the nation's largest housing finance institutions.
Earlier this week OFHEO released its most recent House Price Index (HPI) data, of which the director of OFHEO, James B. Lockhart, said: "These data are a strong indication that the housing market is cooling in a very significant way. Indeed, the deceleration appears in almost every region of the country."
The decline in the quarterly increase in home prices was the sharpest since the beginning of OFHEO's House Price Index in 1975. OFHEO's report lists higher interest rates, a drop in speculative activity and rising inventories of homes as reasons for the decline in home appreciation.
Now let's also make sure we know what this data is telling us. The decline in home appreciation does not mean house prices are falling; it only means that house prices are not rising as fast as they used to. According to the HPI data, home prices increased by an average annualized rate of 10.06% in the second quarter (from the second quarter of 2005), or an annualized average of 8.27% if we measure the increase using purchase transactions only (just a different method). So there is no reason to be alarmed, right?
Chart 1: Annual rate of increase in house prices in the US
The deceleration in the increase of house prices may have been what struck the OFHEO, but what strikes me is how capital flows, the wealth effect and the Fed's interest rate policies have impacted house prices. I have written about international capital flows during the 1990s many times before.
Briefly, large amounts of capital fled to the United States during the 1990s due to currency crises that began with Brazil in 1992, increased sharply with the Southeast Asian Crisis in 1996 and continued into the 2000s. The influx of capital caused a boom in bond prices, stocks prices and real estate prices in the US and the rise in bond prices also meant lower interest rates, intensifying the impact of capital flowing into the country.
As we look at the above chart we can see how moderate annual home price increases of 1% to 3% in the early 1990s accelerated as the wealth effect of the stock market bubble and falling interest rates spurred a buying frenzy, driving up home prices. When the Tech Bubble popped in the late 90s, the Fed decided to drive interest rates down artificially to prevent an economic downturn. The real estate market was already over valued, and with lower with lower interest rates making homes more affordable home prices soared. The average annual increase in home prices across the entire country rose from an average of 6.93% in 2002 to 13.23% in 2005.
Real estate prices in certain areas got completely out of control. In Arizona, for example, the average increase in home prices from the second quarter of 2005 to the second quarter of 2006 was 24%. It was 21% in Florida, 20% in Idaho and 19.5% in Oregon. I have been an investor for long enough to know that when average house prices increase by 20% to 25% then something is wrong.
In a best-case scenario, the average increase in house prices will come back to somewhere in the 2% to 4% range. But even if average house prices do not fall and only appreciate at a lower rate, the wealth effect of rising stock prices and rising house prices is over and with it goes consumer spending.
Consumer spending accounts for 70% of the United States' gross domestic product, so if consumer spending takes a hit because real estate refinancings have dried up, the economy is going to struggle. Can China save the world?
Many investors in natural resource stocks base their investment outlook on the expanding Chinese economy and its demand for base metals. I have long maintained that China is just another bubble looking for a pin and that the Chinese economy is too closely tied to the US economy to withstand a slowdown in US consumer spending without getting dragged down.
Chart 2: Economic Growth in China
If you look at the above chart you will see that China's economic growth has been spectacular. Their economy has been growing at an average annual rate of almost 9% since 1996. Yet, notice that the rate of growth has been relatively stable - at least according to the data I got from the World Bank. But also notice how the export of goods and services has become larger and larger as a percentage of China's GDP. From 1996 to 1999 exports accounted for about 20% of China's economy. By 2004 (latest available data) exports accounted for 34% of GDP. I wonder who is buying all that stuff that China makes? Notice also that China's exports are growing at almost 30% per year, and have been for the past three years (2002, 2003 and 2004).
A simple calculation will tell you that if China's exports are growing at 30%, and exports account for 30% of GDP, then the growth in exports alone will increase GDP by 9%. But hold on, that's how much China's entire economy is growing! So where is the internal demand? Where is the Chinese consumption that will propel base metal prices? Either the World Bank's data is completely useless, or else China's economy is far more dependent on exports that what some people think.
Speaking of base metals, the IMF released a report this week saying that they think "...metal prices will decline progressively from current levels as new production capacity comes on stream," with copper projected to fall by 57% over the next few years. I think I'll stick to gold. Hopefully the gold price will keep trending down in the short term so I can buy some more.
Paul van Eeden
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