Housing Starts and Credit Spreads Show U.S. Economic Rebound Gaining Steam
The S&P 500 Index has completely recovered from its coronavirus losses, rebounding fully from its shocking first-quarter 34% freefall in just under five months. This meteoric rebound from a recessionary trough is among the fastest in modern history.
The broad economic picture continues to brighten – consensus forecasts expect GDP to rebound 20% in the third quarter – but many risks remain. In coming months, data is likely to be mixed as the initial wave of post-lockdown demand ebbs.
Yet the positive movement of leading U.S. economic indicators is confirming that durable market and economic bottoms have formed.
Investors still on the sidelines, or looking to take on more risk, would be well served to re-frame their mindset away from the mercifully brief recession and toward the incipient expansion.
Two key economic indicators are showing the way: housing starts and credit spreads.
The uptick in housing starts signifies that the U.S. housing market is healthy. This is an important component of the overall economy (more than 15% of GDP, according to the National Association of Homebuilders), with a strong multiplier effect from complimentary spending. When a new home is constructed, it creates a great deal of associated economic activity beyond the actual construction, such as the purchase of appliances and furnishings.
In the wake of the Global Financial Crisis and the collapse of the “housing bubble,” starts became sluggish because of excess supply built up during the prior cycle. New construction only began to exceed estimates of baseline demand (1.3 million per year) in late 2019. It peaked in January 2020 just above an annualized pace of 1.6 million.
The COVID-19 pandemic quickly ground activity to a halt, with starts falling below 1 million in April. As stay-at-home restrictions have eased, however, housing has bounced back. This is particularly true in suburban areas that faced more challenging markets over the past decade.
Starts have recovered to a nearly 1.5 million annual pace. While the pace of growth may moderate in the coming months as an initial wave of pent-up demand peters out, this surge from the low is a strong sign that the U.S. economy has turned the corner.
As construction projects are completed in the coming months, there will be a shot of adrenaline into the economy from complementary home-related purchasing activity. This spending should further bolster GDP growth and offset the eventual waning impulse from pent-up demand.
The second positive signal is the narrowing of credit spreads, which helps evaluate returning investor demand for fixed income.
Wider credit spreads equate to a higher required return to compensate for greater perceived risk. In the depths of the COVID-19 crisis, investors demanded nearly 11% on top of the 10-year U.S. Treasury yield to invest in high-yield bonds, about 3.5 times as much as at the start of the year.
At these punitive spreads, credit issuance ground to a halt in March. This exacerbated the volatility in U.S. equity markets as investors called into question a company’s ability to rollover existing debt or raise additional capital.
The quick, decisive actions taken by the U.S. Federal Reserve were in part targeted to support the flow of credit and ease this pressure point. These programs have largely been successful, allowing corporate bond issuance to come roaring back: volatility has receded alongside the premiums fixed income investors are demanding to take on credit risk.
These moves also prove that the old adage, to “not fight the Fed,” still very much applies.
While credit spreads have not fully recovered to their pre-coronavirus lows, they have narrowed considerably, retracing over 80% of their move from earlier this year.
Other major financial indicators are also positive, which is consistent with an economic recovery taking hold on Wall Street to a greater degree than Main Street.
Jeff Schulze is an investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice.
All investments involve risk, including loss of principal. Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
©2020 Legg Mason Investor Services, LLC, member FINRA, SIPC. ClearBridge Investments and Legg Mason Investor Services are wholly-owned subsidiaries of Franklin Resources, Inc. BEN