Think about what a house means to most people. In addition to being a place to live, it also represents the single largest investment one is ever likely to make over a lifetime, typically purchased via a mortgage (i.e., leveraged). It is also relatively illiquid, certainly in comparison with other asset classes that households typically use as a store of wealth (cash, equities, bonds, etc.).
Moreover, it is not just bricks and mortar; people have strong emotional ties with their homes because their housing choice not only reflects their current social standing but also dreams and aspirations for the future. Can one imagine an asset more perfectly designed to be prone to bubble-like behaviour?
A Lesson from History
Unsurprising, history is littered with examples of housing market bubbles that end with an unpleasant bang, often with dire knock-on consequences for the broader economy. This was most visibly demonstrated by the downturn in the US housing market in the mid-to-late 2000s, which proved to be the catalyst for the Great Recession, the worst global economic downturn since the Great Depression.
Back then, when US house prices were sliding, and unsold inventory was piling up, a housing market recovery seemed a dim and distant hope. And yet, fast forward a decade later, and US house prices are almost back to pre-crash highs. What’s more, in many other countries the impact of the Great Recession on the housing markets proved to be so negligible that it barely appears as a ripple in an otherwise strong upward price trend.
As noted in a recent article, global policymakers may not have been able to generate a self-sustaining economic recovery, but they have been very successful at reflating asset prices, including real estate – see chart below.
In light of the continued appreciation in residential house prices over recent years, there is growing concern that another housing market bubble, if not globally, then at least in several countries, has been created.
Where the Problems Reside
According to the OECD’s Interim Economic Outlook, published earlier this month, the high level of residential real estate prices in several advanced economies is one of the key vulnerabilities in the global outlook.
As can be seen in the chart below, based on one of the two most common valuation metrics (price-to-rent ratios), the OECD calculations show residential real estate valuations to be rather stretched in Canada, Sweden, Australia and the UK.
By definition, a bubble occurs when the price of an asset is significantly overvalued, that is to say, it becomes increasingly difficult to justify elevated price levels based on underlying fundamentals (not impossible, because one thing humans are very good at is torturing logic to minimise cognitive dissonance).
In such situations, it is the overriding optimism of the crowd, with unrealistically high expectations, which acts as the propellant for further price gains. Hence, one additional confirming sign of a housing market bubble would be high crowd sentiment towards real estate. However, looking at the latest global crowd-sourced sentiment heatmap for residential real estate there are no obvious overheating candidates.
Does this mean that fears and worries, expressed by the likes of the OECD and shared by many investors, about the formation and therefore potential bursting of another housing market bubble are exaggerated? Perhaps, not.
The Source of the Problem
Drilling down to the country level, one finds some rather concerning sentiment trends – clear warning signs that residential real estate prices in some of the countries highlighted by the OECD are vulnerable to the downside.
Because of the illiquid nature of residential housing – lead times for selling and buying properties can range from several weeks to several months – what one observes is that often sentiment moves down well in advance of house prices. One saw this very clearly in the US prior to the housing market downturn that started in 2007 – see chart below.
Worryingly for the optimists, even though US residential real estate does not appear to be particularly overvalued, with a price-to-rent ratio in line with its long-run trend, similar crowd behaviour is unfolding. There has been a marked deterioration in sentiment towards US residential real estate over the past few months, dragging the index down to levels not seen since the Great Recession.
Most likely, this fall is attributable to the back-up in mortgage rates reflecting the combination of a post-Trump reflation mindset and a Fed more proactively seeking to normalise its policy stance. As such, this highlights a clear vulnerability in the event that US interest rates continue to trend higher.
What about the other housing markets where valuations appear stretched?
Problems Across the Globe
In Canada, the country identified by the OECD as having the highest price-to-rent ratio amongst advanced economies, one finds that crowd sentiment towards residential real estate has rebounded over recent months having been consistently negative for much of the past year – see chart below.
This suggests that robust house price momentum witnessed over recent quarters may have convinced the crowd that it was too pessimistic. While such price/behaviour dynamics are never an encouraging long-run phenomenon (it is the very essence of bubble behaviour), the uptick in sentiment momentum by the crowd suggests that the house price slump many view as inevitable may be postponed a while longer.
Similar crowd dynamics are also evident in Sweden, a country whose housing market the OECD considers to be just behind Canada in terms of stretched valuations. Sentiment, which was firmly negative for much of the past year, moved into positive territory in November and has since remained there.
By contrast, Australia, another housing market where prices have been rising sharply, and valuations look expensive, is seeing a rather different trend in crowd sentiment. Q1 house price data was surprisingly robust but, as can be seen in the chart below, unlike Canada, crowd sentiment has stayed firmly negative.
For an economy which has not experienced a recession in more than a quarter of a century, and where the doomsayers have repeatedly and incorrectly predicted a bursting of the housing market bubble, calling a downturn is always a dangerous exercise.
However, one must conclude that the negative tone of crowd sentiment towards residential real estate in Australia suggests an increased vulnerability, a risk the RBA rather unusually referred to explicitly in the minutes from its last policy meeting published earlier this week.
The Brexit Issue
Finally, in the UK, Brexit worries clearly have had a strongly detrimental effect on the crowd’s view towards the UK housing market. However, the latest figures from the Office for National Statistics (ONS) show that after a slight wobble last year, prices rose just over 6% in the 12 months to January 2017, hitting fresh record highs. This price rise stands in marked contrast to the tone of the crowd towards UK housing, which remains firmly negative – albeit less so than witnessed immediately after the June 23rd referendum vote (a general trend in UK crowd sentiment as noted in last week’s article).
In fact, the last time crowd sentiment towards UK residential real estate was this sustained and negative was in 2008 just before prices dropped sharply, a lead time most likely attributable to the illiquid nature of housing (as mentioned above). So, just like Australia, the UK housing market appears to be increasingly running on fumes.