Two “Data” items today regarding issues recently in the news:
Topic #1: US Home Prices – how long can increases continue at this pace? Today, the Case-Shiller National Home Price Index printed a 7.0 percent annual increase for September. This was the largest year-on-year increase since May 2014, when home prices were finally recovering from the bursting of the housing bubble.
Also notable about today’s data: home price increases are occurring across the US. None of the 20 cities Case-Shiller tracks is doing worse than a 4.3 percent comp to last year (unsurprisingly, that low print belongs to New York) and the best are +10 percent (Phoenix 11.4 pct, Seattle +10.2 pct).
For some historical perspective, here are the annual percentage changes for the Home Price Index back to January 1988 (red, left Y axis) compared to 30-year fixed mortgage rates (blue, right Y axis):
Three points about this data:
Secular growth rate of house prices. While coming up with a normalized cross-cycle historical average annual gain is somewhat subjective, both the simple mean and compounded annual growth rate here are 3.8 percent/year. This is roughly analogous to population growth (1 percent) plus inflation (3 percent over the period, but certainly lower now).
Recent history. Over the last 5 years, the average annual price gain is somewhat higher than that long run average, at 5.0 percent. Even with that uptick versus historical norms, you can see on the chart where higher mortgage rates in 2018 (peak in November) slowed the pace of house price increases to 3.8 percent in June 2019.
What’s happening now. We can explain much of the recent uptick in house prices by simply looking at the decline in mortgage rates in 2019 – 2020. From year end 2018 to now, these have dropped from 4.94 pct to 2.7 pct. That equates to a $319/month decline in a mortgage payment on a $250,000 loan, or 24 percent.
Takeaway: while the virus has certainly played a role in boosting US home demand, in our view the real driver of higher prices is lower mortgage rates. As long as these remain low, house prices can still trend higher. That said, we doubt if mortgage rates can fall much further if long term Treasury yields start to inch higher (our base case). That means future home price increases will likely revert to their long run average of 3-4 percent.
Topic #2: Chinese Corporate Debt – how much should we worry? Chinese corporate bond yields hit 4.0 percent yesterday. Those are their highest levels since June 2019, right in the middle of the US-China trade war. The proximate cause of this backup in rates is several high-profile defaults in recent days, including a coal/power company, a semiconductor producer, and a car company with links to BMW. According to the Financial Times, the turmoil has caused the postponement of at least 20 bond deals over the last week.
While these problems are thus far isolated and potentially more about mismanagement than systematic challenges, they are a good excuse to take a brief look at the Chinese corporate bond market.
2 points on this:
#1: The Chinese corporate debt market is very large and growing quickly. As of the end of Q1 2020 (latest data available), China’s total outstanding corporate debt stood at $3.7 trillion. While that is only 55% of the total amount of US corporate debt, as the chart below shows, the growth rates are much higher (note: log scale chart).
The red line is Chinese corporate debt outstanding since 2010 compared to US corporate debt in blue. In Q2 2010, China’s market was one tenth the size of the US. Now, as noted, it is just over half the size.
#2: A recent note from Fitch Rating forecasts that defaults by Chinese state-owned enterprises (SOEs) would rise “marginally” in 2021. These companies, with ties to local/regional governments, are supposed to be better credits than privately-owned enterprises (POEs). Even still, according to Fitch the Chinese government will allow some greater level of defaults next year in an effort to clean up over-capacitized industries. Given the global Pandemic Recession this year, that was not possible in 2020.
Summing up: we’re very likely to hear more about other Chinese corporate bond defaults in the coming year. There will be a cyclical aspect to these, as there is in US markets, but there is also the government’s need to streamline SOEs. This has been going on for a long time; in 1992 we took public the precursor company to that automotive business we mentioned at the top just defaulted. The story even then was making SOEs competitive… The bright spot for global capital markets is that international investors own very little Chinese corporate debt. This should limit any fallout if defaults ramp significantly in 2021.