What the US housing market reveals about future inflation

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Inflation. It’s the thing that everyone’s watching out for in the markets right now.

This matters. As we’ve discussed many times, it looks as though we’re at the end of the longest financial trend of most of our lifetimes – the bond bull market.

How things unfold from here depends greatly on how signs of rising inflation affect the actions of everyone from central banks to investors to governments.

And given that the US tends to take the lead on all of those things, it’s worth keeping watch on what’s going on over there.

Hence we turn our eyes today to the US housing market.

The US housing market is booming again

Given that it was the epicentre of the financial crisis in 2008, it might seem odd that we don’t pay that much attention to US house prices these days. That’s mainly because the US has largely had a pretty well-behaved housing market, at least relative to its developed-market peers.

The US housing bubble of the early 2000s stood out partly because it was so unusual. While Britain has been booming and busting for decades, US house prices – until that point – tended to go up largely in line with inflation. The nationwide mania for property really stood out as being unusual.

That’s also why people like then-Federal Reserve boss Ben Bernanke could shrug off soaring house prices and the subprime threat by pointing out that the US had never previously suffered a nationwide house price crash (although I must say I’ve read quite a few academic papers recently arguing that there was a “hidden” property crash in the run-up to the Great Depression).

Meanwhile, after the house price crash, it took a long time for US prices to recover. In terms of supply, the US was more like Ireland or Spain than the UK. Housebuilders had simply built too many houses. So it wasn’t just a matter of slashing interest rates (as happened in the UK). For the market to recover, some of that oversupply had to be worked off.

Housebuilders are a lot like miners – the product you produce collapses in price. You can’t make money from it anymore. You have to shut down production and batten down the hatches and conserve cash and pray that you didn’t get too over-leveraged during the boom times.

Executives and industry observers tear at their hair and rend their garments and swear that there’ll never be another market like it. But they’re called cyclical industries for a reason. And eventually, the product you produce starts going up in price again, because there’s not as much of it around as there used to be. You’ve been so badly burnt by the crash that you are hesitant to increase supply. Every glimpse of sun looks like a false dawn. So prices keep rising.

So you start producing more. And at some point, the mood changes, and optimism takes over again. But just as it takes a while to open a mine, so it takes a while to build a house. So you tend to go from having “not enough” of a thing, to having “way too much”.

That’s why bust follows boom, and why the worst time to buy a house builder or a miner is when it looks cheap on a price/earnings basis (because earnings tend to be at a cyclical peak).

Here’s what we call “late-cycle” inflationary pressures

But there’s another interesting phase in the bust-boom-bust cycle, which again, afflicts all cyclical industries.

If you’re building a house, that requires raw materials and labour. If lots of people are building houses, the price of those things is going to go up too. So even as you are ramping up production to profit from those rising house prices, your costs are soaring too.

And that’s where we are now. According to Bloomberg, the latest Case-Shiller house price index showed that prices in 20 big US cities rose by 6.8% in February. That’s the biggest year-on-year gain since June 2014. Inventories of “second-hand” houses are at their lowest level in 19 years – a far cry from supply glut of the post-2008 days.

Meanwhile, though, house builders are all starting to complain about rising costs. The price of lumber rose by 16% in the first quarter of this year alone. Another index of construction costs – “everything from particleboard and plumbing to concrete and insulation” notes Bloomberg – was up 5.1% in March, compared to the previous year. That sort of inflation hasn’t been seen in eight years.

This is why it’s called “late-cycle”, by the way. This is why raw material producers and commodity prices are seen as “late-cycle” plays. It’s because they tend to go up when the economy has been doing well for a while, and it suddenly starts to hit capacity constraints. That’s when you need to build more “stuff” and so demand for raw materials goes up.

Anyway – what’s the point?

Firstly, demand for US houses isn’t yet suffering because of rising prices. So builders are currently able to pass this on. That can only last for so long.

Secondly, there’s the risk that eventually rising costs will hurt affordability or bite into builders’ profit margins or both. Rising interest rates will mean rising mortgage rates. Rising wages may help to offset that for a time if they rise rapidly enough. But again, rising wages probably in turn means higher interest rates.

Thirdly, whatever happens, inflationary pressures will get worse before they get better. It would be nice to think that this might make the building industry more innovative (much as the oil price staying above $100 a barrel for so long gave us shale oil and the renewable energy boom).

But that might be too much to hope for.

In any case, I think it’s safe to stick with the assumption that the long-term bond bull market is over; you still want to have exposure to commodity producers right now; and of course, hang on to your gold (I’ve written all about why that’s a good idea in the latest issue of MoneyWeek magazine, out tomorrow – Sign up here if you haven’t already).