After the market wide correction towards the beginning of 2018, a majority of the market has been able to recoup its losses, and even extend gains, the story is quite the opposite for homebuilders. ITB, a homebuilder iShares ETF is currently off 33.74% from this year’s highs and continues to edge lower. The decline in homebuilders can be attributed to an amalgam of factors, but the rising of interest rates has been the main driver.
After the fed approved the first interest rate hike of 2018 on March 21st 2018, homebuilders have reacted adversely to the news, and for good reason. As interest rates rise, you see the cost of borrowing follow that as well, causing mortgages to get more expensive and deter homebuyers from bidding on houses. With third rate hike of the year in September and another potential hike during the December meeting, the sentiment surrounding homebuilders will continue to sour. For this sentiment to reverse its path, we need to see moderation in hawkish tone from the FOMC members.
Unfortunately for homebuilders, the bad news doesn’t stop at the rate hikes. The current landscape makes for a perfect storm against the industry. The newly imposed 21% tariff on Canadian soft lumber, falling home sales, disappointing earnings/projections and negative analyst sentiment have been weighing down on the sector as well.
One of the larger emerging threats to the industry is tariffs on Canadian lumber imports. This will cut into margins and adversely affect future growth projections for many companies. This increase in cost will most likely be transferred to the consumer, causing further increases in the cost of building new homes while discouraging even more homebuyers. This is already being shown in the forecasted cost of US homes, with a projected increase of 6.4% for the next 12 months.
The homebuilder industry is incredibly cyclical, and trends are seeming to rhyme with past interest rate hikes in 2007. Once the Fed began raising rates in 2006, the homebuilder etf XHB began its descent, falling 55.4% before the actual market downturn, which started a little more than a year later, in October 2007. The current trend is nearly mirroring the past tightening cycles, slowing projected job growth and the increasing frequency of disappointing earnings by companies within the sector.
The homebuilding sector may seem relatively isolated, but it is quite the opposite. The industry is vast and has incredible influence over a sizeable amount of companies, including home inputs like Mohawk, Sherwin Williams, Masonite, Scotts Miracle Grow and Home Depot. Companies within XHB or ITB also have a huge impact on many raw material companies across America. A decline in the housing sector could mean trouble ahead for the rest of the markets.
Although the future for the homebuilding sector looks bleak, some analysts believe that there may be a sweet spot in home builders. The super-affordable segment, consisting of LGI Homes (NASDAQ: LGIH) (avg home 220,000-230,000), NVR (NYSE: NVR) and Meritage Homes Corporation (NYSE: MTH) seems like it may have some value left, considering its more affordable price range.
The bottom line here is that home sales are declining because of rising prices driven by declining inventory of for-sale home due to “mortgage rate lock-in”, rising cost of raw materials due to the trade war, and rising cost of mortgage due to federal reserve rate hikes.
By Baruch IMG’s Portfolio Management Team