A Bursting Bubble or Soft Landing For the Economy?

Economists and journalists love to label. They use words like “growth” and “value” when describing aggressive and conservative styles of investing. And they use phrases like “soft landing” and “bursting bubble” when describing normal or extreme outcomes of the current housing slowdown. Labeling can help simplify complex issues like investing and housing, but it’s also important for current or prospective homeowners to go beyond labels and really understand what is going on. So now we’re going to help you do that.

What Is An Asset Bubble Anyway?
A bubble is filled with air, and when it bursts, there’s nothing left. So it’s justified to call the late-1990s stock market mania an asset price bubble, because constant trading was driving up stock prices of (mostly internet) companies that had no income, or no prospects of income. Higher and higher values in companies were being transferred when no actual products were being created by these companies. However, when it comes to housing, a pricing bubble isn’t the right label. Sure, economists are somewhat justified when they say home sales are just transactions where wealth is merely transferred from seller to buyer and nothing is created (try telling that to a builder). But property is a tangible product valued on the home itself plus the land it sits on – land which can never be re-created.

Property, therefore, is a physical asset that’s changing hands. So if we label the $9 trillion increase in U.S. home values since 2001 a bubble, there would be nothing left if it burst. And that’s just not the case.

Housing Is Slowing, Not Crashing
The more likely case is a soft landing, which means that we will see a correction in housing prices as part of a normal economic cycle. Rising rates which started the housing slowdown have many bubble theorists worried because of the $1 trillion of adjustable rate mortgages set to adjust in 2007. A recent UBS Global Asset Management housing report provides some much-needed perspective by pointing out that this is only 10% of the total outstanding U.S. mortgage debt, and saying: “For the marginal buyer, rates will rise, but they will remain low, and together these two factors are ingredients for a slowdown, not a crash.”

Furthermore, we are nearing the end of the Fed’s rate hike cycle, and may see lower rates by next year. The Fed hiked rates steadily since June 2004 to control asset prices from rising too quickly while the economy was hot. Now much of that inflationary threat seems to be worked out of the system. There are still a couple financial institutions like Lehman Brothers that think the Fed may hike as much as .5% more by the end of 2006. But most Wall Street predictions say that the Fed’s work is done.

Edward McKelvey, senior economist at Goldman Sachs, recently told the New York Times that the Fed’s next move “will be a cut” perhaps sometime next Spring. And Bill Gross, chief investment officer at PIMCO, one of the world’s largest bond managers, says that the 10-year Treasury Note – a key benchmark for mortgage rates – may drop as much as 2% by 2008.

A Soft Landing For Your Financial Plans
PIMCO’s estimate might be extreme, since that would mark a record low, but it’s certainly not too far out of line from the rest of Wall Street’s rate estimates. Consensus estimates call for lower rates in 2007, which will provide some cushion for mortgage holders who’ll be adjusting. And, of course, it will help support the soft landing for the housing sector as a whole.

It’s worth noting that this soft landing scenario doesn’t mean more double-digit housing gains are imminent. While discussing the U.S. housing market last month, The Economist warned against banking on dropping rates to fuel housing prices. They advised that “it is better for Americans to start saving the old-fashioned way by spending less of their income rather than rely on rising asset prices.”

Sage advice for sure, but this is where the macro-economic analysis has to end and your own household financial analysis has to begin. Since a home is often your largest asset and serves as a centerpiece for a broader financial plan, it’s critical to create and execute your property goals correctly – especially in a more challenging market cycle. This is when strategies are made or broken.