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Investment Research — General Market Conditions

15 November 2013

Research US Housing – slower growth but still a tailwind 

We continue to see potential in the housing recovery despite the increase in mortgage rates.



Housing activity remains depressed compared with any longer term sustainable level and prices are not restrictive.



The pace of growth in both residential construction and house prices is set to slow. In our view, this will dampen the positive boost to GDP growth but housing will remain a significant tailwind for the recovery in 2014.

Slowdown but not the end of recovery The housing recovery, which kicked off in 2011, showed impressive momentum late last year and early this year. Since then, the pace of expansion in both home sales and residential construction and house price increases have moderated significantly. One reason for the slowdown is the considerable increase in mortgage rates from May to September this year. We also believe there is some payback from the rapid increase in activity earlier this year, as this was fuelled at least partly by homebuyers fast forwarding their purchases in anticipation of higher funding rates in the future. We do not believe the current slowdown is the end of the housing recovery. Fundamentals support continued positive growth in residential construction and the negative impact of the rapid increase in mortgage rates earlier this year should soon start to fade. In particular, since the peak in September, mortgage rates have declined 40bp, which has helped to ease financial conditions. On top of this, the latest Federal Reserve Senior Loan Officer Survey shows that banks continued to ease lending standards for prime homebuyers in the three months to October. Mortgage rates have increased but have come off the peak 7.0 6.5

%

%

30-year mortgage contract rate

Banks are easing lending standards for most homebuyers 7.0 6.5

6.0

6.0

5.5

5.5

5.0

5.0

4.5

4.5

4.0

4.0

3.5

3.5

3.0

3.0 08

Source: MBA

09

10

11

12

13

100 % of respondents Senior loan officer opinion survey... 80 ...tighter credit standards 60 40 20

Total (discontinued)

100 Subprime

80 60

Prime

40 20

0

0 Non-traditional

-20

-20

92 94 96 98 00 02 04 06 08 10 12

Source: Federal Reserve

Senior Analyst Signe Roed-Frederiksen +45 45128229 [email protected]

Important disclosures and certifications are contained from page 4 of this report.

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We use a recent research paper from the Federal Reserve Bank of Boston to get an idea about the magnitude of the shock to residential investment from the change in interest rates. According to the Boston Fed model, a sustained 100bp increase in 10-year treasury yields would drag down residential investment growth by almost 8pp over one year. The largest drag will come in the first quarters after the interest rate shock and fade over time. We also have to take into account the following decline in yields to get the total impact on activity. Summing the two suggests that the increase and following decline in interest rates should dampen residential construction growth by 1.0-2.5pp in the current and coming quarters. Increase in mortgage rates will slow the housing recovery – not destroy it Impact on annualised growth in residential investment, %-point

Q3 2013

Q4 2013

Q1 2014

Q2 2014

Q3 2014

Q4 2014

Q1 2015

May-September, 100bp increase in 10-year treasury yields

-3.2

-2.4

-2.2

-2.0

-1.9

-1.5

-1.0

September - today, 30bp decline in 10-year treasury yields

-

-

1.0

0.7

0.7

0.6

0.6

-3.2

-2.4

-1.2

-1.3

-1.2

-0.9

-0.4

SUM

Source: Boston Fed model, Danske Bank Markets calculations

Fundamentals remain supportive Despite the increase in mortgage rates, we still view fundamentals as supportive of a continued recovery in the housing market. Looking at the National Association of Realtors housing affordability index, it has come down from its peak but remains at an elevated level of 156. This means that a household earning the median family income has 156% of the income necessary to qualify for a conventional loan covering 80% of a median-priced existing single-family home. Another gauge of housing sentiment is the University of Michigan’s consumer survey, which has a sub-question on home-buying conditions. Although home-buying conditions have come down with the increase in mortgage rates, the index is far from the levels seen in past housing downturns. Although building activity has rebounded from the bottom, there is still a lot of potential left. While it is true that the housing bubble led to an oversupply of houses, the recent six years of undershooting should have cleared the overhang. The decline in both rental and homeowner vacancy rates supports this view. Thus, we expect housing starts to increase gradually towards a long-term average of around 1.4 million annualised from the current level of only 900,000 per year. The trend in household formation is around 1.2 million per year, the estimated loss rate is at 0.4 million per year and additions to the housing stock outside new construction run at 0.2 million per year. This implies that housing starts of around 1.4 million per year will keep the number of housing units per household constant, while continued growth of only 900,000 will imply a continual decline in the number of housing units per household. In addition, if we are right that the economy will show higher growth next year, we see potential for a jump in household formation. Since the recession, the share of young people living with their parents has increased substantially. It is likely this is driven by a need to save money but falling unemployment is likely to allow some of these young people to form their own households.

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US housing affordability and buying conditions 250 Index

Index

210

Housing affordability >>

180

190

160

170

140

150

120

130 110 90 90

220 200

230

<< Michigan home buying conditions 95

00

05

100 80

10

Source: University of Michigan, NAR

Rental and homeowner vacancy rates 3.50 % of total % of total 3.25 3.00 2.75 Rental >> 2.50 2.25 2.00 1.75 1.50 1.25 << Homeowner 1.00 0.75 85 90 95 00 05 10

Source: US census bureau

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11.5 11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0

Research US

Our model for residential construction growth suggests that the pace of adjustment towards the 1.4 million level of housing starts will continue in coming quarters although at a slower pace. The model is based on the deviation from the long-run investment ratio for residential construction, the months of supply of new homes and mortgage rates. It should thus capture both pent-up demand, the extent of over/undersupply of homes and the impact of mortgage rates. The model predicts a slowdown from the current 15% y/y pace of increase in residential construction to between 5% and 10% y/y in coming quarters. Even with this slower pace of construction activity, the housing sector will remain a significant positive factor for the US economy next year. Residential construction on its own should boost GDP growth in 2014 by around 0.2pp. More important, however, is the impact of rising home prices. Even though house prices have risen 11% from the bottom, measured by the FHFA purchase only index, they remain 13% below the peak in 2007. The affordability index suggests that the current level is not restrictive and the same is true when you compare house prices to disposable income per household. We expect home prices to increase further over coming quarters but the pace of increase should moderate. A simple relation between the de-trended expected change in total home sales and home prices suggests that real house price increases should moderate. We look for nominal home price increases to slow to around 3-4% y/y over coming quarters, which will bring real house price growth in line with the model, from the current 8.5% pace. The continued increase in house prices will add to household net wealth and boost consumption. In general, wealth increases affect private consumption with a lag, as households do not adjust their consumption to increases in their net worth overnight. This means we have still not seen the full effect on private consumption of the increase in home prices over the past year. Indeed, we expect the boost to private consumption to peak now and moderate only gradually in coming quarters. In 2014, we expect the positive impact on private consumption to boost overall GDP growth by 0.4pp on average. This means the total impact on GDP growth from the housing market sums to a boost of 0.6pp to annual growth in 2014. This is lower than the average 0.8pp boost to growth this year but, nevertheless, housing will be a significant tailwind next year as well.

Housing start far below long-term equilibrium 2.50 million AR 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 60 70

2.50 million AR 2.25 Housing starts 2.00 1.75 1.50 1.25 1.00 The level of supply suffient to 0.75 keep the number of housing 0.50 units per household constant 0.25 80 90 00 10

Source: US census bureau, Joint Center for Housing Studies, Danske Bank Markets

Danske Bank US residential construction model 60 60 % y/y % y/y 50 50 Residential construction 40 40 Model (based on deviation from LR investment ratio, new homes months 30 30 of supply and mortgage rates) 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 75 80 85 90 95 00 05 10

Source: BEA, MBA, US census bureau, Danske Bank Markets

Housing will remain a significant tailwind to growth 2.0 % - point 1.5

Growth impact % - point from housing Wealth effect from home prices

1.0 0.5

1.0 0.5 0.0

-0.5

-0.5

-1.5

-1.0 Residential construction

-2.0 00

-1.5 -2.0

02

04

06

08

10

12

Source: FHFA, BEA, Danske Bank Markets

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0.0 -1.0

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Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The author of this research report is Signe Roed-Frederiksen, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst’s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts’ rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of highquality research based on research objectivity and independence. These procedures are documented in Danske Bank’s research policies. Employees within Danske Bank’s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank’s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication.

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