Why home builders rallied | Financial Times

Good morning. We receive the April Consumer Price Index report today. As always, the reaction will be as interesting as the data itself. We hear a lot more about recessions than inflation these days. If the report comes out a little warm, will that change, or will the market ignore it as a temporary aberration from the inevitable downward march of inflation? Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Home builders, or why we feel very stupid now

In January, we wrote about ours choices for the FT 2023 stock picker contest. One of them was a short position in PulteGroup, a home builder. We have written:

[Pulte’s] The stock fell along with its peers as Fed tightening drove up mortgage rates. But since September the group has returned to roar. Pulte is back near its all-time highs and, with demand still high and input costs normalizing, his margins are wider than ever. We asked Rick Palacios of John Burns Real Estate Consulting what drove the homebuilder rally. He attributes it to low valuations (Pulte has six times the appetizing forward earnings), lower costs, expectations of cooling inflation, hopes of lower mortgage rates and good balance sheets. We believe rates will fall more slowly than the market expects, even as demand declines, margins need to normalize, and home prices have more room to fall. That low p/e ratio can prove deceptive as the “e” decreases.

So how’s the bet going? Is going abysmalthanks for asking:

Not only have we managed to pick a short sector that is vastly outperforming the S&P; we were able to pick the one stock that is vastly outperforming that sector.

Of course we were dead wrong, but what about, exactly? We were betting on a margin-crushing recession that didn’t come; Mortgage rates are also down slightly from their highs, which has helped homebuilders. But what we really misunderstood was how the very rapid rise in mortgage rates would affect the industry, and especially the relationship between new and existing home markets.

Homeowners — including, ironically, the homeowner who is writing this — have responded to soaring rates by vowing they will never, ever give up their current homes, which are linked to low-rate mortgages that now they look incredibly tempting. The result is that there are historically few existing homes for sale. So even though new home inventory is up, total home inventory is down, and new home prices and demand have stayed there.

Here, from Citigroup’s Anthony Pettinari, is a chart of new homes for sale:

This puts home builders in an excellent position against their main competitor: existing homes. As John Burns’ Palacios told me yesterday, “it’s like a match is being played and a team has decided not to come.” Here’s his graph explaining why homebuilders are, inevitably, gaining ground:

Public home builders are also taking stakes from small private developers, as Citi’s Pettinari points out:

The tightness of the pandemic-related supply chain has led to extended cycle times and large public builders have more resources (procurement size, access to contractor pools) to manage these challenges than their smaller peers and private builders. As a result, the top three public builders. . . have seen their share of new home sales rise sharply after the pandemic (to 30% of new home sales, versus 25% pre-pandemic and 14% post-pandemic) [great financial crisis]). Furthermore, the consequences of the collapse of the SVB and the continued pressure on regional banks could restrict access to capital for small developers

This trend may still have a long way to go, as private developers control three-quarters of the market.

The large public developers have another key advantage: they have internal mortgage units, which can offer buyers a discounted rate. Offering a below-market mortgage has an economic cost, but it has two advantages over cutting the price of the home: more buyers can qualify for a cheaper mortgage, and by avoiding cutting the home’s principal price, you don’t give the next buyer. This is the competitive “bazooka” of public developers, says Palacios. This is especially true because adjustable rate mortgages, historically a key selling tool to rate-sensitive buyers, are less widely available today.

Why did Pulte, in particular, do so well? UBS’s John Lovallo told me that sentiment had been against the stock last year because its industry-leading margins and relatively high prices made it particularly vulnerable to a downturn. But margins held up and the stock rebounded strongly. He also noted that the stock still looks cheap at eight times earnings.

Is there any hope that our miserably bombed short call Pulte can return before the end of the year? Our best hope is that homebuilder stocks are pricing in Federal Reserve rate cuts for the foreseeable future, and they won’t. And, of course, a full-blown recession would be detrimental to home sales. Michael Hartnett’s strategy team at Bank of America has singled out homebuilders as one of the sectors pricing in a “Goldilocks” economic scenario that is unlikely to happen. We tend to agree, but there’s a lot of ground to make up.

Default USD and USA

If the debt ceiling negotiations collapse and the US falls into technical default, will the dollar strengthen or weaken?

One or the other result can be argued; the markets are not pricing much yet. On the strength side, investors tend to flee into dollar assets in times of stress, even (perhaps especially) when the stress comes from the US. On the other hand, the fact that the United States defaults on its debts and erodes the prestige of the dollar is surely the exception.

The last time the US played with default, in 2011, offers some reason to expect strength. Technical default was never achieved, but jitters near “date X” (when the US runs out of liquidity) generated a small dollar rally, especially against emerging market currencies, while pushing higher financing costs in dollars. The Bank of America chart below shows the dollar’s performance against emerging market (light blue) and martial market (dark blue) currencies around date X of 2011:

There is another factor to consider. Global investors and corporations have huge dollar-denominated liabilities, and therefore have no choice but to buy dollars in the event of default. As Corpoy’s Karl Schamotta told us:

This is really the key to the dedollarization debate: the debt side of the equation is more important than the investment side.

The fact that the global economy typically runs a giant carry trade using the dollar as its funding currency means that in events like this. . . people will sell other currencies and buy the dollar. They’re going to melt those [dollar] borrow assets, hedge their exposures and try to protect themselves.

What would you expect to see [in a technical default] is the rise of the dollar

By “giant carry trade,” Schamotta means that market participants tend to borrow in dollars to invest in other currencies. When the US financial system is shaking and access to short-term dollar loans starts to seem uncertain, hoarding all the dollars you can find is rational so you don’t default on your debts.

Adarsh ​​Sinha, an analyst at Bank of America FX, disagrees. In a note yesterday, he argues that high interest rates make this period different from 2011. He explains:

High yields in the US mean that the USD is less likely to be used as a funding currency for carry trades; as a result, higher market volatility (leading to carry trade unwinds) should be less supportive for the USD. Furthermore, the Fed’s peak policy means that the risk balance shifts towards lower US rates; US-specific macro risks may lead to pricing in Fed rate cuts offsetting the impact of USD risk aversion. . .

For FX, the implications for the USD are unclear. Gridlock, possibility of technical default and prices of Fed rate cuts should be negative, but risk aversion could dominate these factors

Steve Englander, head of G10 FX at Standard Chartered, dismissed Sinha’s view, saying it “falls into the category of ‘maybe, but probably not the main story line.'” The main line, thinks Englander, is not so much about yield-seeking carry trades as about the fact that “so many balance sheets, so many financial transactions have an unfortunate dollar leg that can be compromised.” Like Schamotta, he expects a technical default to cause the dollar to jump.

Columbia Threadneedle’s Ed Al-Hussainy, a friend of Unhedged, warns: “No asset class has lost investors more money on any significant investment horizon than speculating on the value of the US dollar.” He points out that forecasting dollar movements in calm times, even with common structures like the dollar smileAlready borders on the impossible. The debt ceiling and the dollar are good intellectual exercise and bad trade. (Ethan Wu)

A good read

Aswat Damodaran love Citi stock.