Why homebuilders have rallied

Good morning. We get April’s consumer price index report today. As ever, the reaction will be as interesting as the data itself. We hear a lot more chatter about recession than inflation these days. If the report comes in a little hot, will that change, or will the market shrug it off as a temporary aberration from inflation’s inevitable march downwards? Email us: [email protected] and [email protected].

Homebuilders, or, why we feel very dumb now

Back in January, we wrote about our picks for the 2023 FT stock picking contest. One of them was a short position on PulteGroup, a homebuilder. We wrote:

[Pulte’s] stock fell along with its peers as Fed tightening drove mortgage rates up. But since September, the group has come roaring back. Pulte is back near its all-time peaks, and with demand still high and input costs normalising, its margins are as wide as they have ever been. We asked Rick Palacios of John Burns Real Estate Consulting what has driven the homebuilder rally. He puts it down to low valuations (Pulte is at a mouth-watering six times forward earnings), lower costs, expectations of cooling inflation, hopes for lower mortgage rates and good balance sheets. We think that rates are going to fall slower than the market expects, even as demand declines, that margins must normalise, and that home prices have more room to fall. That low p/e ratio may prove deceptive as the “e” declines.

So, how’s that bet going? It’s going abysmally, thanks for asking:

Not only have we managed to pick an industry to short that is wildly outperforming the S&P; we’ve managed to pick the one stock that is wildly outperforming that industry.

Obviously we were wildly wrong, but what about, exactly? We were betting on a margin-crushing recession that has not arrived; mortgage rates have fallen a bit from their peaks, too, which has helped the homebuilders. But what we really misunderstood was how the very fast increase in mortgage rates would affect the industry, and in particular the relationship between the markets for new and existing homes.

Homeowners — including, ironically, the homeowner who is writing this — have responded to the spike in rates by swearing they will never, ever give up their current homes, which are attached to low-rate mortgages that now look unbelievably attractive. The result is that there are historically few existing homes for sale. So even though inventory of new homes is high, total home inventory is low, and new home prices and demand have hung in there.

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

This puts homebuilders in an excellent position relative to their key competitor — existing homes. As Palacios, of John Burns, put it to me yesterday, “It’s as if there is a game being played and one team decided not to come.” Here is his chart explaining why homebuilders are, inevitably, taking share:

The public homebuilders are also taking share from smaller, privately held builders, as Citi’s Pettinari points out:

Pandemic-related supply chain tightness has led to extended cycle times, and large public builders have more resources (procurement scale, access to contractor pools) to manage through these challenges relative to smaller peers and private builders. As a result, the top three public builders . . . have seen their share of new home sales rise sharply post-pandemic (to 30 per cent of new home sales, vs 25 per cent pre-pandemic and 14 per cent post [great financial crisis]). Further, the aftermath of SVB’s collapse and persistent pressure on regional banks may tighten smaller builders’ access to capital

This trend could have a long way to run, given that private builders control three-quarters of the market.

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

Why has Pulte, in particular, done so well? John Lovallo of UBS argued to me that sentiment had been against the stock last year because its industry-leading margins and relatively upmarket pricing made it particularly vulnerable to a downturn. But margins have held, and the stock has bounced hard. He also noted that the stock still looks cheap at eight times earnings.

Is there any hope that our miserably bombed-out Pulte short call could make a comeback before year-end? Our best hope is that the homebuilder stocks are now pricing in Federal Reserve rate cuts in the near future, and that does not happen. And, of course, an outright recession would be bad for home sales. Michael Hartnett’s strategy team at Bank of America has been singling out homebuilders as one of the sectors pricing in a “goldilocks” soft-landing economic scenario that is unlikely to happen. We tend to agree, but there is an awful lot of ground to make up.

USD and US default

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

One can make the case for either outcome; markets aren’t pricing in much yet. On strength’s side, investors tend to flee towards dollar assets in times of stress, even (perhaps especially) when the stress comes from US. On the other hand, the US falling through on its debts, and denting the dollar’s prestige, is surely the exception.

The last time the US toyed with default, in 2011, offers some reason to expect strength. Technical default was never reached, but jitters near the “X-date” (when the US exhausts its cash) did generate a small dollar rally, mostly against EM currencies, while pushing up dollar funding costs. The Bank of America chart below shows dollar performance against EM currencies (light blue) and DM currencies (dark blue) around the 2011 X-date:

There is another factor to consider. Global investors and companies have huge dollar-denominated liabilities, and so have little choice but to buy dollars into a default. As Karl Schamotta of Corpay told us:

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

The fact that the global economy is typically running a giant carry trade using the dollar as a funding currency means that in events like this . . . people are going to sell other currencies and buy the dollar. They’re going to unwind those [dollar] borrowing possessions, cover their exposures and attempt to hedge themselves.

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

By “giant carry trade”, Schamotta means that market participants tend to borrow in dollars to invest in other currencies. When the US financial system trembles, and access to short-term dollar loans starts looking unsure, nabbing any dollars you can find is rational, so that you won’t default on your own debts.

Adarsh Sinha, Bank of America FX analyst, disagrees. In a note yesterday, he argues high interest rates make this time different than 2011. He explains:

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

For FX, the implications for the USD are not clear. Gridlock, possibility of technical default and pricing of Fed rate cuts should be negative but risk-off sentiment may dominate these factors

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

Columbia Threadneedle’s Ed Al-Hussainy, friend of Unhedged, offers a warning: “No asset class has lost investors more money over every meaningful investment horizon than speculating on the value on the US dollar”. He points out that forecasting dollar movements in calm times, including with commonplace frameworks like the dollar smile, already borders on impossible. The debt ceiling and the dollar make for a good intellectual exercise and a bad trade. (Ethan Wu)

One good read

Aswath Damodaran likes Citi stock.