The Euro & U.S. Housing Market
August 27, 2022
Time to buy the Euro?
The EUR/USD has fallen below parity on Monday, weakening 19% since last Summer. The Euro’s unrelenting decline over the past year has made it an attractive buy from a valuation perspective.
If we look at the long-term relative valuation chart as measured by Purchasing Power Parity model, the U.S. dollar is more overvalued than it was in 2000 and about as overvalued as it was at its peak in 1985. The Purchasing Power Parity model would suggest that investors could reap a 6% annualized return over the coming years if the EUR/USD reverts to its fair value.
Although, there are still short-term risks for the Euro. European energy prices are rising, highlighting the uncertainty surrounding securing energy supplies heading into the winter months. Higher energy prices are ultimately negative for Eurozone growth and detrimental to the inflation outlook. This would all argue for an even weaker Euro. However, we believe U.S. inflation pressures are easing. If U.S. inflation has peaked, then the market will price a less aggressive path for Fed interest rates, lessening support for the dollar. At the same time, other G10 central banks are still seeing accelerating inflation, which will keep them on a tightening path.
Short-term currency movements are always impossible to predict, but the valuation difference points to significant upside potential in the Euro in the longer term.
For that reason, we are actively adding currency hedges to our portfolio strategies for our Euro or Pound Sterling based portfolios this week.
U.S. housing market cooling underway
The housing market is slowing faster than expected, with the July data coming in below consensus expectations. New home sales dropped 12.6% month-month to 511k in July; marking the lowest level since Jan 2016. Moreover, total existing home sales declined 5.9% to a 4.81 million rate in July, down from 5.11 million in June. Lower turnover for existing home sales suggests that existing owners choose not to move and give up their low-rate mortgage (around 3%) to take on a new mortgage (above 5%). Meanwhile, the median home sales price has yet to cool down, picking up to $439k compared to $415k in June. Higher prices are likely exacerbating the Fed-induced slowdown in housing activity, but the appreciation pace (+8.2%, Y-Y) took a big step down from figures around 20% Y-Y reported a few months ago.
Stricter lending standards and strong demographic demand from millennials suggest a moderate drop in housing prices going forward. We expect the slowdown in housing to be absorbed less in pricing but more in real activity. We note that inventory of new homes for sale stands at nearly 11 months (highest level since 2008) vs. 3.3 months’ supply for existing homes for sale. Between home buyers being discouraged or priced out by higher mortgage rates and builders slowing their construction activity in response to higher rates, new home sales are doubly impacted by the rise in mortgage rates, which have roughly doubled from 3% to 6% over the last year on the back of Fed tightening. We thus remain cautious on homebuilders as new home prices are still at risk; particularly as existing home sale inventory gradually rises.
With shelter costs accounting for 1/3 of CPI inflation, housing is an important sector for the transmission of monetary tightening into the real economy. For the Federal Reserve, home prices are the more significant variable to track as opposed to the pace of sales as they look to quell shelter prices (rent & owner’s equivalent rent – OER) to curb inflation (CPI). Some market rent measures have shown signs of cooling in year-over-year rent growth recently, but CPI and PCE rent inflation data lag these rent growth measures by about one year. As such, according to the Dallas Fed, year-over-year OER inflation is expected to continue rising from 5.4 percent in June 2022 to 7.7 percent in May 2023 before easing. Likewise, rent inflation is expected to increase from 5.8 percent in June 2022 to 8.4 percent in May 2023. If the Fed over-focusses on these lagging indicators, the risk of a hawkish policy error may increase.
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