Recently I have indicated I see a lot of problems in asset markets despite the economic acceleration in Europe, Japan, and the US. For example, there is a liquidity mismatch in high yield bond and leveraged loan markets and technology shares are priced for perfection. Commercial real estate is also a problem that I want to highlight briefly since I believe it will be a locus of distress in the next global downturn.
Here’s the picture to focus on:
The UBS Housing Bubble Index shows a number of cities with house prices at significant risk of a future correction pic.twitter.com/3dzXUDfPMU
— Edward Harrison (@edwardnh)
There are eight markets at greatest risk here. But there are several other markets with overvaluation, including San Francisco and LA, which were caught up in the last US housing bubble. I mention that because negative equity is one way that the leverage in this sector creates distress and these are markets that have a significant number of households that have just escaped negative equity very recently.
Here are the statements from the UBS study that I would highlight:
- “The Index does not predict whether and when a correction will set in. A change in macroeconomic momentum, a shift in investor sentiment or a major supply increase could trigger a decline in house prices.”
- “world cities have regularly endured greater price corrections than countries. After the widespread bust period in the late 1980s, most cities did not recover until the early 2000s. For example, it took New York’s housing market 20 years to recover relative to US-wide prices. A homebuyer in London in 1988 had to wait 25 years, i.e. until 2013, for her investment to outperform the UK average.”
- “Looking back at boom-bust periods of housing markets in the last 35 years, we infer that fundamentals matter. Nine out of 10 real estate crashes of at least minus 15% were preceded by a distinct overvaluation signal based on the UBS Global Real Estate Bubble Index methodology. Real-time calculations derived from it for the period 1980 to 2010 estimated the likelihood of a crash after a bubble-risk warning signal within the subsequent 12 quarters at 50–60%. This compares to an ex-ante probability of a real estate crash of about 12% in a given quarter during that time.”
So what should we take away from this?
First, I think the so-called bubble cities are indeed at significant risk of a major price correction. Second, I believe the trigger for those corrections to become pronounced is macroeconomic ie. recession. House prices in Australia and Canada show you that a mild or no recession allows elevated prices to continue rising. Third, we should expect work-out periods to be long; and for Amsterdam, London, LA and San Francisco, this is particularly relevant given that we are seeing a second round of overvaluation. The London experience is instructive because while the market was slow to overcome the early 1990s correction, a lot of the upside was given back in the correction during the crisis. Brexit puts London at risk for another correction. And if London’s 2-correction experience is anything to go by, property owners in San Francisco, LA and Amsterdam cannot rest easy.
Let me stop there and leave you with former Fed Chair Ben Bernanke’s view:
“I am not confident that the current monetary toolbox would prove sufficient to address a sharp downturn. We should be thinking now about adjusting the framework in which monetary policy is conducted, to provide more policy ‘space’ in the future.”
Something to think about as this cycle lengthens