Many consider the outlook for housing in 2014 to be bleak, but the team at BofA Merrill Lynch say it’s not time to write it off.
That was the core message from the BAML analysts in their presentation Tuesday to clients and press entitled “Housing Recovery or Not?”
Michelle Meyer, chief U.S. economist, said that growth will be slow, but there will be growth.
“We do think the recovery will continue. We are not calling for a pause or decline,” Meyer said. “This market is not normal. We have to be patient when talk about this recovery.”
Chris Flanagan, MBS/ABS strategist for BAML, said mortgage activity is going to underperform in 2014.
“We were expecting $1 trillion in gross issuance for year (at the start of 2014.) We’re at about $200 billion now,” Flanagan said. “So we’re on track for $750 billion for year, which is less than expected.”
He said credit remains a headwind for buyers.
“We came into this year knowing credit would be tight,” Flanagan said. “We hear anecdotal evidence that credit is loosening, but (when you consider mitigating factors to the anecdotal evidence) the end result is credit is still very, very tight.”
Flanagan said that while the FHA has lowered its threshold for FICO scores by 15 points, it hasn't translated into increased mortgage originations.
"Credit will be loosened, but gradually, in a slow, multiyear process," he said.
Rising rates, in part the result of the tapering of the Federal Reserve’s quantitative easing, are also a problem for housing.
“Mortgage production will be challenged by a rising mortgage rate environment from here on,” Flanagan said.
Flanagan noted that in the current earnings season, the big banks have suffered from a massive drop off in mortgage activity.
Bank of America (BAC) reported that its first quarter mortgage originations fell 65% year-on-year in its earnings report. Wells Fargo (WFC) reported record net income of $5.9 billion, up 14%, or $1.05 per diluted common share, for first quarter 2014, where as JPMorgan Chase (JPM) recorded a first quarter 2014 net income of $5.3 billion, a drop from $6.5 billion in the first quarter of 2013.
Mortgage originations are at their lowest level in 14 years and everyone is expecting that will only get worse as mortgage rates creep up.
Meyer said that early housing indicators show that the recovery is slowing but that there is evidence growth will continue. Inventories remain stubbornly low. She said that affordability will be stretched, but that household formation will pick up.
Flanagan also noted that home prices have been declining year-over-year in all segments except the high-end home market.
From the investment perspective, the analysts say that increasing investor focus on builder differentiation.
The advise to focus on builders that can succeed in today’s market – those oriented to move-up/luxury homes, those with long land positions and prudent land purchasers.?
Builders with long land positions are generally better suited for today’s environment, they say. “Land light” builders will be potentially confronted by margin compression.
They suggest that investors look for builders with the ability to drive margin growth, especially given more modest home price increases.
However, they say, investors should be mindful of government policy.?Recently lowered FHA loan limits could further pressure first-time buyers.
The BAML survey of builders found they cited weather as the primary driver for the weaker sales pace in January and February, and they were constructive that demand would accelerate once weather normalized.
Among builders, 35% of respondents believe the sales pace is consistent versus a month ago; 51% of respondents believe the sales pace is better versus three months ago, and 48% of respondents stated that there has been a decline in the amount of time it takes to sell a home, indicating that demand for existing homes remains strong.
Based on their overall forecast, the analysts suggest investors look at Toll Brothers (TOL) as a company to watch. The custom builder is well positioned.
BAML also suggests Standard Pacific Corp. (SPF) given the company's exposure to the California housing market, long land base, advantageous land purchases during the downturn, and BAML’s expectation of increasing returns on equity.