Tuesday, August 21, 2007

How much more will construction fall?

So far, the only direct, significant impact of the housing downturn on the economy has been the drop in residential investment. It's certainly been a nasty fall. After representing 6.3% of GDP in the 4th quarter of 2005 (a level not seen since 1951), it stood at 4.9% of GDP in the second quarter of this year. In real terms, it has fallen 18.6% during this period.

This drop subtracted 0.3% from total GDP growth in 2006, with an additional 0.9% and 0.5% over the last two quarters. So is the bottom in sight?

Yes, according to the median forecast in the Federal Reserve's Survey of Professional Forecasters. The forecasters expect an additional 4% drop in residential investment between the second quarter and the first quarter of 2008, after which it'll start a slow recovery. That roughly implies that it'll represent, at the bottom, around 4% of GDP.

This seems a bit optimistic given recent events and historical precedent. In previous housing downturns, residential investment has bottomed at around 3.3% of GDP. In addition, housing starts are still around 1.4 million and traditionally they fall to below one million during rough times (actually, the median forecast sees this level as the bottom and sees a slow rise in 2008).

Needless to say, forecasters seem unduly optimistic on residential investment. Although they've already cut the GDP forecast for this year from 2.6% late last year to 2% currently, negative surprises seem to be, unfortunately, quite likely. (And this is not even taking into account the possible impact on consumers).