By Alison Rice. The recession may have ended in March, but the economy hasn't fully escaped its grip. In October, consumer confidence fell to its lowest level since 1993. Businesses remain cautious, waiting for the right time to buy new equipment, expand their inventories, and hire new workers. Economic growth has slowed, raising concerns about stagnation.

"What's really happened here is that the economy seemed to be coming together nicely, and then the economy clearly hit a series of unforeseen shocks," says NAHB chief economist David Seiders, citing those troubles at the NAHB's fall construction forecast conference: the aftereffects of terrorism; Wall Street crises such as Enron, WorldCom, and Arthur Andersen; and the possibility of once again, war with Iraq. "Big things have happened to depress economic activity," he says. "Things are in flux, and it ain't good."

Things are also in flux for builders, who face their first economic recovery cycle without an expected post- recession surge in housing demand. Unlike past recessions, where builders have suffered from high interest rates and delayed demand, this time housing has thrived as low mortgage rates drove buyers to purchase homes at record-breaking rates. With rates expected to creep upward in 2003, builders will probably see housing starts and new-home sales taper off during the recovery, in a reversal of historical trends.

Ken Goldstein, an economist at The Conference Board in New York, explains the situation by alluding to the fictional Minnesota town created by radio storyteller Garrison Keillor, a place "where all the women are strong, all the men are good looking, and all the children are above average."

"We live in the United States, not Lake Wobegon," Goldstein says. "We can't always be above average. It's time to take a break in terms of the feverish activity in the housing market."

Stabalizing starts

Many economists agree with Goldstein. According to the October edition of the Blue Chip Economic Indicators, a consensus forecast based on 50 firms' economic projections, housing starts are projected to hit 1.61 million in 2003, a slight dip (2.4 percent) from its average forecast for 2002.

"We expect the housing market not to weaken, but to moderate," says Goldstein of The Conference Board, which forecasted one of the lower housing starts numbers. "The pace has been so far ahead of the demographics--they're not just building an apartment for the kid that's moving out of the house or a home for the first-time buyer."

The slight mismatch between pace and demographics also concerns David Wyss, chief economist for Standard & Poor's, who also predicts 1.60 million starts in 2003. "Although mortgage rates remain low, they don't go any lower," he says. "In addition, there has to be a limit on the number of households who will buy a house. We are running well above demographic norms. The result is a rising homeownership rate (68.1 percent), but how much higher can it go? [Starts of] 1.60 million are still very high compared with the demographic trend of about 1.45 million" household formations.

Photo: Alex Williamson

Builders disagree, saying that the industry is nowhere close to meeting housing demand. "In terms of demographics, you can see that the population growth in the 1990s was the greatest ever at over 32 million [people], but housing production dropped to the lowest level since the 1960s," says Ian McCarthy, CEO of Beazer Homes in Atlanta. "It is forecast that housing production needs to increase by 20 percent in this decade to meet demand. The latest forecasts for population growth in this decade, to 2010, show a 31 million to 34 million increase [in population] which we believe will sustain housing well into the next decade."

Housing has proved unpredictably resilient. Last spring, economists at Macroeconomic Advisers suggested housing would be "relatively weak" during the recovery, compared with the industry's recent strength. This fall, the firm projected 1.66 million starts for next year--an upward revision based on the Federal Reserve's November decision to slash interest rates yet again. "[Mortgage] rates have stayed lower for longer, showing more strength in the housing sector than expected," says Ken Matheny, senior economist at the St. Louis-based firm.

Those rates won't stay at 6 percent forever. Housing economists expect 30-year fixed rates to begin rising in mid-2003 as the economy stabilizes. Builders may not feel the slackening right away--"When rates start to drift up, there will be a brief flurry of activity," Matheny predicts--but they'll see the impact as higher rates slightly dampen the pace of housing starts and new-home sales. Builders shouldn't panic: "The rates will hamper the housing market relative to the strong activity in the past," Matheny says, "but it's not going to cause it to collapse."

Depending on their location and product mix, some builders doubt the expected higher rates will leave a dent in their business. "Even if there's a 200 basis point increase, it's not going to impact our buyers because people realize they are getting an incredible deal on interest rates," says Mitchell Hochberg, president and CEO of Spectrum Skanska, a Valhalla, N.Y.-based builder that expects to close 325 homes and generate $200 million in revenue in 2003. "I don't think they're buying now because it's an affordability issue [because of the low rates]. They're buying more house or more upgrades."

Lingering questions

Compared to last year, when the terrorist attacks left everyone--from experts to everyday consumers--searching for any signpost that might indicate how the economy might perform in 2002, the economic indicators for 2003 seem positively straightforward.

But many of the issues that arose last year--questions about consumer confidence, the threat of war or terrorist actions, the wariness of businesses to spend money--still remain today. "All these things are still lingering," says Scott Brown, chief economist for equity research at Raymond James & Associates in St. Petersburg, Fla. "They are still being played out." (For more on the threat of war, see "Wartime Worries".)

"Our concerns are always centered on job growth and now, terrorism. When you live here awhile, it's easy to forget just how hot this market is," says Tom McCormick, president of Astoria Homes in Las Vegas, which expects 1,200 closings and $180 million in revenue in 2003. "We had slow job growth this year, and if it continues, I'm sure we'll see activity slow. The terrorism issue is obvious, but if we should have another attack that involves air travel, I think we will be harder hit than at Sept. 11."

Business investment remains a key concern. Long expected to take the stalwart consumer's spot in supporting the economy, business has hung back, with lots of excess manufacturing capacity, negative performances in industrial production, and cuts in fixed investment. Why does that matter to builders? "You should care about capital spending right now, because it's the most important part of the economy," Michael Moran, chief economist of Daiwa Securities America in New York, told attendees at the NAHB conference in October. "It's not going to feel like a better economy until business investment performance improves."

That may have finally begun. "Businesses are showing signs of life," says Matheny, pointing to third-quarter numbers that revealed a sharp uptick in business purchases of high-tech equipment. So are corporate profits, which may finally take the pressure off the consumer. "Once we finally have some cash flow, then we'll get consumption and investment," Goldstein says. "What we've got now is consumption. When we have consumption plus investment plus inventory, we'll see sustained job growth and a real recovery."

Many economists expect those jobs to start being created in 2003's second quarter. "Job creation is already picking up," says David Berson, chief economist for Fannie Mae. "If you compare it to 1991-1992, we're doing a little better. It's still not good, but part of the reason job growth has been relatively weak is because of strong productivity."

Job-growth numbers will be worth watching for builders, who could find themselves briefly caught in an economic Catch-22. As the economy improves, interest rates will jump, but potentially before creating all the new jobs needed for would-be home buyers to purchase a house. "There will be two conflicting forces working on the housing market [in 2003]," acknowledges Matheny.

Others say the overall impact of that will be limited, as a strengthening economy and stock market cancel out the potential negative effects of incrementally rising mortgage rates. "We expect a housing market very similar to [2002]," Berson says.

Of course, for the public builders, interest rates (and the prospect of rate hikes) affects more than their sales pace; it also influences the perceived value of their companies on the stock market.

"I think most investors still think that the group has yet to be truly tested by the economy, that the test is still right around the corner," says John Stanley, a former UBS Warburg housing analyst who recently launched his own firm, Vermont-based SticksSpin Consulting, which works with public builders on valuation and investor issues. "To the extent that concern eases, then for sure the next hurdle will be the anticipation of higher rates. There are clearly concerns that demand has borrowed from the future because of low rates, so the industry will have to show that it has not suddenly become counter-cyclical when rates move up."

Contradictory consumers

But the most important question for many builders is more basic: Will customers continue to buy homes? After October's slide in consumer confidence, many experts wondered if the reliable spenders had started closing their wallets.

"There are two possibilities," Goldstein says of the fall numbers. "It could be an over-response to all the worries and concerns we were hearing about during the election, or it could be something far more serious--they've gotten scared. We could see the change in their spending on homes or cars or far more mundane things."

Or not. While debt levels are up, so are assets. And with personal incomes rising and home appreciation continuing (although that's expected to moderate as well in 2003), homeownership remains appealing even in a shaky economy. "Consumer confidence numbers can be lousy, and people still go out and buy a house," points out Robert Van Order, Freddie Mac's chief international economist. "The reason is that housing is still a good deal."

Wartime Worries

The prospect of war with Iraq looms over the economy. Despite their relative optimism, economists acknowledge there is a wild card that could torpedo their vision of a strong but moderating housing market in 2003: the ongoing dispute with Iraq and the ripple effects on oil, the economy, and the housing market.

The worst scenario: oil supply issues, dramatic price jumps, and a very unfriendly economic situation for housing. "If oil prices start spiking for an extended period of time, it could push the economy back into recession," says David Berson, chief economist for Fannie Mae. "Inflation will go up. Interest rates will go up."

"The odds of this happening are low," he says, "but it is a worst-case outlook."

Other economists also doubt that oil price spikes will be a problem this time. "Oil prices have already gone up in anticipation of trouble," says Robert Van Order, Freddie Mac's chief international economist. That's a big change from 1990, when oil prices soared in response to the Middle East conflict. "When Iraq invaded Kuwait, it was a surprise," Michael Moran, chief economist of Daiwa Securities America, told attendees at the NAHB fall economic forecast in October. "No one will be surprised if the United States invades Iraq."

There could be other differences as well. "This war will be more expensive that the one 10 years ago," predicts Van Order, who says U.S. allies picked up much of the Gulf War's price tag. "This time, they're estimating [the cost of the conflict] at 1 percent of the economy. Still, that's not a huge burden, and there could be some stimulus there."