By Robert A. Kleinhenz, Ph.D.; Sara Chaloen; and Oscar Wei

Expectations for the nation's economic health and California's real estate market

As we hit the midpoint of the year, 2003 appears to be a continuation of 2002, with continued strong home sales against a backdrop of a struggling economy. Mixed economic signals prevailed through the first half of the year as consumers and businesses alike expressed concerns about the situation in Iraq and the prospects for economic recovery in 2003. By March, consumer confidence plunged to the lowest level in over a decade. Nevertheless, low interest rates kept the housing market active, although home prices rose at a slower rate than in 2002. Below we take a look at the prospects for the balance of the year.

The Big Picture

Fueled in part by an increase in defense-related government spending, the nation’s gross domestic product (GDP) rose 2 percent in the first half of the year. Consumers kept up their spending habits, although at a lower pace than in 2002. Business investment spending, which registered its first increase in several quarters at the tail end of 2002, continued to expand at a slow but steady pace. Meanwhile, the national unemployment rate remained stuck in the high 5-percent range since the start of the year; and while inflation rose slightly, it has remained below 3 percent. The nation’s housing market continued to serve as a mainstay of the economy with near-record levels of sales and consistent increases in the median price, all driven by the lowest interest rates in more than a generation. And with the war in Iraq concluding and the situation in the Middle East becoming clearer, consumers and businesses should be poised to increase their expenditures through the rest of the year.

Against the backdrop painted by these factors, the economic and housing market outlooks for the balance of the year depend upon two issues: a growth in business-investment spending and low interest rates. To experience economic growth in the 3-percent range, business-investment spending will have to increase at much higher rates than we have seen in recent months. Corporate profits are sufficiently sound for such an increase to take place, but businesses will hesitate to invest and grow while concerns about security, both in the U.S. and abroad, remain. Moreover, a reduction in the unemployment rate will come about only when there's a significant increase in economic activity. There is sufficient excess capacity in the economy to keep inflation even as the economy expands in the coming months.

To keep the housing market on track for the rest of the year, interest rates must remain low. With excess capacity in both the labor and capital markets and growth at or near the 3-percent level, inflation should remain in check and long term rates should inch up but remain favorable throughout the year.

Despite rising home prices and falling affordability levels, historically low mortgage rates have continued to affect the housing market for the past 18 months. This March, the Federal Reserve decided to leave the federal funds rate unchanged at the 41-year low of 1.25 percent. With the current slow economic conditions, the Fed's decision to keep interest rates steady was spurred by expectations that inflation will stay in check for now.

But the federal funds rate doesn't directly affect long-term interest rates such as mortgage rates. Historically, yields on mortgage rates move in line with yields on long maturity U.S. government bonds such as the 10-year Treasury note. As yields on the 10-year Treasury note reached a 40-year low of 2.48 percent in March, yields on 30-year fixed-rate mortgages also attained their lowest level since 1965, dropping to 5.67 percent in February, according to Freddie Mac.

Changes in expectations are the biggest influence on long-term interest rates. Although changes in short-term interest rates don't affect long-term rates directly, they are tied to expected inflation. Specifically, if inflation is expected to increase in the near future, we may see long-term interest rates head upward.

The fundamental concerns of investors in the long-term market have to do with the profitability of those bonds. If inflation is higher than the yield for a long-term bond, investors tend to shy away from putting money into such an investment. Thus when the economy is slow, inflation is unlikely to rise rapidly, allowing for the low long-term interest rate environment we have been experiencing lately.

Of course, a change in the economy or expectations of where the economy and inflation rates are going will definitely cause long-term rates to change course. The Bush administration's plan to cut taxes and boost spending may result in the issuance of more long-term debt. As the supply of Treasury bonds increases to fund the deficit, the price of these bonds will drop and cause their yields to rise. And according to historical trends, mortgage rates most likely will follow suit. A faster-paced economy, coupled with an increase in defense spending in the coming months, may cause slight upward pressure on long-term interest rates, including mortgage rates.

As the nation sees economic activity accelerate in the coming months, the state economy also will get back on track, and jobs growth will resume while the unemployment rate wilt decline gradually and drift down toward the 6-percent level. Provided interest rates remain favorable, the California housing market will turn in another impressive year with an anticipated 540,000 sales of detached single-family homes. While sales will show a 7 percent decline compared to 2002 levels, it should be remembered that last year was the best year on record. The state median home price is expected to climb nearly 10 percent in 2003 to $345,900. Without a doubt, affordability across the state will be adversely affected by the combined effect of price increases and interest rate hikes. Inventory levels will ease somewhat compared to last year, but will continue to remain very low by historical standards. In short, 2003 is very much poised to serve as a sequel to 2002.

Closer to Home

Within California, the housing market for the Bay Area has been slumping in recent months, with home sales dropping more than 20 percent from last year's levels. Part of the reason for the slowdown is sluggish employment in the region. Overall, the region has lost jobs since mid-2001. In addition, population growth continues to slow and is expected to slow over the next five years as people start moving out of the high-priced housing areas and migrate to more affordable regions.

The median home price in the Bay Area peaked in June 2002, but has since fallen by an average of 1.3 percent for the past eight months. Both the sales pace and the median home price are likely to rebound somewhat through the peak season, but neither is likely to see much of a year-over-year increase.

Over the long run, the picture looks brighter: As home prices make it more expensive to do business in the Bay Area, the ability to attract jobs will increase as home prices start coming down. In fact, declines in employment appeared to have bottomed out at the beginning of 2002. In recent months, the labor market seemed to show signs of improvement and the bleeding appeared to be coming to a stop. Indications of revival already have begun to appear in Oakland and Napa. Once the labor market is back on track, stabilization in the housing market will follow.

Comparatively, home sales in Southern California peaked in May 2002 and have been decreasing gradually since then. Ongoing geopolitical tension and the existing uncertainty about terrorist attacks have negatively affected the region's tourism industry and the retail business, and the economy has been weakened. Nevertheless, Southern California has shown some slight growth in non-farm employment in recent months. Although the rest of the region has had tenuous jobs growth in the past six months, Riverside and San Bernardino experienced some healthy rates of employment growth that helped to propel the region forward.

The median home price has increased significantly throughout the last 18 months, but the recent pace has slowed somewhat. Even though median home prices still are expected to show double-digit percent increases over last year's prices, the rate of increase will be below that of last year.

In the Central Valley, home-sales growth has shown a stronger performance than that of the state since November 2002. The region's population growth is a major contributing factor to the area's healthy housing market, with the population increase in many parts of the region being a direct result of the migration of residents from urban regions of the state in search of more affordable housing and a lower cost of living. Many of the large cites in the region are expected to grow rapidly in the coming years.

Healthy jobs growth is another determining factor for an expansion of the Central Valley's housing market. The sluggishness of the IT sector and the volatility of the stock market have had less of an impact on the regional economy than on other parts of the state, so jobs across the Central Valley continued to increase even while other regions saw no jobs growth or even job losses. The region's non-farm employment is currently growing at a faster pace than the rest of the state. At the same time, the recent population growth exerts pressure to expand housing development and commercial centers, thus creating more job opportunities.

As housing demand remained strong in the region, home prices in the Central Valley have been appreciating at a much faster rate than the state since August 2002. Nevertheless, the median home price is still among the lowest in the state since August 2002. Nevertheless the median home price is still among the lowest in the state at $213,550 as of April. And the affordability index for the Central Valley may not match that of the U.S., it is 10 points above the state's figure. With rapid population gain, healthy employment growth, and a median price lower than the state average, home sales in the Central Valley will continue to grow in the near future. Home prices, as a result of higher demand for housing, will increase as well.

Robert A. Kleinhenz, Ph.D., is CAR's senior economist; Sara Chaloen is a research analyst for CAR.; Oscar Wei is senior research analyst for C.A.R