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May’s industrial production rebound helps homebuilders like Lennar

Brent Nyitray, CFA, MBA

Key investor takeaways from May's industrial releases (Part 5 of 5)

(Continued from Part 4)

Industrial production is an important indicator of economic activity

Industrial production is a good top-down macroeconomic indicator and it helps forecast the labor market, final demand, consumption, and inflation. While manufacturing is no longer the primary driver of the U.S. economy, it still influences the economy to a large degree—particularly for unskilled workers. U.S. manufacturing has been undergoing a bit of a renaissance lately due to cheap energy prices. While there’s still a difference between wages overseas and wages here, low natural gas prices are offsetting that difference. Also, as wages rise overseas, the cheap labor arbitrage (taking advantage of lower wages) is fading away.

Increases in industrial production generally signal increases in employment. Lower-skilled workers have struggled since the financial crisis, which has dampened aggregate demand and consumption. Things are finally starting to improve as construction jobs rebound and more companies start to move toward onshore production.

Strength follows the Q1 weather-related slowdown.

Industrial production rose 0.6% in May, and April was revised upward to -0.1%. Utility output fell, while mining and natural resource production increased.

Implications for homebuilders

Homebuilders are highly sensitive to the economy. Any sort of slowdown can leave them with excess inventory, and if home prices don’t rise, then builders are stuck with depreciating inventory that costs them to maintain and finance. They will look at the production numbers and conclude that the economy is still expanding moderately. If anything, increasing production portends an increase in hiring, which is definitely bullish (positive) for the economy.

Recovery in the homebuilding market will be driven primarily by first-time homebuyers. They’re still struggling to find jobs, and until we see employment growth go back to normalcy, it may be difficult to see the 1.5 million housing starts that are typical of an expansion. The market recently broke 1 million, which historically has been a very depressed level.

Homebuilders have noted that the increases in interest rates and home prices have begun to hit demand, particularly at the lower price points. This is the first-time homebuyer market. Although the cost of renting is way higher than the cost of owning, the first-time homebuyer is still not comfortable enough with the labor market to purchase a home. Increases in manufacturing employment will go a long way toward settling this problem. Specific homebuilder stocks that will be positively affected by changes in consumer sentiment include D.R. Horton (DHI), Lennar (LEN), PulteGroup (PHM), and Toll Brothers (TOL). An alternate way to invest in the sector would be via the S&P SPDR Homebuilder ETF (XHB).

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