As expected, the Federal Reserve hiked funds rate for the second time this year by a quarter percentage point to a range of 1.75% to 2%. Moreover, chances of two more rate hikes this year are high. The rate hike was imminent given the solid economic scenario backed by low unemployment and solid wage growth along with a rise in prices.

The unemployment rate fell to an 18-year low in May to 3.8% from the previous month. For the first time since 2000, the number of job openings now exceeds the number of workers to fill in the positions. Fed expects the rate of the unemployment rate to be 3.6% this year, down from 3.8% expected earlier.

A tight labor market invariably leads to an increase in wages, with total wages up 2.7% in the last 12 months. Again, more income in the hands of individuals leads to increased demand for goods and services which in turn leads to higher prices. In the 12-month period through May, the Consumer Price Index (CPI) was up 2.8%, its biggest year-on-year rise since early 2012. The core CPI measure, which excludes volatile food and fuel costs, rose 2.2% from May 2017. Fed expects inflation to rise 2.1% for this year through 2020.

Therefore, to put a check on inflation, an interest hike was quite imperative. Though an increase in interest rates increases the cost of borrowing, Fed officials are confident that the economy won’t be affected by higher borrowing costs. The committee sees economic growth of 2.8% for 2018, highlighting an increase of 0.1 percentage point from the estimates issued in March 2018.

Impact of Rising Rates on Homebuilders

With two more hikes expected this year along with three in 2019, investors in the housing space are jittery. Shares of prominent homebuilders like D.R. Horton (DHI - Free Report), Lennar Corporation (LEN - Free Report), Toll Brothers (TOL - Free Report) lost around 4% while that of PulteGroup (PHM - Free Report) fell 6.7% and KB Home (KBH - Free Report) slipped about 7%.

A hike in the benchmark Federal Funds’ target rate will probably lead to a rise in mortgage rates in the remainder of 2018 or thereafter. High mortgage rates dilute demand for new homes as mortgage loans become expensive. This lowers the purchasing power of buyers and hurts volumes, revenues and profits of homebuilders.

Will This Lower Affordability?

The rise in interest rates comes at a time when home prices are increasing owing to supply constraints and increased raw materials costs. Builders are spooked by higher aluminum and steel costs, thanks to the newly-imposed tariffs. This coupled with increased lumber prices owing to an import tariff is denting builders’ margins, prompting them to bump up prices. Further, troubles like labor shortage and limited land availability continue to make things difficult.

Additionally, the rise in mortgage rates may impact affordability at a time when millennials are taking baby steps into the housing market. Higher interest rates will only flare up such issues but will also delay home purchases by millennials.

Total mortgage applications fell 1.5% in the week ending Jun 8 as is evident from the latest Mortgage Bankers Association report. Purchase applications for new loans fell 2% from the previous week, while refinance applications plunged 2%.

Are Housing Stocks a Safe Shelter Now?

Though myriad problems have been decelerating the homebuilding industry of late, as is evident from the 17.2% year-to-date decline against a 3.9% rise of the S&P 500 Composite, the larger picture is convincingly strong.

Consumer demand is robust as is evident from the new home sales data that point to an 11.6% increase year over year in April despite the month-to-month irregularity. Housing starts were up 10.5% from April 2017 buoyed by a 7.2% increase in single-family homes and a 19.1% rise in apartments. Again, permits were 7.7% above the April 2017 level prompted by a 7.9% rise in single-family homes and 6.4% growth in buildings with five units or more. Also, builder confidence remained above 50 in the first five months of 2018, indicative of a favorable outlook.

The solid momentum is expected to continue in the rest of 2018, courtesy of an improving economy, modest wage growth, low unemployment levels and positive consumer confidence.

Picking the Right Stocks

Investors can consider four homebuilding stocks that are currently trading at a discount and have ample room to run. We have shortlisted homebuilding stocks with a favorable Value Style Score of A or B. Our Value Style Score separates the wheat from the chaff by using multiple criteria to truly find the most attractive value stocks.

The stocks also have a solid Zacks Rank #1 (Strong Buy) or 2 (Buy). Back-tested results have shown that stocks with a favorable Style Score of A or B coupled with a bullish Zacks Rank are the best investment options.

Beazer Homes USA, Inc. (BZH - Free Report), a Zacks Rank #2 stock, has a Value and Growth Score of A. Earnings estimates for the 2018 and 2019 have moved north by 9.3% and 5.6%, respectively, over the past 60 days. 

Century Communities Inc. (CCS - Free Report) saw solid earnings estimate revision of 9.9% over the past two months with an expected earnings growth rate of 47%. The stock has a Zacks Rank #1 (Strong Buy) and a Value Score of B.

M.D.C. Holdings, Inc. (MDC - Free Report) carries a Zacks Rank #1 and a Value Score of A. The stock has seen the Zacks Consensus Estimate for current-year earnings being revised 15.1% upward for 2018 and 11% for 2019 over the last 60 days. The Zacks Consensus Estimate projects EPS growth of 33.3% for the current year.

Meritage Homes Corporation (MTH - Free Report), a Zacks Rank #2 stock, has a Value Score of A. Earnings estimates for 2018 and 2019 have moved 3.1% and 5.6% north, respectively, over the past 60 days. The Zacks Consensus Estimate calls for EPS growth of 42.5% for the current year.