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UK Housing: waiting for the fall

The new year seems to give rise to new economic forecasts, as people try to guess what the next few months will hold. Now we are into February, the game seems to be correcting previous forecasts, and so it has been going with UK house prices. This hardy perennial of boring dinner parties seems to be a particular focus right now, and yet it is clear that all is not well. The latest forecasts seem to show that the British economy will recover and that house prices will recover even more quickly. Except that House prices have not actually fallen too much in the first place. The latest (revised) forecast from CEBR is that house prices will rise a further 6% over the course of 2010. If so, then that is a potentially very dangerous number.

An average salary in the UK is, depending on how you measure it, just under £30,000 a year before taxes. The average property price is roughly £130,000. This represents an earnings: house price ratio of roughly 4.3x. This in itself is quite a high ratio historically, and even allowing for savings and previous equity, it also implies a high level of average mortgage debt. This is particularly true recently, because of the high levels of loan:value that banks were prepared to offer on mortgages over the past decade.

However, such large debts are still supportable on an average income if interest rates remain low. Over the course of 2008 and 2009, interest rates fell dramatically, with the result that the "affordability" of homes increased dramatically, that is to say the proportion of income used to fund mortgage debt fell sharply, as interest rates touched bottom. The result has been that many households have actually found themselves dramatically better off despite the severity of the crisis.

On the back of this, commentators are now predicting that the general economic recovery will indeed bring a more vigorous housing market. It could certainly be the case that there will be a short term spike in house prices, because there is clearly a low level of current supply. The reasons for this are complex, but amongst others, there is the fact that many are now locked into low fixed mortgages that they would have to re-peg upwards were they to move house, which is a strong incentive not to move at all.

Nevertheless there are several constraints on the UK housing market which I believe make the current optimism irrelevant. The first is that although the UK state debt has increased massively: from roughly £450 billion to roughly £900 billion over the course of the past two and a half years, this is dwarfed by the over £4.6 trillion of total British indebtedness. Household debt is a multiple of the government number. While it is true that there was a certain amount of de-leveraging of personal debt, with a sharp reduction of credit card debt being seen in the early part of the crisis, the c. 10% increase in house prices over 2009 has cancelled this out, and indeed the lower interest rates are now fuelling personal expenditure too: and the result is a sharp acceleration personal debt (and not co-incidentally in UK inflation too).

The British are returning to their bad old profligate ways. But why does this matter? The answer lies in revisiting the total debt number: roughly £4.6 trillion. This is a debt to GDP ratio of 466%. In the developed world, only Japan has a higher debt:GDP ratio (roughly 470%). The United States has roughly 300%, while Germany's debt: GDP is roughly 280%. The level of British debt is very high overall, and with the government deficit for 2010 now forecast to be over £120 billion- a higher percentage deficit than Greece- the UK is also increasing its level of debt at a faster rate than virtually any other developed economy.

The Bank of England has dramatically increased the money supply, through its quantitative easing programme and the government has run huge deficits, both policies designed to stimulate economic activity. Both policies have clear implications for the British currency: the Pound. The government will have to undertake a large programme of Gilt issuance- issuing new government bonds- and there is a finite level of demand for this paper. The amount of money the government needs to borrow is so large that they are going to have to offer higher interest rates in order get investors to buy Gilts. The problem is that with inflation already headed over 3%, the level of interest rates needed simply to ensure demand from investors will need to be at least 5%.

Which brings us back to the housing market. If we remember that the average Bank of England base rate- the benchmark interest rate in the British economy- since it was founded in 1694 is 5%, then the idea of talking about "affordability" when we see base rate at 0.5% and mortgage rates of only around 3-4% is very dangerous. The -incidentally unregulated- estate agency business has a clear interest in talking up prices. It has worked: housing prices have in real terms more than doubled and on some measures nearly quadrupled since 1975. The ratio between average salary and average house price is currently close to an all time high. Total indebtedness is also at an unsustainable level. All of this comes at a time when the interest rate cycle is set for a steep tightening.

On top of all of this is that, despite the fiscal stimulus, despite the dramatic fall in Sterling, from €1.40=£1.00 to €1.14=£1.00, the British economy is losing jobs. Glaxo is axing 4,000 jobs in the UK, Bosch nearly 1000 and there will be indeterminate job losses from the sale of Cadbury to Kraft. These are jobs in sectors that should have benefited from the fall of the Pound. All of these job losses come before the rise in rates that will be needed to be able to sell the amount of UK government debt that is coming onto the market over the course of 2010 and 2011. Higher rates and fewer jobs are not good for the fundamentals of the UK housing market.

So, at a fundamental level, it seems clear that there should be fall in house prices. My best guess is that about a 20% fall is justified by the fundamentals. However, the short term technical spike - lack of supply- could keep prices rising for a while. In addition Mr. Cameron now echoes Mr. Brown in saying that cuts in government expenditure will be more gentle than he had previously thought. To me that means unemployment may be lower, but that inflation will be higher. Usually that would mean interest rates rising, but the Bank of England has delayed its hike in rates.

I think that means that the policy makers are therefore relaxed about Sterling falling further. However I think it is a tightrope walk between trying to maintain economic stimulus and not letting inflation cause a meltdown in the currency and an emergency interest rate rise. I think the record of policy makers in avoiding these crises is very poor.

I therefore think there is going to need to be an emergency tightening -possibly even before the general election, particularly if the hung Parliament scenarios become common currency. The impact of a return to rates above 5% will show the current observers of the UK housing market to be living in a fools paradise. British Households did not pay down their debts while they had the chance- they inflated the housing market instead. The consequences will be dire.

So, as the punters adjust their views of the UK in the light of the January numbers. I do not: I still see a fundamental crisis in UK home ownership and a serious instability in Sterling. The effect on living standards, especially when combined with higher taxes to fund the bloated government sector is going to be bad. The only issue it seems to me is going to be the timing: and that I cannot judge just yet.


Anonymous said…
Perhaps the biggest concern at the World Economic Forum in Davos was the sense that economic power is shifting eastwards, writes Stephen King in The Independent. Davos will look very different in 25 years' time, he predicts - individual European countries will have little of importance to say and will, increasingly, be ignored.
Joe Kay said…
You reason:

An average salary in the UK is, depending on how you measure it, just under £30,000 a year before taxes. The average property price is roughly £130,000. This represents an earnings: house price ratio of roughly 4.3x. This in itself is quite a high ratio historically, and even allowing for savings and previous equity, it also implies a high level of average mortgage debt. This is particularly true recently, because of the high levels of loan:value that banks were prepared to offer on mortgages over the past decade.

In historical terms this is correct; but how many mortgages are now paid by just one wage/salary earner? Changes to the structure of household earning (i.e. women in the workforce), means that historical comparisons only tell you so much.
Cicero said…
Joe- that is kind of my point, it now takes two salaries to fund a property that could once have been funded by one. All that has happened is that the property price has increased, but living standards have actually fallen even though more of us are working.

There comes a point when- through unemployment or parenthood- two incomes are not available, and we are so much in debt that this means trouble.
Joe Kay said…

I see what you are saying, but surely the level of house-prices (as controlled by mortgages issued) is derived, in part, on the basis of household income, not individual salary income. Basic economics suggests that if there is a rise in consumer incomes, the overall volume of demand rises. Dual income is higher than single income. As supply is largely fixed, house prices were bound to rise beyond the historical trend line as more women entered the workforce.

I agree with you that this has many unfortunate social effects (I'm referring to housing - not women in the workforce!), and that - in terms of housing - living standards have in effect fallen.

However, the impact of unemployment on households is lessened. In a situation of only one wage/salary earner, unemployment would have a devastating effect on household income. Now, with more dual income households, when unemployment hits households are more likely to be resilient because they still have one income to fall back on unless they are very unfortunate. Life will be hard, and households will struggle to pay their bills, but the aggregate effect will be less damaging than in a past where households tended to have only one wage/salary earner.

While I share your desire to see some kind of rebalancing of the housing market (largely by gradually freeing up supply, I suggest), I am suggesting that the market is not massively over-valued, nor is the debt necessarily to great to bear.
Tallet said…
The house price ratio of 4.3 x average earnings may also lack historical validity because of inheritance. In the London area home ownership for ordinary people is now into its fourth generation (think of the interwar estates of £75 houses now worth £k100s)and some of this capital passes down through families to current first-time buyers. Another source of inequality in British society.
Cicero said…
Tallet: yes you are right inheritance does improve the ratios, but I think that the net effect is fairly neutral: parents have been helping their kids onto the housing ladder for some time. I am not in favour of the abolition of inheritance tax for precisely this reason.

Joe- The problem is that when the so-called housing professionals, i.e. estate agents with property to sell, talk about affordability they are only discussing it on the basis that rates do not adjust to their historic averages, still less to a higher peak. I submit that an increase in base rates to the historic average of 5% is likely to happen very soon. At the same time, I fear a double dip in GDP growth. The combination is likely to lead either to a house price capitulation or a Sterling capitulation or, I fear, both. I think the latest deficit and inflation numbers point to the bearish end of my expecations.
Cicero said…
This comment has been removed by the author.
Joe Kay said…

I agree that base rates are likely to rise in the medium term, but at the moment there is no sign of a rise. We are not at the moment of a debt crisis, and while inflation is at 3.5% this in part due to rising oil prices and the VAT hike on 1 January.

I still think you need to incorporate the structure of household income into your thinking about the supply of houses in the secondary market. As long as employment holds up, as long as there is at least one salary earner in a household, I don't see why supply will be increased to see a dramatic drop in prices. Similarly, rates would have to rise markedly to achieve the same effect (i.e. precipitate large-scale mortgage default).

If there is a double-dip and a sovereign debt crisis, then yes, house prices will likely depress further. But this is a bleak assessment, and a worst case scenario. Only if the government removes the stimulus too soon will we see the double-dip. The moment of fiscal tightening is going to be harder to judge, however.
Cicero said…
Joe- all fair points, but in fact I AM suggesting that we face the worst case scenario. Despite Sterling devaluation, export jobs are being lost, and the public sector is now the primary motor of the UK economy- funded by an unsustainable deficit. The markets have already rattled Greece, and they do not have the option of devaluation, because the UK does, then the risk premium on Gilts is going to gap up- and this could happen at any time, now that the US has started to tighten. It is an old fashioned Sterling crisis, but writ large, because the capacity and productivity of the UK are in such a terrible state. Of course you are right to say that Household vs Individual income is the key driver, but what I am saying is 1) household disposable income is going to be much weaker as the result of taxation and energy prices. 2) That unemployment will spike 3) The deficit will force a significant rise in rates. It may be that inflation means that the nominal value of house prices falls relatively little, but in real terms they will be down sharply, either because Sterling capitulates but I think that a rise in rates will force sales and prices will actually fall as well. Housing is overvalued in the UK on virtually every historic measure- unleveraged yield is a good example- except "affordability" and that number is a function of artificially depressed rates. I think that if the BoE does not tighten soon, then the market will its job for it- and I think it could involve violent market movements.
alfred said…
government need to inforce new property and housing regulations on the bamking industry.

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