Brexit negotiations are likely to prove a very uncomfortable ride for UK consumers as Russell Napier of Eric, the online research platform, warned last week:
□ ”Public sector debt remains at near-historic highs (in peace time!) and for the first time this public sector debt comes with a private sector bubble
□ Credit card debt is rising at its fastest rate in a decade — 9.3% in the year to February
□ Unsecured debt as a whole is rising at more than 10% and some 6,300 new cars are bought on credit in the UK every day”
Companies and investors already face growing uncertainty as March 2019 approaches, as discussed on Monday. UK consumers now face similar challenges as their spending power is further squeezed by the pound’s fall in value since June, as the chart confirms, based on official data:
UK earnings for men and women have been falling in real terms since the financial crisis began in 2008
Male earnings are down 5% in £2016, and female earnings down 2%
Since June, unsurprisingly, cash-strapped families have had to raid their savings to fund consumption
New data shows the UK savings ratio hit an all-time low of just 5.2% last year – and was only 3.3% in Q4
One key issue is that monetary policy has reached its sell-by date, with Retail Price Inflation hitting 3.2% in February as a result of the pound’s fall. Interest rates may well have to rise to defend the currency and attract foreign buyers for government bonds. Foreigners currently fund more than a quarter of the government’s £2tn ($2.5tn) borrowing, and cannot easily be replaced.
Unfortunately, these are not the only risks facing the UK consumer. As I feared in June:
“ Many banks and financial institutions are already planning to move out of the UK to other locations within the EU, so they can continue to operate inside the Single Market
There is no reason for those which are foreign-owned to stay in the country, now the UK is leaving the EU
This will also undermine the London housing market by removing the support provided by these high-earners
In addition, thousands of Asians, Arabs, Russians and others will now start selling the homes they bought when the UK was seen as a “safe haven”
Lloyds, the global insurance insurance market, has just announced plans to move an initial 100 out of 600 jobs to Brussels, so that it can continue to serve EU clients. Frankfurt, Paris, Amsterdam, Dublin and Copenhagen are also lining up to offer attractive deals to companies wishing to maintain their EU passports to trade. And last month saw an ominous warning from JP Morgan Chase CEO, Jamie Dimon:
“The clustering of financial services in London is hugely efficient for all of Europe. Now you’re going to have a de-clustering, which creates huge duplicative cost which is expensive to clients. Nevertheless, we have no choice.”
Dimon’s warning was reinforced on Tuesday by the leader of the powerful European People’s Party in the European Parliament, who told reporters 100k financial services jobs would likely relocate from London due to Brexit:
“EU citizens decide on their own money. When the UK is leaving the EU it is not thinkable that at the end the whole euro business is managed in London. This is an external place, this is not an EU place any more. The euro business should be managed on EU soil.”
Until now, many consumers have been cushioned from the fall in real incomes by the housing bubble. But as I discussed in December, the end of such bubbles is normally quite sudden, and sharp:
Worryingly, UK house prices fell in March for the first time in 2 years
The Bank of England also reported that mortgage approvals are falling
And normally, lower mortgage volume leads to lower house prices
Certainly it would be no surprise if prices did now start their long-overdue collapse, as highly-paid financial professionals start to leave the UK. One key indicator – the vastly over-priced 9 Elms development – now has an astonishing 1100 apartments for sale. And if the housing market does collapse, then recession is inevitable.
The key problem is that consumers do not have many options when the economy moves into a downturn. New sources of income are hard to find if mortgage costs start to rise. All they can do is to cut back on spending, and boost their savings – to help them cope with any future “rainy days”. This in turn creates a vicious circle as consumption – over 60% of the economy – starts to fall.
There are therefore no easy answers when trying to plan ahead for likely storms. But being prepared for a downturn is better than suddenly finding oneself in the middle of one.
London’s housing market was always going to have a difficult 2017. As I noted 2 years ago, developers were planning 54,000 new luxury homes at prices of £1m+ ($1.25m) in central London, which would mainly start to flood onto the market this year.
They weren’t bothered by the fact that only 3900 homes were sold in this price range in 2014, or that the number of people able to afford a £1m mortgage was extremely limited:
□ The idea was that these would be sold “off-plan” to buyers in China and elsewhere
□ They had all heard that London had now become a “global city” and that it offered a safe home for their cash
□ There was also the opportunity to “flip” the apartment to a new buyer as prices moved higher, and gain a nice profit
Of course, it was all moonshine. And then Brexit happened. As I warned after the vote, this was likely to be the catalyst for the long-delayed return of London’s house prices to reality:
□ “Many banks and financial institutions are already planning to move out of the UK to other locations within the EU, so they can continue to operate inside the Single Market
□ There is no reason for those which are foreign-owned to stay in the country, now the UK is leaving the EU
□ This will also undermine the London housing market by removing the support provided by these high-earners
□ In addition, thousands of Asians, Arabs, Russians and others will now start selling the homes they bought when the UK was seen as a “safe haven””
Confirmation of these developments is now becoming evident. A new study from the Bruegel research group suggests up to 30,000 bank staff and £1.5tn of assets could now leave London, as it becomes likely that the UK will not retain the vital “passport” required to do business in the Single Market after Brexit. This would be around 10% of the estimated 363k people who work in financial services in Greater London.
They will also likely be more senior people, able to afford to buy London homes with cash from their annual bonuses, rather than the more junior people who need to rely on a mortgage based on a multiple of their income. And there is no shortage of tempting offers for these bankers, with Frankfurt, Paris, Amsterdam and Dublin all lobbying hard for their business.
Now, another threat has emerged to prices, in the shape of China’s new capital controls. China has seen its foreign exchange reserves tumble by $1tn over the past 18 months, due to its revived stimulus programme. January data showed they were now just below $3tn, perilously close to the $2.6tn level that most observers suggest is the minimum required to operate the economy. As we have reported in The pH Report:
□ China has now banned the use of the annual $50k foreign currency allowance for foreign real estate transactions
□ It has also banned State-Owned Enterprises from buying foreign real estate valued at $1bn+
The rationale is simple. The country can no longer afford to see money disappearing out of the country for purposes which have nothing to do with the real needs of business. And the impact on London’s property market (and that of other “housing bubble” cities such as New York, Singapore and Sydney) could be huge, as Chinese have been the largest buyers of new residential homes globally according to agents Knight Franks – and were responsible for 23% of commercial deals in central London last year.
Central London prices fell last year by 6%, and by 13% in the most expensive areas according to agents Savills. And now London’s Nine Elms development (pictured) at the former Battersea Power Station has just revealed a serious shortage of new buyers.
It was intending to build 3800 new homes, and originally found an enthusiastic response back in 2013 when the first 865 apartments went on sale. But 4 years later, just 1460 homes have been sold in total – and yet residents are supposed to be moving into the first phase later this month. Even worse, 116 of these original sales are now back on the market from buyers who no longer wish, or can afford, to take up residence.
Some of these buyers have already taken quite a hit on price. As property journalist Daniel Farey-Jones reports, one anxious seller originally listed his apartment for sale at £920k. Having failed to sell, he had cut the price by Friday to £699,995 – a 24% reduction.
Nine Elms is just one of many sites where developers are anxiously watching their cash flow, and hoping a flood of new buyers will rush through the doors. Sadly, they are not the only ones who may soon be panicking.
In recent years, large numbers of home buyers – many of them relatively young and inexperienced – have been persuaded to buy unaffordable homes on the basis that London prices could never fall. I fear that, as I have long warned, they are now about to find out the hard way that this was not true.
Monetary policy used to be the main focus for running the economy. If demand and inflation rose too quickly, then interest rates would be raised to cool things down. When demand and inflation slowed, interest rates would be reduced to encourage “pent-up demand” to return.
After the start of the Financial Crisis, central banks promised that lower interest rates and money-printing would have the same impact. They were sure that reducing interest rates to near-zero levels would create vast amounts of “pent-up demand”, and get the economy moving again. But as the chart shows for US GDP, they were wrong:
□ It shows the rolling 10-year average for US GDP since 1950, to highlight longer-term trends
□ It confirms the stability seen between 1983 – 2007 during the BabyBoomer-led economic SuperCycle
□ The economy suffered just 16 months of recession in 25 years, as monetary policy balanced supply and demand
□ But the trend has been steadily downwards since 2008, despite the record levels of stimulus
The clear conclusion is that monetary policy is no longer effective for managing the economy.
Encouragingly, the UK Parliament’s Treasury Committee has now launched a formal Inquiry to investigate ‘The Effectiveness and impact of post-2008 UK monetary policy‘. We have therefore taken the opportunity to submit our evidence, showing that demographics, not monetary policy, is now key to economic performance. We argue that:
It was clearly important until 2000, when the great majority of people were in the Wealth Creator 25 – 54 age group (which dominates consumption and therefore drives GDP growth). But its impact is now declining year by year as more and more BabyBoomers move into the 55+ age group – when incomes and spending begin to decline quite rapidly
Friedman’s analysis of the effectiveness of monetary policy, when he argued that “inflation is always and everywhere a monetary phenomenon”, is therefore no longer valid. Modigliani’s “Life Cycle theory of consumption” is similarly out of date
The issue is simply that both Friedman and Modigliani were working in an environment which assumed that people were born, educated, worked – and then died soon after reaching pension age. In these circumstance, their theories were perfectly valid and extremely useful for modelling the economy
Today, however, the rapid increase in life expectancy, together with the collapse of Western fertility rates below replacement level, means that a paradigm shift has taken place. People are now born, educated, work – and then continue to live for another 20 years after retirement, before dying
The essential issue is that “you can’t print babies”. Monetary policy cannot solve the demographic challenges that now face the UK (and global) economy
We therefore hope that the Committee will conclude that monetary policy should no longer be regarded as the major mechanism for sustaining UK growth
Please click here if you would like to read the evidence in detail.
“Will economists start to consider demographics when making their forecasts and developing government policies?”
This was the question on my mind at a recent discussion on the topic of “An economy that works for everyone” at the UK’s Institute for Government. The speaker was the Chief Economist of the Bank of England, Andy Haldane, and the Institute’s Director, Bronwen Maddox kindly invited me to ask my question as part of the discussion. You can watch the Q&A by clicking here. The transcript is below.
Critically, Haldane acknowledges that economists need to rethink their approach. Until now, they have focused on developing policies that impact “the average person”. Instead, he agrees that they now “need to be super-granular, household by household”, in terms of demographics and other relevant detail.
Andy Haldane is a leading central banker. His statement that “we shouldn’t have fixed views on how monetary policy works” is therefore very important. New ideas are urgently needed, and his comment opens the door for debate. As I have discussed here in earlier posts (Policymakers’ out-of-date economic models fail to create growth, again, Age range and income level key to future corporate profits), I believe there is an urgent need to develop an alternative economic model based on the ”competing populations” concept developed by the biologists.
“Andy. Thank you very much indeed for the stimulating talk. You made a comment just now about “is it something else” (that is causing the post-2008 recovery to be so slow and uncertain), and at the start you talked about the need perhaps to reinvent or rethink economics. You also made a point about the failure of conventional economics to explain this difference between the frontier companies (who are leading in their fields) and the others.
Just before Christmas the bank put out a survey of spending with relation to interest rates and monetary policy which suggested that again and I quote almost exactly “conventional economics would have said that if you pass on lower interest rates, people will spend more. “But in fact only 10% of people did. So what I wanted to ask you was,
“Is this something else” to do with really significant demographic changes in the economy – that we now have a group of BabyBoomers, the largest-ever group of people in the population, who are refusing to die at 65 as they would have done in the past. In fact they are living now for another 20 years, and we have around one in five of the population in that age group.”
My question really is therefore “do you think that investigating this demographic impact, which has never happened before in the world, could be useful”? Because I think that it might provide the key (a) to the new type of economics and also (b) to the question of how we raise UK productivity.
“Paul, your work on this is a very good example of how demographics in mainstream economics has been under-emphasized for too long.
That I think is changing by the way – that I think is changing and we are seeing for example when people tell the story that I mentioned earlier on about secular stagnation – the kind of Bob Gordon, Larry Summers-type hypothesis – one of the facts that is pointed towards would be demographic factors nudging us in that direction.
When we’re trying to make sense of why it is that interest rates globally – not ones set by central banks, ones set by financial markets – why they are so low, for as far as the eye can see, part of the explanation, I think, lies in evolving demographics and the implications that has about saving and for investment.
The study you mention, I think of households, which we conduct a regular basis to try and understand their patterns of spending and saving is, in some ways, a brief example of all we discussed today. It’s a vertical distribution. It’s saying we can’t take the average person, the so-called representative agent and hope that by studying them we can make sense of what’s going on. We need to be super-granular, household by household:
Conditioning on whether they are a borrower or a saver, whether they are young or whether they are old, whether they live in the North East or whether they live in the South West
And using that to condition our policy responses including our monetary policy responses
It could be the case we reach the point where interest rates are a bit less potent in stimulating spending than was the case in the past. We shouldn’t have fixed views or fixed multipliers about how monetary policy works.
It can change as the economy can change and by looking at this more granular data, like Michael Fish* did after 1987, we can perhaps tomorrow, or failing that the day after tomorrow, do a somewhat better job of making sense of what happens next in the economy.”
* Michael Fish was the BBC weather forecaster who famously denied on-air in October 1987 that a hurricane was about to hit the UK. Haldane had earlier noted that this failure had prompted a complete rethink of weather forecasting, which was now much better as a result. He hoped that economists’ failure to forecast the 2008 Crisis might end up causing a similar process of rethinking and reinvention to take place.
It is hard to be optimistic about the outlook for 2017.
The good news is that policymakers are finally giving up on the idea that stimulus can somehow return us to the growth levels seen when the Baby Boomers were young. As the Bank of England note in a new Report:
”Economic theory suggests that a fall in interest rates should lead to higher household spending, because lower returns on savings decrease the amount of future consumption that can be achieved by sacrificing a given amount of spending today
But as the chart shows, “when asked about how they might respond to a hypothetical further fall in mortgage payments, households reported that paying off debt and saving more were likely to be a more common response than increasing spending”
45% said they would save more, 50% said they would use money saved on mortgage payments to pay down debt and only 10% said they would increase their spending.
Unfortunately, companies and investors will now pay the costs of this failed experiment, as markets return to being based on supply and demand fundamentals, rather than central bank money-printing. Five major risks face the global economy, as my new 2017 Outlook highlights:
□ Global recession: The American Chemistry Council (ACC) index of global capacity utilisation is the best indicator that exists in terms of the outlook for the economy. As I noted last month, it has been falling since December 2015, and its latest reading is close to the all-time low seen in March 2009
□ Populist policies are gaining support: Populists provide simple answers to complex questions, and 2016 saw them gain major success with the Brexit vote for the UK to leave the EU, Donald Trump winning the US Presidency, and Italy’s referendum creating the potential for the country to vote on leaving the euro
□ Protectionism is replacing globalisation: One key result of these changes is that countries are turning inwards. The Doha and Transatlantic Trade and Investment Partnership trade deals are effectively dead, and President-elect Trump has promised to cancel the Trans-Pacific Partnership deal on coming into office
□ Interest rates are rising around the world: Investors have begun to worry about return of capital, rather than just return on capital. Benchmark 10-year interest rates have doubled in the US since the summer. They have also trebled in the UK and doubled in Italy, while negative rates in Germany and Japan have turned positive again.
□ India’s economy is under major strain as a result of the currency reforms, and China’s debt levels remain far too high for comfort. Its housing bubble in the Tier 1 cities has reached price/earnings ratios double those of the US subprime bubble. Its currency is also falling as the economy slows, creating the potential for further trade friction with the new Trump administration
Please click here if you would like to read the full Outlook, and click here to view my 6 minute interview with ICB’s deputy editor, Will Beacham. You can also click here to download a copy of all my New Year forecasts since 2008, when I was warning of a coming financial crash.
London’s house market has been slowing for some time, as I noted last year. The issue is affordability. Artificially low interest rates make the monthly payment seem cheap. But the key question is whether your salary will allow you to repay the capital borrowed over time.
Sadly, this has become increasingly impossible for many actual and potential buyers, due to the Bank of England’s increasing use of stimulus policies since 2000.
The chart shows house prices on the left, and the ratio to earnings on the right. (Prices are adjusted for inflation since 1971, to enable long-term comparison):
Prices used to fluctuate between ratios to earnings of 3x to 6x
The market would bottom when prices were around 3x average earnings, and peak at around 6x earnings
But after the dotcom crash in 2000, the Bank deliberately allowed prices to move out of line with earnings As the Governor, Eddie George, later told the UK Parliament in March 2007:
“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… One had only two alternatives in sustaining demand and keeping the economy moving forward: one was public spending and the other was consumption….
“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession, just like the economies of the United States, Germany and other major industrial countries. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
Of course, as the chart shows, George’s successors did the very opposite. Ignoring the fact that a bubble was already underway, they instead reduced interest rates to near-zero after the subprime crisis of 2008, and flooded the market with liquidity. Naturally enough, prices then took off into the stratosphere.
Back in January 2015, I suggested in an interview with the UK’s Moneyweek magazine that:
“We’ve seen price falls in the housing market in the past in the early 1990s and they went down 50% in real terms, and I think that we’re at the start of that kind of decline now …it’s just something we have to go through to get to reality.”
The problem, of course, is that a bubble of this size, deliberately encouraged by a major central bank over more than a decade, does not just unwind of its own accord. It needs an external catalyst. And as I suggested at the end of June, the Brexit vote seems to have become such a catalyst:
The interest rate rises that Brexit has already caused have now led major lenders to increase their mortgage rates
Buy-to-let sales, which were the main force behind the ascent to such dizzying heights, have fallen by over 50%
A further hit is on the way, as Airbnb has agreed to limit landlords’ London lettings to no more than 90 days/year
Transaction volumes (usually a good leading indicator for prices) have also plunged from 15 to just 9 per surveyor
Prices have not yet started to fall on a widespread basis, but the top end of the market is already seeing falls of up to 40%, as a leading broker told Bloomberg last week:
“It’s a substantial reduction, fully reflecting the challenging post-Brexit market of today”
With prices now collapsing at the top end, it is likely that prices further down the scale will soon start to be impacted.
This is, of course, unlikely to happen overnight. As in the past, it will take years for the full collapse to take place. The reason is that buyers tend to disappear when prices start to fall and interest rates start rising. Anyone owning a home may therefore have to wait a long time until a buyer appears – even if the price has been greatly reduced.
This will be a disaster for many buyers, who believed the assurances of the experts that prices would always rise, due to London having now become a “global city”. First-time buyers will be badly hit, as they have less equity in their homes, and will discover they have bought at prices which were up to double normal price/earnings ratios:
They probably never knew that Nationwide data showed first-time buyer ratios in London were as low as 3.7 in 1983
Nor did they know that ratios fell to 2.6x earnings at the bottom of the last major downturn in 1995/6
Instead, they were encouraged to buy at ratios ranging from 6.2x in 2010 up to this year’s peak of 10.4x
Plenty of people are already angry about the housing market, due to rents having soared due to the bubble that has been created. I fear this anger will seem like a child’s tantrum, however, if prices do now start to fall back to their normal ratios to earnings.