London house prices edge closer to a tumble

After the excitement of Wimbledon tennis and a cricket World Cup final, Londoners were back to their favourite conversation topic last week – house prices. But now the news has become bittersweet as the price decline starts to accelerate.

As the London Evening Standard headline confirms:

The London property slump has dramatically accelerated with prices falling at their fastest rate in a decade, official figures reveal… The latest “punishing” downward lurch means that more than £21k ($26k) was wiped from the value of the average London house over the period, according to the Land Registry… The number of sales is still in decline with just 5947 recorded in March, down from 7350 a year previously.”

‘Reversion to the mean’ is always the most reliable of investment guides, and the chart shows prices could have some way to fall before they reach this level – and, of course, prices often over-correct after the type of sharp rise that has been seen over the past 20 years:

  • Most people have to buy houses on a mortgage, where the ratio of price to income is the key factor
  • As the chart shows, prices and ratios have seen 2 distinct periods since 1971 (when records began)
  • Prices (inflation adjusted) have had an upward trend since 2000, with today’s 11% fall the worst
  • 1971-1999 saw more violent swings – eg between 1983-1993 they doubled and then halved
  • The average ratio since 2000 has been 9.3, which would bring prices down by a further 23%
  • The average ratio between 1971-1999 was 4.8, which would bring prices down by a further 60%

WHY DID PRICES RISE?
London prices have been boosted by 4 main factors since 1971:

Demographics.  Most fundamentally, the BabyBoomers (born between 1946-1970) began to move into their house-buying years. This dramatically increased demand (as I discussed last week), whilst supply was slow to respond due to planning restrictions etc.

In addition, women began to go back to work after having children, creating the phenomenon of 2-income families for the first time in history. The younger Boomers saw the benefit of this as affordability rose; those who followed them paid the price in terms of higher prices.

Buy to let. London became the capital of ‘Buy-to-let’. UK tenancy law changed in 1988 and by the mid-1990s, parents realised it would be cheaper and better to buy apartments for their student children, rather than paying high rents for shoddy lodgings. Others followed in the belief that property was “safer” than stock markets”.

Falling interest rates (they were 15% during the 1992 ERM crisis) made the mortgage payment very affordable – particularly with tax relief as well. But since 2017, tax relief has been reducing, and disappears next year. And today’s ageing UK population, where nearly 1 in 5 people are now aged 65+, means the Boomers no longer have spare cash to spend on buying property.

The global city.  After the financial crisis, London property appeared an oasis of calm as the Bank of England supported house prices by cutting interest rates to near-zero, dramatically boosting affordability. Everyone knew by then that “house prices only increased”, as memories of the 1970-1980s were forgotten, and so capital gains seemed assured.

This made London, along with other “global cities” such as New York, very attractive to Russians, Arabs, Asians and anyone else who was worried that their government might try to grab their money. Europeans also bought as the eurozone crisis developed. And then the success of the 2012 London Olympics made it the city where everyone wanted to live, especially as its financial sector was booming due to central bank stimulus programmes.

WHAT WILL HAPPEN NEXT?
The question now is whether these drivers will continue.  Brexit, of course, has already cast a shadow over the idea of the UK as an island of stability in a troubled world. And whilst the collapse of the currency since the referendum makes property more affordable for foreign buyers, it means that those who bought at the peak are nursing even larger losses.

And, of course, the fall in the actual volume of sales is another worrying sign. Volume usually leads price, up or down. And housing markets aren’t like stock markets, where you can usually trade very quickly if you want to sell. Instead you have to wait for a buyer to appear – and even then, the UK’s property laws make it possible for them to pull out until the very last moment.

All in all, it would therefore be surprising if prices didn’t continue falling, back to the average house price/earnings ratio of the past 20 years.  A temporary over-correction, where they went even lower, would also be normal after such a long period without a major fall.

Whether they go lower than this, and return to the 1971-99 ratio, probably depends on what happens with Brexit.  If those who believe it will open up a new ‘golden age’ for the UK economy are right, then  prices might well stabilise and could even rise again, after the initial disruption. But if it proves an economic disaster, then a return to the troubled period of the 1970s would be no surprise at all.

 

G7 births hit new record low, below Depression level in 1933

If a country doesn’t have any babies, then in time it won’t have an economy. But that’s not how the central banks see it.

For the past 20 years, through subprime and now their stimulus policies, they have believed they could effectively “print babies”.  Even today, they are still lining up to take global interest rates even further into negative territory.

But common sense tells us their policy cannot work:

  • New data shows 2018 births in the G7 richest Western countries were just 7.8m
  • This was the lowest level seen since records began in 1921
  • It was even lower than at the height of the Depression in 1933 when births dropped to 7.99m/year
  • By comparison during the 1946-70 BabyBoom, they averaged 10.1m/year and peaked at 10.6m

The chart above confirms the unique nature of the Western BabyBoom.  Births jumped by 15% versus the previous 25 years, and since then they have fallen by an average 17%. Every single country is now having fewer births than at the peak of the Boom:

  • US births were 3.79m last year, versus a peak of 4.29m in 1959
  • Japan had 0.92m versus 2.7m in 1949; Germany had 0.79m versus 1.36m in 1963

The BabyBoom mattered because the Boomers were part of the richest society the world has ever seen.  In 1950, the G7 were half of the global economy, and they were still 45% in 2000. The “extra babies” born during the Boom, effectively created a new G7 economy the size of Canada.

But since 1970, the West has not been replacing its population, as fertility rates have been below 2.1/babies per woman.  This matters, as the second chart shows for the USA, the world’s largest economy.

Consumer spending is 70% of GDP, and it peaks in the 25-54 Wealth Creator generation – when people are building their careers and often settle down and have children.  Spend then drops by over 40% by the age of 75.

This didn’t matter very much for the economy in the past, when most people died around pension age:

  • In 1950, for example, there were just 130m Westerners in the Perennials 55+ age group.  By comparison, there were 320m Wealth Creators and 360m under 25
  • But today, there are 390m Perennials compared to 515m Wealth Creators and just 350m under-25s

This means it is impossible to recreate the growth of the Boomer-led SuperCycle.

Does this matter? Not really.

Most of us would prefer to have the extra 15-20 years of life that we have gained since 1950.  But because policymakers have pretended they could print babies via their stimulus programmes, they were able to avoid difficult discussions with the electorate about the impact of the life expectancy bonus.

Now, this failure is catching up with them.  Perennials are, after all, effectively a replacement economy. They already own most of what they need, and their incomes decline as they move into retirement. So we need to adjust to this major change:

  • In 1950, it was normal for people to be born and educated, before working to 65 and then dying around pension age
  • Today, we need to add a new stage to this paradigm – where we retrain around the age of 55, probably into less physically demanding roles where we can utilise the experience we have gained
  • This would have tremendous benefits for individuals in terms of their physical and mental health and, of course, it would reduce the burden on today’s relatively fewer Wealth Creators
  • It is completely unfair, after all, for the Boomers to demand their children should have a lower standard of living, and instead support their parents in the Perennials cohort

There is, of course, one other fantasy peddled by the central banks as part of their argument that monetary policy can always create growth.

This is that the emerging economies have all now become middle class by Western standards, and so global growth is still going to power ahead. But as the third chart shows, this simply isn’t true:

  • It shows the world’s 10 largest economies (the circle size) ranked by fertility rate and median age
  • Only India still has a demographic dividend, with its fertility rate just above replacement levels
  • But India’s GDP/capita is only $2036: Brazil’s is just $8968 and China’s $9608
  • By comparison, the US is at $62606, Germany is at $48264 and France/UK are at $42600

Companies and voters have been completely fooled by these claims of a “rising middle class” in the emerging economies.  In reality, most people have to live on far less than the  official US “poverty level” of $20780 for a 3-person household.

In China, average disposable income in the major cities was just $5932 last year, and only $2209 in the poorer rural half of the country. Its great success has actually been to move 800m people out of extreme poverty (income below $1.90/day) since 1990.

Demographics don’t lie, and they clearly challenge the rose-tinted view of the central banks that further interest rate cuts will somehow return us to SuperCycle days.

Their real legacy has been to create record levels of debt, which can probably never be repaid.

Smartphone sales decline begins to impact global stock markets

The bad news continues for the world’s smartphone manufacturers and their suppliers.  And President Trump’s decision to add a 25% tariff on smartphone component imports from China from June 25 is unlikely to help. Morgan Stanley estimate it will add $160 to the current US iPhone XS price of $999, whilst a state-backed Chinese consumer boycott of Apple phones may well develop in retaliation for US sanctions on Huawei.

Chances are that a perfect storm is developing around the industry as its phenomenal run since 2011 comes to an end:

  • Global sales fell 4% in Q1 as the chart shows, with volume of 330m the lowest since Q3 2014
  • China’s market fell 3% to 88m, whilst US volume fell 18% to 36m
  • Apple has been badly hit, with US sales down 19% in Q1 and China sales down 25% in the past 6 months
  • Foldables have also failed to make a breakthrough, with Gartner estimating just 30m sales by 2023

This downbeat news highlights the fact that replacement cycles are no longer every year/18 months, but have already pushed out to 2.6 years.  Consumers see no need to rush to buy the latest model, given that today’s phones already cater very well for their needs.

Apple’s volumes confirm the secular nature of the downturn, as its volume continued the decline seen in 2018 as the iPhone comes to the end of its lifecycle. Its market share also fell back to 13%, allowing Huawei to take second place behind Samsung with a 17.9% share.  This decline came about despite Apple making major price cuts for the XS and XR series, as well as introducing a trade-in programme. Meanwhile, Samsung saw its profits fall 60%, the lowest since its battery problems in 2017.

The President’s tariffs are also set to impact sales, as manufacturers have to assume that today’s supply chains will need to be restructured. Manufacturing of low-end components can perhaps be easily relocated to countries such as Vietnam and other SE Asian countries.  But moving factories, like moving house, is a very disruptive process, and it is certainly not easy to find the technical skills required to make high-end components – which represent the core value proposition for consumers.

This highlights how second-order impacts are often overlooked when big announcements are made around tariffs and similar protectionist measures.  Not only do prices go up, as someone has to pay the extra costs involved. But companies along the supply chain see their margins squeezed as well – Apple suppliers Foxconn and Pegatron saw their gross margins fall to 5.5% and 2.3%, the lowest level since 2012, for example. So they will have less to spend on future innovations.

We can, of course, all hope that the current trade war proves only temporary. But President Trump’s decision to embargo Huawei from US telecom equipment markets suggests he is digging in for a long battle. Ironically, however, Huawei was one of the few winners in Q1, with its volume surging 50% despite its planned 2018 US entry being cancelled due to congressional pressure.  And other governments seem notable reluctant to follow the US lead.

The bigger risk, of course, for investors is that the profit downturn caused by protectionism cannot be “solved” by central bank stimulus. Since 2009, as the chart of the S&P 500 shows, they have rushed to support the market whenever it appeared poised for a return to more normal valuations. But it is hard to see how even their fall-back position of “helicopter money” can counter the impact of a fully-fledged trade war between the world’s 2 largest economies.

Ageing Perennials set to negate central bank stimulus as recession approaches

The world’s best leading indicator for the global economy is still firmly signalling recession.  That’s the key conclusion from the chart above, showing latest data on global chemical industry Capacity Utilisation (CU%) from the American Chemistry Council.

The logic behind the indicator is compelling:

  • Chemicals are one of the world’s largest industries, and also one of the most diverse
  • Every country in the world uses relatively large volumes of chemicals
  • And their applications cover virtually all sectors of the economy
  • They include plastics, energy and agriculture as well as detergents and textiles

If you want to know the outlook for the global economy, the chemical industry will provide the answers.

It also has an excellent correlation with IMF data, and benefits from the fact it has no “political bias”. It simply tells us what is happening in real-time in the world’s 3rd largest industry.

And now it is telling us that the CU% is continuing to fall. It was down at 83.1% in January, well below the long-term average of 86.5%.  In fact, it has fallen sharply from that level since December 2017.

Ironically, it was exactly a year ago that the world’s major central banks were congratulating themselves on the success of their policies. “Yes”, they said, “it had taken longer than expected, but we can finally declare victory for our post-2008 stimulus policies”.

Unfortunately, however, this confidence was misplaced as the second chart suggests.

It shows there was a brief rebound in 2010 after the 2008 Crisis as the first round of stimulus took place. But then growth fell back again.

Instead of learning the lesson, the banks decided to do more of the same.  But repeating the same action in the hope of a different result is not terribly sensible.  And so it has proved.

Next month will see the IMF’s new estimate for 2018’s GDP growth (black line). Chemical industry CU% data (the red line) suggests it will have to be revised downwards, once again.

Already, it seems, the central banks are preparing their next round of stimulus. They have finally recognised the slowdown underway in the key areas of the economy such as autos, housing and electronics:

  • China has already panicked, with January seeing record levels of loans
  • Similarly the US Federal Reserve has promised it will go slowly with any further interest rate rises, or might even reduce them
  • The Bank of Japan’s former deputy governor has warned of recession as global demand weakens
  • Most recently, the European Central Bank has completely reversed course, after suggesting as recently as December that strong growth meant further stimulus was unnecessary

As the 3rd chart shows, the key aim for the western central banks is simply to support stock markets such as the S&P 500. They are determined to keep them moving steadily upwards, in the belief this will stimulate growth. But this, of course, is wishful thinking.  As the Financial Times reported last week, the combined result of stimulus and President Trump’s tax cuts has been that:

“US companies handed their shareholders a record-shattering $1.25tn through dividends and buybacks last year, lifting the post-crisis bonanza to nearly $8tn.”

And as the independent Pew Research Center reported last year:

“Today’s real average wage (that is, the wage after accounting for inflation) has about the same purchasing power it did 40 years ago. And what wage gains there have been have mostly flowed to the highest-paid tier of workers.”

YOU CAN’T PRINT BABIES – AND IT IS PEOPLE THAT CREATE DEMAND

The final chart highlights the “problem” for the central banks.  Their financial models, and all their thinking, are based on the experience of the post-1945 BabyBoomer SuperCycle.

The vast numbers of babies born between 1946-70 first created massive inflation in the 1960s-70s, as demand outstripped supply. But then they created more or less constant growth as the Boomers moved into the workforce. They turbo-charged demand as Western women stopped having enough children to replace the population after 1970, and instead went back into the workforce – creating the two-income family for the first time in history.

But after 2000, this growth began to weaken as the oldest Boomers moved out of the Wealth Creator 25 – 54 age group, when consumption peaks along with earnings.  And today’s “problem” is really that, wonderfully, we now have a entirely new generation of Perennials aged 55+.

They will soon be over one-fifth of the global population, double the percentage in 1950.  In the developed western economies, they are already a third of the population, due to the collapse of fertility rates.  This is great news for us as individuals. But it is bad news for economic growth as Perennials already own most of what they need, and their earnings reduce as they retire.

The S&P 500 and other asset markets are already rising due to central bank promises of more support.

But one thing is certain. Third time around, the main result of more stimulus will again be to increase today’s already high levels of debt and inequality.  It cannot return us to SuperCycle levels of growth.

Déjà vu all over again for oil markets as recession risks rise

Back in 2015, veteran Saudi Oil Minister Ali  Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.

As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4.  But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand.  And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:

“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”

Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.

Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:

  • Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
  • But its short-term need is to support prices by cutting production, in order to fund its spending priorities

The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past.  It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.

The reason is that high oil prices reduce discretionary spending.  Consumers have to drive to work and keep their homes warm (and cool in the summer).  So if oil prices are high, they have to cut back in other areas, slowing the economy.

CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014

There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.

They were creating tens of $tns of free cash to support consumer spending.  But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report.  It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:

“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.

SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS

Oil prices are therefore now on a roller-coaster ride:

  • Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
  • The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December

Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd).  But as always, its “allies” have let it down.  So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.

Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:

Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds.  As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.

But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.

Companies and investors therefore need to be very cautious.  Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.

Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.

 

*Total cost is number of barrels used multiplied by their cost

The BoE’s pre-emptive strike is not without risk

The Financial Times has kindly printed my letter below, arguing that it seems the default answer to almost any economic question has now become “more stimulus” from the central bank.

After 15 years of subprime lending and then quantitative easing, last week’s warning from the Bank of England suggests there are fewer and fewer economic questions to which the default answer is not “more stimulus”.

But it is still disappointing to find the Financial Times supporting this reflex reaction when considering the risks associated with Brexit next month (“Bank of England must grapple with the risks of a no-deal Brexit”, February 6). Nobody would dispute that the bank has a critical role in terms of ensuring financial stability through the Brexit transition. As the FT says, the “potential outcomes are discrete and the impacts vary widely”.

But the bank has already fulfilled this role by publishing its November assessment of the no-deal risks for government and parliament to consider. There is therefore no justification for the bank to pre-emptively impose its views by deciding to keeping interest rates artificially low.

The political risks associated with such an intervention would be large, particularly if the bank’s assessment or its proposed solution proves wrong. And there is also the risk of unintended consequences.

The history of stimulus does, after all, suggest that the only certain outcome of lower interest rates would be a further rise in today’s already sky-high level of asset prices.

Paul Hodges
The pH Report