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

London house prices risk perfect storm as interest rates rise


2000 should have been the natural end of the BabyBoomer-led economic SuperCycle. The oldest Boomer (born in 1946) was about to leave the Wealth Creator 25 – 54 age group that drives consumer spending and hence economic growth.  And since 1970, Boomer women’s fertility rates had been below replacement level (2.1 babies/woman).  So relatively fewer young people were joining the Wealth Creator generation to replace the Boomers who were leaving.

But instead, central banks decided that demographics didn’t matter.  They believed instead that monetary policy could effectively “print babies” and create sustainable demand.  So instead of worrying about financial stability – their real role – they aimed to stimulate the economy by boosting financial asset prices – primarily shares and housing markets.

London’s housing market was a key target as the Bank of England’s Governor told 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… 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… That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”

But instead, when the Subprime Bubble burst, policymakers did even more stimulus via Quantitative Easing (QE).

The chart of London house prices since 1971 (in £2017) therefore shows 3 distinct phases:

  • 1971-1999.  Prices were typically Cyclical – (1) up 51%, down 31%; (2) up 37%, down 15%; (3) up 109%, down 43%.  But they averaged around 4.8x average London earnings
  • 2000-2007.  Central banks panicked after the dotcom crash and kept interest rates artificially low – creating the Subprime Bubble as prices rose in more or less a straight line, till they were up 196% from the previous trough
  • 2008-2017.  The market tried initially to return prices to reality, and they slipped 10%.  But then central banks rushed to flood it with liquidity and created the QE Bubble, causing prices to soar 46%

Now, however, the Stimulus Bubble is ending and a “perfect storm” is developing as 3 key myths are exposed:

The end of the ‘London is a global city’ myth.  The house price/earnings ratio averaged 4.8x between 1971-1999.  But it then took off into the stratosphere to reach 11x today, as the myth grew that Londoners weren’t relevant to the housing market.  Instead, it was said that London had become a “global city” where foreigners would set the price.

Chinese and Asian buyers boosted this myth as vast new apartment blocks were sold off-plan in the main Asian cities – often to buyers who never even visited their new “home”.  But the myth ended last year when China introduced severe capital controls – capital outflows collapsed from $640bn in 2016 to just $60bn in 2017.

The scale of the this retreat is overwhelming as The Guardian reported recently:

“The total number of unsold luxury new-build homes, which are rarely advertised at less than £1m, has now hit a record high of 3,000 units, as the rich overseas investors they were built for turn their backs on the UK due to Brexit uncertainty and the hike in stamp duty on second homes….

“Henry Pryor, a property buying agent, says the London luxury new-build market is “already overstuffed but we’re just building more of them.  We’re going to have loads of empty and part-built posh ghost towers. They were built as gambling chips for rich overseas investors, but they are no longer interested in the London casino and have moved on.””

The end of the buy-to-let mania.   Parents of students going away to college began this trend in the mid-1990s, as they bought properties for their children to use, rather than rent from poor quality landlords.  After the dotcom crash, many decided that “bricks and mortar” were a safer bet than shares, especially with the major tax breaks available.

Banks were delighted to lend against an asset that was supported by the Bank of England, finding it far more attractive than lending to a business that might go bust.  And so parents held on to their investments after their children left college – further reducing the amount of housing available for young people to buy.  But as The Telegraph reports:

“Buy-to-let investors now face tougher conditions. A weakening housing market, tough new legislation and the tightening of affordability checks by lenders are but a few problems causing landlords to run for the hills.  According to the National Landlords Association, 20% of landlords plan to sell one or more of their properties in the next 12 months.”

Interest rates will never rise.  Of course, the key to the Subprime and QE Bubbles was the Bank’s decision to collapse interest rates to stimulate the economy.  Monthly payments became much more affordable – and ever-rising prices meant there was no longer any need to worry about repaying the capital.

But some people still couldn’t afford to buy even on this basis, and by 2007 around 30% of mortgages were “interest-only” with no capital repayment at all.  These buyers should have been forced sellers when the Subprime Bubble burst; prices would then have returned to more normal levels.  But instead, the Bank of England stepped in again, as the Financial Times has reported:

“During and after the 2008 financial crisis Britain’s mortgage lenders took a more tolerant approach to non-payers through the use of forbearance ….at the height of the housing market troubles in 2011 Bank of England research suggested that as many as 12% of all UK residential mortgages were in some form of forbearance.  This helped prevent the downturn from developing into a 1990s-style crash, the Bank suggested.”

PRICES WOULD FALL 60% IF THE HOUSE PRICE/EARNINGS RATIO “REVERTS TO MEAN”
All “good things” come to an end, of course. And the London property bubble is probably no exception. Its 3 key drivers are now all reversing, and there seems little sign of any new factors that might help to keep the bubble inflating.

The risk is that interest rates continue to rise, forcing many owners to sell and bursting the Stimulus Bubble.  UK 10-year rates have already trebled from their 0.5% low in Q3 2016.  Most rates seem likely to go much higher now the 30-year downtrend has been broken, as I discussed last week.

Today’s high prices will also make it difficult for sellers to find local buyers, as the number of homes being bought/ sold each year has fallen 25% since the 2007 peak.  Most young people cannot afford to buy.  And if many people do decide to sell, potential buyers might panic, causing the slump to continue for many years – as happened before 2000.

Nobody knows how low prices might go, if they start to fall.  But ‘reversion to mean’ is usually the best measure.  If this happened, today’s average London home, selling at 4.8x earnings, would cost £193k – a 60% fall from 2017’s average price of £475k.  This figure also highlights the risk that policymakers’ denial of demographic realities has created.

The post London house prices risk perfect storm as interest rates rise appeared first on Chemicals & The Economy.

Interest rates and London house prices begin return to reality

10 yr rates Sept17

Global interest rates have fallen dramatically over the past 25 years, as the chart shows for government 10-year bonds:

  UK rates peaked at 9% in 1995 and are now down at 1%: US rates peaked at 8% and are now at 2%
  German rates peaked at 8% and are now down to 0%: Japanese rates peaked at 4% and are now also at 0%

But what goes down can also rise again.  And one of the most reliable ways of investing is to assume that prices will normally revert to their mean, or average.

If this happens, rates have a long way to rise.  Long-term UK interest rates since 1703 have averaged 4.5% through wars, booms and depressions.  If we just look more recently, average UK 10-year rates over the past 25 years were 4.6%.  We are clearly a very long way away from these levels today.

This doesn’t of course mean that rates will suddenly return to these levels overnight.  But there are now clear warning signs that rates are likely to rise as central banks wind down their Quantitative Easing (QE) and Zero Interest Rate stimulus policies.  The problem is the legacy these policies leave behind, as the Financial Times noted recently:

In total, the six central banks that have embarked on quantitative easing over the past decade — the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England, along with the Swiss and Swedish central banks — now hold more than $15tn of assets, according to analysis by the FT of IMF and central bank figures, more than four times the pre-crisis level.

“Of this, more than $9tn is government bonds — one dollar in every five of the $46tn total outstanding debt owed by their governments.  The ECB’s total balance sheet recently topped that of the Fed in dollar terms. It now holds $4.9tn of assets, including nearly $2tn in eurozone government bonds.”

The key question is therefore ‘what happens next’?  Will pension funds and other buyers step in to buy the same amount of bonds at the same price each month?

The answer is almost certainly no.  Pension funds are focused on paying pensions, not on supporting the national economy.  And higher rates would really help them to reduce their current deficits.  The current funding level for the top US S&P 1500 companies is just 82%, versus 97% in 2011.  They really need bond prices to fall (bond prices move inversely to yields), and rates to rise back towards their average, in order to reduce their liabilities.

The problem is that rising yields would also pressure share prices both directly and indirectly:

  Some central banks have been major buyers of shares via Exchange Traded Funds (ETFs) – the Bank of Japan now owns 71% of all shares in Japan-listed ETFs 
  Lower interest rates also helped to support share prices indirectly, as investors were able to borrow more cheaply

Margin debt on the New York Stock Exchange (money borrowed to invest in shares) is now at an all time high in $2017. Ominously, company buy-backs of their shares have already begun to slow and are down $100bn in the past year.

London House Sept17

House prices are also in the line of fire, as the second chart shows for London.  They have typically traded on the basis of their ratio to earnings

  The average ratio was 4.8x between 1971 – 1999
  But this ratio has more than doubled to 12x since 2000 as prices rose exponentially during subprime and then QE

The reason was that after the dotcom crash in 2000, the Bank of England deliberately allowed prices to move out of line with earnings. As its 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.

Today, however, the Bank is finally recognising – too late – that it has created a bubble of historical proportions, and is desperately trying to shift the blame to someone else.  Thus Governor Mark Carney warned last week:

“What we’re worried about is a pocket of risk – a risk in consumer debt, credit card debt, debt for cars, personal loans.

Of course, the biggest “pocket of risk” is in the housing market:

  Lower interest rates meant lower monthly mortgage payments, creating the illusion that high prices were affordable
  But higher prices still have to be paid back at the end of the mortgage – very difficult, when wages aren’t also rising

The Bank has therefore now imposed major new restrictions on lenders.  They have ordered them to keep new loans at no more than 4.5x incomes for the vast majority of their borrowers.  And lenders themselves are also starting to get worried as the average deposit is now close to £100k ($135k).

Of course, London prices might stay high despite these new restrictions.  Anything is possible.

But fears over a hard Brexit have already led many banks, insurance companies and lawyers to start moving highly-paid people out of London, as the City risks losing its “passport” to service EU27 clients.  Over 50% of surveyors report that London house prices are now falling, just as a glut of new homes comes to market.  In the past month, asking prices have fallen by £300k in Kensington/Chelsea, and by £75k in Camden, as buyers disappear.

The next question is how low could prices go if they return to the mean?  If London price/earning ratios fell back from today’s 12x ratio to the post-2000 average of 8.2x level, average prices would fall by nearly a third to £332k.  If ratios returned to the pre-2000 level of 4.8x earnings, then prices would fall by 60% to £195k.

Most Britons now expect a price crash within 5 years, and a quarter expect it by 2019.  Brexit uncertainty, record high prices and vast overs-supply of new properties could be a toxic combination, perhaps even taking ratios below their average for a while – as happened in the early 1990s slump.  As then, a crash might also take years to unwind, making life very difficult even for those who did not purchase when prices were at their peak.

London house prices face perfect storm as Brexit risks rise

London houses May17The UK goes to the polls on 8 June in a surprise General Election.  And premier Theresa May has clearly decided to base her campaign on a ”Who governs Britain?” platform, as she highlighted when launching her campaign last week:

“Britain’s negotiating position in Europe has been misrepresented in the continental press, the European Commission’s stance has hardened and threats against Britain have been issued by European politicians and officials. All of these acts have been deliberately timed to affect the result of the general election that will take place on June 8….there are some in Brussels who do not want these talks to succeed. Who do not want Britain to prosper.”

In reality, of course, all that has happened is that Brussels is behaving exactly at Theresa May herself forecast, when campaigning a year ago for the UK to Remain in the EU:

“In a stand-off between Britain and the EU, 44% of our exports is more important to us than 8% of the EU’s exports is to them….The reality is that we do not know on what terms we would win access to the single market…It is not clear why other EU member states would give Britain a better deal than they themselves enjoy. 

May’s rhetoric will no doubt give her a large majority, given the weakness of the Labour opposition.  She has also promised to be “a bloody difficult woman” during the Brexit negotiations that follow the election. But what is good for an election win, may not be such good news for London house prices.  These are at all-time record levels in terms of the critical price/earnings ratio, and were already heading into an inevitable downturn as the City AM chart shows:

  Massive over-building at the top end of the market means there are now 59k high-end apartments under construction in London, yet annual sales of new-build flats are just 6k
  Sales have also been hit by the hike in purchase tax (stamp duty) to 10% above £925k ($1.2m) and 12% on purchases over £1.5m
  The UK’s 2 million ‘buy-to-let’ landlords, most of whom are in London, have also been hit by a combination of a higher tax take on their income and tighter borrowing criteria for mortgages
  China’s capital controls means its buyers have had to pull back, as it becomes more difficult to move money overseas.  They have been the largest buyers of residential property in central London

Now this downturn could well become a perfect storm, as May’s “battle with Brussels” risks an exodus of highly-paid finance and other professionals from London.  As the BBC reports: “More than one million people work in the financial services sector in the UK and it pays over £70bn a year in taxes to the government, 11.5% of all receipts.

FINANCIAL SERVICES ARE PREPARING TO LEAVE LONDON 
The CEOs of the world’s 2 largest investment banks have already warned of difficult times ahead.

  JP Morgan CEO, Jamie Dimon, has warned:  “The clustering of financials in London is hugely efficient for all of Europe. Now you’re going to have a declustering which creates huge duplicate costs which is expensive to clients, but we have no choice.”
  Goldman Sachs CEO, Lloyd Blankfein, has highlighted the risks caused by uncertainty over the terms of the UK’s exit: ”Without knowing how things will turn out we have to plan for a number of contingencies,” Mr Blankfein said about possible job losses. “If there is no period of time to implement whatever changes are brought about in a negotiation, we may have to do things prematurely and we may have to do a range of things as a precaution and take steps.”

Unsurprisingly, buyers are starting to sit on their hands and waiting to see what happens, as The Guardian reports:

“London estate agents have begun to offer free cars worth £18,000, stamp duty subsidies of £150,000, plus free iPads and Sonos sound systems to kickstart sales in the capital’s increasingly moribund property market. The once super-hot central London market has turned into a “burnt-out core.”

How much will prices fall, and how long will it take for prices to bottom?  These are now set to become the key questions at London dinner-parties.  Logic suggests prices will need to fall at least 50% to bring them back to more affordable levels.  And the pain is likely to stretch out over years, as leading buying agent, Henry Pryor, has warned:

In my 28 years in the property business, we have done this twice before, and each time it takes around five to seven years before things recover.”

We must all hope that May will use her potential landslide election win to quickly reverse her recent rhetoric, and return to the common sense positions she staked out before the Referendum.  It is not too late for her to agree to remain in the Single Market, the Customs Union and accept the jurisdiction of the European Court of Justice.

Without such a move, London home owners will face a perfect storm as the financial services industry “de-clusters” to Frankfurt, Paris, Brussels, Dublin and Amsterdam next year.

 

London house prices start their collapse

House prices Dec16

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.

German markets stumble as “Sell in May” theme continues

German mkts Jun15

My 4 May post was titled “‘Sell in May and go away?’ as US, German bond yields jump“.  Since then, US interest rates have continued to soar and the US stock market is starting to wobble, as I discussed last week.  Now emerging markets are in the line of fire.  $9.3bn was withdrawn last week – the highest figure since the financial crisis began.

But developments in German markets have been most extraordinary, as the above charts from ThomsonReuters show.  Germany is the world’s 4th largest economy, and had been seen as a beacon of stability in an uncertain world:

  • Just 2 months ago, on 10 April, its DAX Index of leading shares hit an all-time high of 12374 (top chart)
  • On 17 April, the German 10 Year bond yield hit an all-time low of just 0.049% (bottom chart)
  • Last Friday, the DAX closed down 10% versus its high at 11196
  • And the yield on the 10 year bond was 17x higher than its low, at 0.85%

Even more worrying is that the consensus view of major analysts completely failed to forecast these developments. Instead, they all believed that German interest rates would continue to fall and its stock market would rise. Thus on 16 April, Bloomberg quoted one leading interest rate analyst as forecasting:

There’s room for them to fall further given the ECB’s policy. There are willing buyers and not many willing sellers because they can make capital gains if yields keep falling.”

Whilst on 10 April, the Financial Times reported that “the Xetra Dax in Frankfurt and London’s FTSE 100 both ended at record peaks.”

The problem is that most analysts have only ever known a world where central banks kept pumping markets higher, and interest rates lower, via their liquidity programmes.  These began as long ago as Q4 1999 with the Y2K liquidity injection, and then continued through the subprime mania to the post-2008 QE programmes.

The result is that very few people in the markets remember a period when the fundamentals of supply/demand set prices, and markets themselves were a vehicle for price discovery.  This is why I fear we will see massive volatility as Stage 2 of the Great Unwinding of policymaker stimulus gets underway.

The debt mountains around the world are each frightening enough in themselves.  But together they represent a ‘Ring of Fire‘.  Greece is moving closer to crisis, and Reuters last week confirmed my argument that European governments fear major domestic upset if Greece defaults on its debt, and thereby destroys their ‘pretend and extend’ policy:

IMF chief Christine Lagarde is hinting that European governments need to give Greece debt relief to make the numbers add up, but since this is politically unacceptable in Germany, she has had to talk in code in public…Behind closed doors, IMF officials are telling the Europeans that Greece will not survive without a third bailout program, which will require debt restructuring by European governments.”

And if it is not Greece, then it could easily be house prices in markets such as China, Singapore, London or New York.  These are all held aloft, as the saying goes, “on a wing and a prayer”: they long ago lost contact with the borrower’s ability to repay out of their income.  And if not house prices, then energy markets, where vast investment ($1.2tn in the US alone) has created major surpluses, at a time when demand growth is slowing sharply.

The issue is that the market’s obsession with US interest rate policy has blinded it to the reality of today’s New Normal world.  We urgently need our political leaders to begin sensible conversations with the voters about the hard choices that need to be made.  They cannot continue to hide behind the figleaf of monetary policy forever.

WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments: 
Benzene Europe, down 41%. “The recent spate of cracker outages seen in Europe was also potentially having a tightening effect on benzene availability.”
Brent crude oil, down 39%
Naphtha Europe, down 36%. “Strong gasoline demand in the US and Asia continues, with the July naphtha crack spread staying strong in line with the exceptionally high gasoline refining margins.”
PTA China, down 29%. “export orders for their products were also slow, resulting in strong resistance for feedstock prices..”
HDPE US export, down 17%. “Domestic export prices held steady”
¥:$, down 21%
S&P 500 stock market index, up 7%