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.

From subprime to stimulus…and now social division

The blog has now been running for 12 years since the first post was written from Thailand at the end of June 2007. A lot has happened since then:

Sadly, although central banks and commentators have since begun to reference the impact of demographics on the economy, they refused to accept the fundamental issue – namely that economic growth is primarily driven by the needs of the Wealth Creator 25-54 age group:

  • Their numbers are reducing because Western fertility rates have been below replacement level (2.1 babies/woman) for nearly 50 years
  • Central bank attempts to effectively “print babies” via stimulus policies have therefore only increased debt to record levels

As a result, the world has become a much more complex and dangerous place. None of us can be sure what will happen over the next 12 months, as I noted last week.  But clearly, the risks are rising, as UK Justice minister, David Gauke, has highlighted:

“A willingness by politicians to say what they think the public want to hear, and a willingness by large parts of the public to believe what they are told by populist politicians, has led to a deterioration in our public discourse.  This has contributed to a growing distrust of our institutions – whether that be parliament, the civil service, the mainstream media or the judiciary.

“A dangerous gulf is emerging, between the people and the institutions that serve them. Such institutions – including the legal system and the judiciary – provide the kind of confidence and predictability that underpins our success as a society. 

“Rather than recognising the challenges of a fast-changing society require sometimes complex responses, that we live in a world of trade-offs, that easy answers are usually false answers, we have seen the rise of the simplifiers. 

“Those grappling with complex problems are not viewed as public servants but as engaged in a conspiracy to seek to frustrate the will of the public. They are ‘enemies of the people’.”

THANK YOU FOR YOUR SUPPORT OVER THE PAST 12 YEARS
It is a great privilege to write the blog, and to be able to meet many readers in workshops and conferences around the world. Thank you for all your support.

Resilience amidst headwinds is key for H2

Resilience is set to become the key issue as we look forward to H2, as I note in a new analysis for ICIS Chemical Business. None of us have ever seen the combinations of events that are potentially ahead of us. And none of us can be sure which way they will develop. So it seems essential that we start to create contingency plans to build corporate resilience ahead of their possible arrival.

Of course, we can all hope that we are just seeing a series of false alarms, and that business as usual will end up as the outcome. But hope is not a strategy. Even if we optimistically believe it is an 80% probability, the scale of the potential problems under more pessimistic scenarios suggests it would be prudent to decide ahead of time how to tackle them. Everyone will have their own list of possible outcomes. Mine is as follows:

  • Business as usual. Central bank rate cuts avoid recession risk; Presidents Trump and Xi reach stable agreement to roll back tariffs; oil market tensions disappear in the Middle East; Brexit uncertainty is put on hold with another extension period; sustainability concerns over single use plastics are put on back-burner
  • Gathering clouds. China’s vast offshore borrowing creates increasing risk of corporate defaults as growth slows, particularly if the trade war continues; geo-political risks mount in the Middle East; Brexit leads to major friction between the UK and EU27; more major consumer products companies decide to end use of single-use plastics
  • Storm warnings issued. Debt problems morph into major bankruptcies, impacting a range of supply chains around the world; US – Iran tensions mount in the Middle East causing oil prices to rise sharply; regional tensions mount as the world settles into a new Cold War between the USA and China; polymer volumes are hit by a rapid escalation of consumer concerns over single-use plastics

Asia is likely to prove the catalyst for this potential next crisis, if it hits. China has begun to deleverage over the past 2 years, taking $2tn out of its high-risk shadow banking sector. But unfortunately this tightening has driven many of the riskiest businesses into the offshore dollar markets, where naïve western fund managers have rushed to place their bets – driven by their need to achieve higher returns than are available in their domestic bond markets.

If world trade continues to slow as the chart from Reuters shows, and the remnimbi starts to weaken, then some of these borrowers will inevitably default. In turn, this risks a chain reaction across world markets, impacting not only the zombies but also their supply chain partners.

What would your company do in these circumstances? As the American writer Ernest Hemingway noted in ‘The Sun also Rises’, there are two ways to go bankrupt, “gradually, then suddenly”. And the suddenness of the final stage makes it almost impossible for companies to survive if they have not used the gradual stage to create contingency plans. History unfortunately shows that when markets turn, executives suddenly find they have very little time in which to think through how to respond.

Governments will also be in the line of fire, due to their debt levels. And it is unlikely that politicians will know how to respond. They used to be clear about the key issue for the voters, as Bill Clinton famously observed in 1992 – “it’s the economy, stupid”. But today’s politicians instead simply assume that central banks can always print more money to overcome financial and economic crises. They have forgotten the simple mnemonic that many of us learnt at school, namely that “to ASSUME can make an ASS of U and ME”.

Time spent now on building your company’s resilience to potential future challenges may therefore prove time very well spent, if hopes for ‘business as usual’ turn out to have been wishful thinking.

Please click here if you would like to download the full article.

Perennials set to defeat Fed’s attempt to maintain the stock market rally as deflation looms

Never let reality get in the way of a good theory. That’s been the policy of western central banks since the end of the BabyBoomer-led SuperCycle in 2000, when the oldest Boomer moved out of the Wealth Creator 25-54 age group and into the Perennial 55+ cohort.

Inevitably this led to a slowdown in growth, as the Perennials already own most of what they need, and their incomes decline as they enter retirement.  40% of Americans aged 65+ would have incomes below the poverty line, if Social Security didn’t exist.

The well-meaning folk at the US Federal Reserve chose to ignore this development, and instead launched their subprime experiment   But demographics are destiny, and their first attempt to effectively “print babies” ended in 2008’s near-disaster for the global economy.

Their problem, as John Maynard Keynes noted in his conclusion to his 1936 General Theory, was that:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.

And in the case of today’s central bankers, they are enslaved to the theories of 2 defunct economists:

  • One is Franco Modigliani, who won the 1955 Nobel Prize with his “life-cycle hypothesis”, which suggested individuals plan out their  lifetime income and spending in advance, so as to even out their consumption over their entire lifetime
  • The other is Milton Friedman, who won the 1975 Prize for his argument that “inflation is always and everywhere a monetary phenomenon”, ignoring the importance of supply and demand balances

Modigliani and Friedman were working before anyone realised a BabyBoom had taken place.  When John Richardson and I were researching our book ‘Boom, Gloom and the New Normal: How the Western BabyBoomers are Changing Demand Patterns, Again’ in 2010, the authoritative Oxford English Dictionary gave the earliest use of the word as being in 1979.

So they might have some excuse for not being aware of the demand pressures caused by the fact that the number of US babies rose by 52% in 1946-64, compared to the previous 18 years.   But today’s central bankers have no such excuse.  Common sense, or a quick glance at the charts above would immediately confirm:

  • Increasing life expectancy and falling fertility rates mean that an entirely new generation, the Perennials 55+, is alive today for the first time in history
  • And the data shows very clearly that their spending falls off away once they turn 55, and is down 43% by the time they reach the age of 75

Similarly, common sense suggests that inflation is not a monetary phenomenon, but a function of supply and demand balances. The post-War BabyBoom  was inevitably going to create a lot of demand and hence inflation, particularly as factories had first to be converted back from military production.

Similarly, when all these babies moved into the workforce, it was almost inevitable that:

  • We would see more or less constant demand, as the Boomers reached their Wealth Creator years
  • This demand would be turbo-charged as women went back into the workforce after starting a family, creating the two-income family for the first time in history

Fertility rates fell below replacement levels of 2.1 babies/woman as long ago as 1970. Inevitably, therefore, the number of Wealth Creators has plateaued – just as increasing life expectancy means that the number of Perennials is growing rapidly.

Since 2008, the Fed has completely failed to recognise this critical development for supply/demand balances.

Instead it has “doubled down” on the subprime policy, via record levels of stimulus.  If you ask them why, they will tell you their core economic model – the Dynamic Stochastic General Equilibrium model – doesn’t need to include demographic detail, as it is based on  Modigliani and Friedman’s theories.

We are therefore now almost certainly approaching a new crisis. As the chart on the left from Charlie Bilello confirms :

  • The total of government bonds with negative interest rates has now reached $13tn
  • The stock market is ignoring this evidence of slowing demand, and is still powering ahead

One or the other is soon going to be proved wrong.

THE END-GAME FOR THE STIMULUS POLICIES WILL LIKELY BE MAJOR DEFLATION
The central banks have spent the past 10 years following Friedman’s theory, believing they could create inflation via stimulus policies.  Instead, their low interest rates encouraged companies to boost supply, at a time when the rise of the Perennials meant demand growth was already slowing.

Unsurprisingly, therefore, interest rates are going negative, as the Fed’s policies have effectively proved deflationary.  Very worryingly, around 14% of US companies are already unable to service their debt, because their earnings are not enough to pay their interest bills.

Had the Fed focused on demographics, it would have been obvious that the best way to create demand was to increase the spending power of the Perennials, who typically rely on savings for extra income.  But instead of allowing markets to set higher interest rates, the Fed chose to lower them, making deflation almost inevitable.

History suggests their next round of stimulus policy, if/when the S&P 500 weakens again, will be to introduce Friedman’s idea of “helicopter money” – and electronically transfer perhaps $500 to every American’s bank account.  This will be the ultimate test for Friedman’s theory, as if it doesn’t magically create inflation, the Fed will have nothing more to do.

Maybe, this final burst of stimulus will work.  But probably most Perennials, and many Wealth Creators, will instead save the money – alarmed by the Fed’s sense of desperation.  In turn, this will turbocharge the deflationary cycle – forcing interest rates even lower and risking major economic turmoil.

Europe’s auto sector suffers as Dieselgate and China’s downturn hit sales

Trade wars, Dieselgate and recession risk are having a major impact on the European auto industry, as I describe in my new video interview with ICIS Chemical Business deputy editor, Will Beacham.

One key pressure point is created by the downturn in China’s auto industry. As the chart shows, it has been a fabulous growth market in recent years due to China’s stimulus policies, with sales growing nearly five-fold from 550k/month in 2008 to a peak of 2.5m/month last year. And German car exports did incredibly well as a result, due to their strong reputation amongst consumers.

But the start of the US/China trade war last year – plus the $2tn taken out of China’s speculative shadow banking sector over the past 2 years by the government’s deleveraging campaign – means sales have been in decline for almost a year. 2018 saw the first downturn in the market since 1992, and since then the pace of decline has been accelerating with May volumes down 17%.

European car sales have also been falling since September as the second chart confirms. And unfortunately, the industry is confronted by a near-perfect storm of problems, which make it likely that the current downward trend will continue and probably accelerate.

The most immediate issue is the slowdown in the EU economy, with consumers becoming nervous about making high-ticket car purchases. Added to this, of course, are concerns over Brexit – which led sales in the UK (the 2nd largest market) to hit a 6-year low in the normally buoyant sales month of March, 14.5% below the 2017 level.

And then, of course, there are concerns over China’s slowdown, particularly for Germany’s export-oriented manufacturers such as BMW, Audi, Mercedes and Porsche – plus rising concerns over the potential for a European trade war with the USA.

But the real concern arises from the continuing fall-out from Dieselgate, which led diesel’s share of the EU market to fall by 18% in 2018 versus 2017 to 5.59m. Diesel cars accounted for only 35% of EU auto sales, the lowest level since 2001. And in turn this is wrecking the industry’s plans for meeting the new EU rules on CO2 emissions, which VW estimates has already cost it around €30bn, at a time when all the carmakers are also having to invest heavily in EV technology.

As the European Environment Agency (EEA) noted last month:

“For the first year since 2009, petrol cars constituted the majority of new registrations in 2017 (53 %). New diesel cars, which were on average around 300kg heavier than new petrol cars, emitted on average 117.9g CO2/km, which is 3.7g CO2/km less than the average petrol car. The average fuel efficiency of new petrol cars has been constant in 2016 and 2017, whereas the fuel-efficiency of new diesel cars has worsened compared to 2016 (116.8 g CO2/km). If similar petrol and diesel segments are compared, new conventional petrol cars emitted 10%-40% more than new conventional diesel cars.”

Manufacturers have no easy options. They can, of course, aim to accelerate Electric Vehicle (EV) sales in order to gain “super-credits” towards the new limits. But EVs are currently less than 2% of the EU market, so the scope for a major ramp-up in volume is very limited, and their profit margins are much lower due to the battery cost. UBS therefore suggest that automakers earnings per share will be badly hit, with PSA down 25%, VW down 13%, Renault down 10%, Daimler down 9% and BMW down 7%.

The saga highlights how the diesel makers’ decision to cheat on reported emission levels in order to maximise short-term profit has led to major long-term damage for many manufacturers. FCA’s need to enter a “pooling arrangement“ with Tesla to reduce its potential fines, and to exit sales of its most heavily polluting models, highlights the scale of the problems.

In turn, as I discuss, this is all very bad news for major suppliers to the auto industry such as the petrochemical sector.  Please click here if you would like to see the full interview.