UK Government Debt Levels Explode Higher
Gordon Brown for 10 years banged the drum of the 40% public sector debt rule as a sign of fiscal responsibility. However, following Northern Rock's collapse, the government has increasingly employed creative accounting to hide the fact that the rule has long since been broken. The nationalisation of Northern Rock and then Bradford and Bingley put paid to that. This was followed by the budget busting bank bailouts of September totaling £600 billion. Having thrown in the towel, the Labour government is going for broke with ever larger spending announcements that look set to take UK debt towards £1 trillion by the end of 2009, lifting public debt to more than 80% of GDP.
However the consequences of the borrowing binge is the crash in sterling, as investors adjust to the new climate of growing budget deficits.
The government's deficit spending will continue into 2010 and right up to the general election deadline as the government is expected to announce even more tax cuts and spending programmes in an attempt to win votes. Therefore the first 5 months of 2010 could also witness another £100 billion additional debt, which would push government borrowing beyond 90% of GDP onwards and upwards towards 100% of GDP. That will leave a huge inflationary hangover for many years following the 2010 election deadline. However, the true level of liabilities as the above graph highlights are significantly above the £1 trillion that may prove to be the officially recorded public debt level instead of the actual levels of above £3 trillion by 2010.
The consequences of government borrowing and ever expanding liabilities are below trend economic growth and high inflation. This supports the view that the UK housing market will enter a real terms depression following the ongoing crash, with little on the horizon that could ignite a new bull market for at least the next 4 years.
There also exists the doomsday scenario that the government may yet be forced to nationalise the entire banking sector, which would involve liabilities expanding by an additional £5 trillions. Under those circumstances, Britain would be heading for hyper-inflation which whilst supporting house prices in nominal terms, would greatly erode their value an real terms as Britain's real GDP would contract by significantly more than the 4% that the current recession is expected to shave of the economy.
UK GDP House Prices Trend
Whilst many methods have been utilised in determining future housing market trend such as on the basis of average earnings, mortgage interest rates, currency valuation, inflation adjusted, comparison against other housing markets and real disposable earnings, this item brings to the table housing market analysis against UK GDP growth. The assumption here is that the value of assets after stripping out inflation should increase in in line with the country's actual growth rate as measured by gross domestic product.
The above graph illustrates that the UK housing market is very sentiment driven, and in many ways exhibits the same sort of behaviour as that of the stock market by moving between extremes of over valuation and under valuation against the UK's GDP growth trend.
Despite house prices having fallen by about 19% to date, the trend from an extreme reading of more than 45% above the GDP valuation has barely begun its decline. This is as a consequence of contracting GDP and the crash in inflation. Both factors will put a continuing severe strain on the UK housing market as an economy in recession is unlikely to halt the pace of house price declines let alone suggest a bottom any time soon.
At worst this is suggesting a further 50% fall in house prices. However, the government has at its disposable the ability to ignite inflation possibly towards the end of 2009. Therefore, this more probably suggests a further fall in nominal house prices of 30%, i.e. implying a total fall approaching 50%. Similarly, should the economy start to recover starting in 2010, this will contribute towards the equalisation of house price values without anywhere near as severe a fall as the above graph suggests at this time.
UK Real House Prices - Inflation Adjusted
The real house prices graph illustrates why the housing bust of the early 1990's contributed to the UK heading for recession and a loss of confidence in the housing market that persisted for over 5 years.
Why were people reluctant to buy houses in the period 1993 to 1997 when nominal house prices had stabilised and started to rise? The answer is that in real terms house prices were still falling and in fact did not bottom until 1996 with the uptrend only being confirmed during the beginning of 1998. Therefore, it is only when house prices stopped falling in real terms that the house price uptrend started to gain momentum and trigger the following bull market. It took a further 4-5 years before house prices crossed the previous peak of 1989 some 13 years later.
The subsequent uptrend, fed by low inflation and low interest rates, proved to be remarkably strong. The above implies that UK house prices in real terms are expected to fall by 45% with the downtrend projecting into mid 2010.
USA / UK Housing Market Trends and Sterling Currency Crash
UK house prices had risen by 177% from January 1999, against US house prices that rose by 150% to their peak. However, taking into account the currency trend, UK house prices rose by 238% with most of the gain occurring in the last 2 years of the bull market exaggerated by the U.S. Dollar Bear market. Whilst the rate of decline for both housing markets is similar, allowing for the lag between each market's respective peak, what does stand out is the impact of sterling's crash over the past few months. It has wiped out a further 30% of the value of UK house prices in terms of other major currencies including the U.S. Dollar and Euro, which therefore translates into a crash in UK house prices to date of 49%.
What this means is that the Labour government, whether by design or circumstance, is embarked on a programme of severe currency devaluation, the effect of which is to inflate UK assets in nominal terms including the housing market. The immediate effect of the currency crash is to mask the crash in UK house prices from the public. However, going forward, this will result in much higher inflation and therefore a stagnating housing market for many years. Therefore, the implications are for UK house prices to fall at a much lower rate than during the previous year.
Japan's House Price Depression
Many of the reasons put forward during the UK housing boom as to why house prices would not fall in the UK as elaborated earlier could equally apply to the Island of Japan. However, whilst we in the UK enjoyed a booming housing market, the Japanese endured a severe bear market as the below graph illustrates.
Japan's house prices peaked in 1991, and 18 years later still stand an average 60% below their peak. Whilst I am not saying that Britain's house prices could replicate Japans housing crisis some 18 years from now, however the Japanese experience does illustrate that house prices are NOT a one way bet, even on a long-term basis.
Credit Crisis Warning from Japan
The big warning from Japan's credit crisis that resulted in what has come to be called the "lost decade" was that the bankrupt banks and corporations were NOT allowed to go bust. Instead, Japan cut and kept interest rates near 0%, which ignited the overseas carry trade that fueled the asset price booms around the world as financial institutions borrowed at 1% from Japan and invested / loaned it out elsewhere, which was further magnified by the use of leverage. This, coupled with America's own experience with ultra low interest rates of just 1%, laid the ground for investor cash seeking ever riskier returns at increasingly leveraged levels that helped magnify U.S. subprime mortgage exposure by several orders of magnitude than the originating loan values.
Clearly the lessons from Japan have not been learned. Instead of UK interest rates trending towards 3.5%, they are now at 2% and destined to hit 1% in January. This, coupled with the money printing presses in full swing pumping out record amounts of debt, is repeating the same mistakes as Japan, however with some major differences, both of which are negatives for the UK. For example, we do not have a trade surplus with the rest of the world, nor are we sitting on foreign currency reserves north of $1 trillion. Therefore unlike Japan, economic deflation is likely to be followed by stagflation for the UK. It is far too early to say how high inflation will go as we have yet to feel the ill force of deflation. However this suggests that we won't experience prolonged asset price deflation Japanese-style on nominal terms basis at least.
For more on the credit crisis see the Free Credit Crisis Survival toolkit.
UK Money Supply
UK Money supply M4 (blue) has risen sharply from the 10% targeted low of mid 2008 to the current level of 16.6%, on face value this is highly inflationary and has been taken by many economists and market commentators to suggest much higher forward inflation. However, the money supply adjusted for the velocity of money which takes into account the state of the economy as a consequence of the credit freeze tells a completely different story. The UK economy is now in extreme real monetary deflation of approaching -5%. The leading indicator of the implied money supply is suggesting recent deep interest rate cuts of November's 1.5% and December's further 1% cut will lift future money supply growth out of extreme deflation. However, it will still be far from supporting the levels north of 15% which accurately forecast forward inflation during 2008.
This therefore implies that that the whole of 2009 will be a deflationary period and thus supports a continued sharp downtrend in house prices on par with that of the last 12 months at the rate of 16% per annum.
UK Inflation / Deflation
Recent analysis concluded that the UK is heading for real deflation during 2009, as the below graph illustrates that the RPI inflation measure is expected to go negative and spike lower around July 2009 as the RPI is sensitive to falling mortgage interest rates. The CPI will also continue to fall sharply into July 2009, which is targeting a rate of just below 1%. This therefore supports the view of a much weaker housing market during the first half of the year than the second half of 2009.
UK House Price Crash and Depression Forecast 2007 to 2012
In conclusion, the sum of the above analysis suggests that house prices, having fallen by 19%, are about halfway to the lows, and therefore suggest that house prices will decline by 38% from the August 2007 peak. The housing market trend is clearly currently in the panic stage as we are witnessing near unprecedented house price falls at the rate of more than 16% per annum, far beyond that of the 1990's bear market. This rate of decline is not sustainable, and I am expecting this phase of the housing bear market to come to an end during the second half of 2009. However, my expectation is that following the crash, the market will enter a period of depression spanning several years after the market puts in a nominal price low and then embarks upon a weak up trend as the below graph illustrates.
Risks to the Forecast
The prime risk to the nominal house price forecast is the currency crash induced inflation, as earlier analysis suggested that house price falls can be brought to a halt by a significant currency devaluation, which has already taken place to the tune of 30%. This will mask the real terms house price fall that will make itself evident in the protracted housing market depression where house prices are not able to keep pace with inflation and therefore continue to erode in real-terms.
My next newsletter will aim to forecast the major trends for financial markets during 2009. To receive this on the date of publication subscribe to my always free newsletter.