Over the past 3 years, we saw that the uncertainty around Brexit has weighed on the UK economy, lowering the consumption growth rate from 0.6% (between 2009 and 2016) to 0.3% after June 2016, reducing business investment (see article here) and, therefore, lowering growth expectations. Figure 1 (left frame) shows the change in regime in the past few years following a long period of low uncertainty according to the Economic Policy Uncertainty (EPU) index (developed by Baker et al., 2016).
Another important factor was also the dynamics in the housing market, which has not experienced a significant drop as some economists predicted prior to the vote but has been slowing down in the past two years. Figure 1 (right frame) shows that nationwide house prices fell gradually, from 4.5% in February 2017 to 0.7% in March, while prices in London collapsed from 4.1% to -3.8% during the same time frame. Hence, the capital city has been the most affected by Brexit uncertainty, with prices declining at their fastest rate in a decade, while the overall UK housing market seems to have bottomed.
Source: Baker et al. (2016), Eikon Reuters
1. Mortgage interest rate dynamics and UK Housing
In January 2018, Nomura published an interesting analysis looking at the long-term dynamics of the UK property market. The persistent decline in mortgage interest rates over the past three decades was one of the major drivers of the rise in UK house prices (5 times in nominal terms, 2.5 in real terms). Figure 1 (left frame) shows that the mortgage interest rate averaged 7.5% in the late 1980s, then 3.5% in the years preceding GFC, then 1.7% post 2009. With a repayment-to-income ratio now exactly in line with the LT average of 23.5%, how much could house prices to fall if interest rates rise?
Assuming that the Bank Official Rate will rise to 4% by 2030 (25bps increase per year), that the mortgage rate to Bank rate remains at around 230bps and that average nominal household income grows at 2.5% percent per year, they found that house prices will remain flat until 2030 in nominal terms and fall by 20% in real terms (Figure 2, right frame).
However, the uncertainty around Brexit has been delaying the Bank of England’s decision on the trajectory of the short-term rates, and therefore, leaves lower room in case of a sudden economic downturn. In the second part, we will look at a few leading indicators, which mainly show that the upside gain on the UK property market will be very limited within the next 6-12 months.
2. Leading indicators of UK housing market
Even though building a long-term view on the property market is crucial for investors’ allocation to risky assets, we also like to have a shorter-term view in order to capture the current market dynamics. First, if we look at the UK Residential Market Survey (RICS), which tends to capture the current and future climate conditions in UK residential sales and lettings, it is clearly not pricing a rebound in prices yet. Figure 3 (right frame) shows the strong co-movement between RICS survey (6M Lead) and house prices (Nationwide) since 1992. The RICS indicator has dropped from 54 in February 2019 to -24 in March 2019, pricing in a sluggish growth in house prices in the months coming ahead.
The second leading indicator we like to watch for UK house prices is the annual growth of mortgage approvals. Figure 3 (right frame) shows that a rise in mortgage approvals tends to be beneficial for house prices within the next 6 months. As mortgage approvals have been fairly flat in the past few years, fluctuating around 65,000 per month (20K below its long-term average), the indicator has not priced in a significant rebound in house prices coming ahead.
Source: Eikon Reuters
Our excess liquidity indicator, which we compute as the difference between real M1 money growth and industrial production, has also shown a strong relationship with house prices since 1992. Figure 4 (left frame) shows that excess liquidity tends to lead (9M) house prices over time. After falling significantly from 12% in June 2016 to 0 in early 2018, excess liquidity has remained poor in the UK amid slowing M1 growth. Despite the slowdown in inflation (CPI decrease from 3.1% in November 2017 to 1.9% in February 2019), excess liquidity is still not pricing in a rebound in the UK housing market for the months to come.
Finally, our last leading indicator is the Chinese credit impulse. We saw previously that the annual change in China’s Total Social Financing (TSF), a liquidity measurement tool borne in 2011 and considered to be a better indicator than traditional measures of money supply, tends to lead risky assets such as equities in the next 6 months. Figure 4 (right frame) shows some co-movement between UK house prices and China TSF since 2004. The Chinese stimulus we saw earlier this year, with the bank loans and TSF rising to a record high of CNY 4.64 trillion in January, reverted the downward trend of the credit impulse. However, we will need to see strong annual growth rates in the coming months in order to start considering taking a positive outlook for UK houses.
Source: Eikon Reuters, Rothko Research
We saw that according to some of our leading indicators, the upside gain on UK house prices is very limited for the next 6-12 months to come despite the BoE keeping their policy rate steady at 75bps. Therefore, we will need to see at least one of the indicators rising significantly in order to start building a positive outlook for the UK property market.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.