ValueWalk's Raul Panganiban interviews JP Lee, Product Managers at VanEck, and discusses the video gaming industry. Q4 2020 hedge fund letters, conferences and more The following is a computer generated transcript and may contain some errors. Interview With VanEck's JP Lee ValueWalk's ValueTalks ·
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way.” Charles Dickens in 1859 “A Tale of Two Cities”
“Will the last person to leave Britain please turn out the lights.“ The Sun Newspaper, 1992 Election
“Britain’s economy is a must avoid….Gilts are resting on a bed of nitroglycerine” Bill Gross – “Mr Bond Market”
“Much has been written about panics and manias… but one thing is certain that at particular times a great deal of stupid people have a great deal of stupid money.” Walter Bagehot, ‘Essay on Edward Gibbon’
In this post I am going to venture into deep waters, discussing several of the macroeconomic headwinds facing the UK and ultimately why I think this is a very large negative for two assets I am trying desperately to limit my exposure to; the Pound Sterling and UK Housing. I will be testing the bounds of my limited circle of competence here as I am not a trained economist but hopefully for everyone’s sake I’ll be able to keep it simple and thankfully many of my sources have already done the hard work!
The UK Economy
The 2000s were a decade of growth for the UK, but that growth was an illusion. It was not borne out of productivity gains or of diligent savings but instead out of rising debt levels. Our seeming prosperity was, and remains, false.
From 1996 to 2010 exports and investments as a share of GDP declined whilst government consumption grew. The UK economy stopped selling things abroad, stymied private sector investment and instead focused on the expansion of its own government sector. As you can see below Public Spending as a percentage of GDP moved up from a trough in 1999 of 37% to today’s level of 46%.
From 1999 to 2009 public spending grew by 53% and public debt rose 73% (before including exceptional costs like the bank bailouts), despite all this spending, an effective stimulus or boost to growth, Real GDP grew only 16%. A painful example of the inefficiency inherent in government directed spending.
The growth that the UK has had over the last 10-15 years has been heavily reliant upon the extension of credit at every level of the economy; household, corporate, financial and government.
If you combine public and private borrowing, the UK has since 2003 borrowed an annual average of 11.2% of GDP, a clearly unsustainable amount. When the government deficit jumped from 2.4% to 11.2% between 2008 and 2009 all the government was doing was filling the void by replacing the private demand for borrowing which had been crushed by the global financial crisis.
Swimming in Debt
The chart below put together by Morgan Stanley serves to highlight the scale of the problem. The entire developed world is mired in debt but we really seem to be leading the pack, partly as a result of our banks failed attempts to take-over the world in the middle of the last decade. As a percentage of GDP our financial sector exposure is vast compared to other nations, even the apparently banking centric Swiss.
“Households took on rising levels of mortgage debt to buy increasingly expensive housing, while by 2008 the debt of nonfinancial companies reached 110 per cent of GDP. Within the financial sector, the accumulation of debt was even greater. By 2007, the UK financial system had become the most highly leveraged of any major economy…” (UK Budget Report, 2011)
Reliance On Ex-Growth Industries or the Public Sector
“Three of the eight largest sectors of the economy – real estate, construction and financial services – have enjoyed huge growth fuelled overwhelmingly by private borrowings. These three sectors alone account for 39% of economic output.
Another three of the ‘big eight’ sectors (accounting for a further 19%) are health, education, and public administration and defence, each of which has grown as public spending has ballooned.” Dr Tim Morgan
In my opinion there are still way too many financial sector jobs. The financial sector not only employs around 1.1m UK workers but they are often some of the best paid and the sector contributes massively to the UK tax take at around 12% of total tax revenue (PWC 2010 report) relative to their being around 5% of the workforce. The sector is shrinking inexorably but at a very slow pace, I see substantial downside risks to property and employment prospects in finance hubs like Edinburgh and London. However, the UK economy as a whole is highly geared to FIRE (Finance, Insurance and Real Estate) jobs so this shrinkage does not bode well.
The chart below shows the extent of the rebalancing on the UK economy that has taken place over the last 20 years with the “FIRE” sectors stealing share from the traditional industries.
Austerity is going to be a struggle given the current backdrop, the economy is already in recession whilst Europe implodes and the US slows dramatically. There is a comparison with Spain which also made commitments to harsh fiscal tightening to maintain the confidence of the bond market. The markets have not responded favourably, punishing the Spanish sovereign yield because they realise that the banks are heavily burdened with housing market losses which will eventually have to be socialised onto the sovereign balance sheet.
How does Financial Repression impact the UK?
“Financial repression includes directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some banks or through heavy ‘moral suasion’.
Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases (as in the United States from 1933 to 1974), or the placement of significant amounts of government debt that is non-marketable. A large presence of state-owned or state intervened banks is also common in financially repressed economies. In the current policy discussion, financial repression issues come under the broad umbrella of “macroprudential regulation”, which refers to government efforts to ensure the health of an entire financial system.” Carmen Reinhart
Regulatory changes like Basel require increased capital for non sovereign assets. The effect seems to be that in these times of extremely scarce capital banks are forced to own UK gilts as these are afforded a zero-risk weighting and therefore improve capital adequacy. The interlinkages between banks and sovereigns increase whilst the return on assets for banks is ground down by these low yielding holdings.
House prices are interesting to me because price discovery is so slow to happen.
If people selling their house aren’t offered what they believe their house is “worth” they just don’t sell and therefore realised prices are always slightly better than the price at which you could sell on any short(ish) time horizon. Because there is no daily quote on property, there is also no volatility which makes property owners feel much more secure than they should. Your house is not subject to a constant bid like the stocks in your portfolio are. You are also not leveraged 10x on your stock portfolio like you might be on your house – something worth thinking about!
A Global House Price Bubble
As the chart below demonstrates the problem of a housing bubble was truly global, however it also shows that in the post bubble world the German and UK markets have not suffered anything like the declines that the other major markets have.
One might argue that part of this is capital flight from the European periphery nations flowing into the closest safe havens. If that were the case then hopefully my analysis above suggests that the UK’s safe haven status is misplaced and furthermore one might consider how permanent that capital is – what happens if the Greek shipping magnates decide in a few years that it’s to repatriate their wealth? Do you know many people who can afford a £8m two bedroom apartment in SW1? If so, do please point them in my direction.
Housing in the UK takes up a world leadingly disproportionate share of our income. Now an Englishman’s home is his castle but this has always been thus so why has the multiple of disposable income doubled since the 30s or 50s when I’m sure our predecessors were just as house proud?
“Comparing a typical dwelling price with per capita personal disposable income. Such a comparison shows a significant mean-reverting tendency) for real estate prices over time for most countries (the UK appears to be an exception here). It provides some important evidence that the US market is at a very low value in relation to income levels (also this is true for Germany and Portugal).” Julian Callow, Barclays Capital
House Price to Earnings Ratio
The house price bubble in the 1970s in the UK was the result of 30% YoY increases but houses still only topped out at 3.8x average income, falling to 2.8x by the end of the mid 70’s. Today real wages are stagnant to declining and the price/income ratio remains elevated at 5x having peaked at 6.5x.
Now clearly there are only two ways for this ratio to mean revert – a sustained increase in wages so that we grow into housing affordability or alternatively a downward adjustment in house prices. Which seems more likely in a recessionary, over-indebted, 8% unemployment economy; a wages boom or a house price fall?
Repossessions – An Inventory Problem
Property market bulls point out that mortgage arrears and house repossessions have peaked at much lower levels than during the crash of the early 1990s.
(Source: FSA Dec 2011 Mortgage Report)
Repossessions and arrears have been less pronounced during this crisis because the economic crash was so much worse than the 1990s downturn. Because UK banks have been in such a fragile state, “extend and pretend” or “ever-greening” have been the tactics du jour. The government and mortgage lenders have gone to huge lengths to stop any tidal wave of repossessions.
According to the FSA, 5-8% of all mortgages are subject to some form of forbearance. This might mean moving to an interest-only mortgage, reducing your monthly payments, taking payment holidays or increasing the term of your mortgage. All of these steps help the borrower stay current and help the bank pretend they don’t own an impaired loan.
These clearly distressed but currently propped up mortgages aren’t included in arrears statistics and so the headline statistics.
Analysts at the FSA examined the payment patterns of these mortgages which are in arrears. Their report showed payments received as a percentage of normal expected payments due were down to 58.3% of the contractual amount.
Around 8.5% of mortgage borrowers in northern regions were in negative equity, where the loan amount exceeds the property value, in Q4 2011, compared with 3.3% in the south. Ratings agency S&P said that borrowers in the north were 30% more likely to be behind in mortgage payments than homeowners in the south.
Interest Only Mortgages
The chart below shows that in 2007 three quarters of interest-only loans taken out had no repayment plan backing them. This is nothing more than a call option on rising house prices. These interest only products just did not exist prior to the housing bubble.
Both parties to the loan are implicitly assuming that the house will at some point be sold for a higher price to pay off the principal. This is Hyman Minsky’s Ponzi finance in action.
MoneyWeek says “These mortgages are a big problem for lenders. They account for 36% of all mortgages outstanding (43% if you include buy-to-let mortgages). During the next ten years, 1.5 million interest-only mortgages with a value of £120bn (10% of all outstanding mortgages) are due to be repaid. How?
Who knows? Some will be backed by sensible repayment plans, but we wouldn’t be surprised if many have to be extended, putting further stress on lenders and borrowers….
The problem with the UK is that the housing market and the banks are two sides of the same coin. If the housing market falls to sensible levels of affordability, then the banks will be in trouble.”
Government policy has been targeted at protecting the banks and not requiring them to realise losses on housing related loans or securities. Because of this the housing market is taking longer to correct. The problem is that precedent suggests this may not work, Japanese banks were allowed to extend and pretend but it turned them into zombie institutions still struggling with the bubble hangover twenty years later. The housing market has been held up by cheap money and lax policy. For reference the Japanese property market is down around 80% since their peak.
Unwilling Lenders – The Banks
“Ongoing economic uncertainties and high unemployment will likely cause many consumers to postpone moving home or buying for the first time, depressing demand for new mortgage loans. On the supply side, unsecured bank debt has fallen increasingly out of favour with investors, and lenders’ pursuit of secured funding alternatives – in the form of RMBS and covered bonds – has triggered a relative renaissance in these sectors.
But the costs of all types of funding remain high, and combined with tougher regulatory capital requirements, this may incentivise many lenders to curb lending or even shrink their balance sheets.” Andrew South, Standard & Poor
If we pretend that the chap above doesn’t work for a ratings agency, his points are quite credible. Banks are looking to quietly and gradually offload their commercial and residential inventory in the hope they don’t flood the market and collapse prices, however they are cumulatively a huge weight of supply which will cap prices for years to come. We have a Mexican Standoff where no banks want to liquidate as it will damage prices and they would rather extend and pretend. However, each bank wants to be the first to liquidate because it knows the liquidations will force prices lower.
With unemployment rising and home values falling, lenders are less willing to provide new credit or refinance existing loans. Last year, £141bn of mortgages were originated compared in the U.K. with £363bn in 2007, according to the Council of Mortgage Lenders.
This all matters of course because without the extension of loans there is no-one to buy property. Rental yields are not yet attractive enough to provide compelling unlevered returns and the average family or FTB must get a mortgage to participate. In a deleveraging balance sheet recession world where financial repression is part of the policy toolkit it is completely rational that banks take the proceeds of loans that are repaid and roll that money into government bonds rather than their mortgage book. This will improve their capital base and risk weighted assets. There is however a fallacy of composition in that what is right for one bank to do becomes a systemic issue if all banks act the same way.
The growth of credit extended to the Private Sector is intuitively a very strong predictor of the changes in house prices in the UK.
Extreme Sensitivity to Interest Rates
Regulators are requiring banks to strengthen their balance sheets and make greater provisions against loans. The effect of this is a creep higher in all funding rates but particularly on standard variable rates which comprise almost 70% of outstanding mortgages in the country.
Low rates have masked the extent of the UK’s problems as they have forestalled consumer deleveraging. Lower rates have postponed and prolonged the emergence of mortgage and consumer loan delinquencies as they remain serviceable and current.
Fixed rate mortgages now equate to only 30% of the mortgage market as banks have shifted the risk of changes in interest rates onto the borrower via variable rates or “trackers”. The average Standard Variable Rate is 75bps higher than the average 2 year fixed mortgage. Using the average outstanding loan value this equates to an increase of £900 per year or almost 25% of UK average real disposable income.
The risk here is huge given the already stretched households.
More worryingly, the SVR spread over base has jumped to 300bps and creeping higher from a pre-crisis average of around 150bps.
The great thing about demographics is how predictable they are. We can say with near certainty that we know now how many 40 year olds there will be in 10 years time looking to move from their first home to their main family residence. Unfortunately the demographic pyramid tells us the answer is – quite a lot less than we might need. Now demographics are not destiny but without a major change in immigration policy they allow us a glance at the secular quantum of buyers and sellers in the future.
As the UK ages the demand for housing will decline, the velocity of transactions will decrease as people do most of their moving when they are younger, the under 25s move twice as often as the over 50’s. The eldest segments of the population also require fewer square feet per person than families do. Furthermore, older people are less capable or willing on average of bearing the debt burden of a large mortgage and are unlikely to lever up to buy a house. Although the UK’s demographic time-bomb is not as bad as some other countries like Japan’s or China’s it is considerably worse than the US’s young, dynamic and constantly evolving population. Rather than a middle age spread one would desire a pyramid shape to the chart below.
For each person that moves back into their parental home, or each elderly person that moves in with their children, another unit of excess inventory is created. Despite current record low interest rates most young couples cannot afford the average house – the most logical way for this re-adjust is with lower prices. The average age for a first time buyer in the UK is 35 years old; compared to 31 in the United States. Given the cultural similarities it is fair to assume much of this differential is down to affordability.
Home ownership is waning due to unemployment, inability to meet mortgage standards and a general disdain that is beginning to take root for owning an asset which is no longer guaranteed to appreciate. The fact it’s no longer a certainty to make you rich, a huge mindset shift from a few years ago, may make young people question if home ownership is worth the hassle – rent or stay with your parents instead. A secular shift to a realisation that houses are liabilities and not assets is perhaps afoot.
Unhealthy Growth – Rising Inequality
The gap between rich and poor is greater in the UK today than at any stage in the last 40 years. It is wider in the UK than in three quarters of OECD countries.
No-one needs to own Sterling. Our fiscal largesse and austerity mirage would suggest that we have the benefit of being a reserve currency or a global trade currency – we do not.
The currency market will eventually reflect the reality that most of the fiscal austerity of the Conservative government is an elaborate ruse with government spending today £22bn higher than it was in 2008 and only down 1% or so on last year. Given the squanderous starting point this is hardly drachonian.
I believe sterling has benefited from being a comparative safe haven relative to the Euro over the last 24 months. Unfortunately, I think we have more in common with the Italians or Spanish than we do with the Germans.
I believe that we don’t just have an overvalued property market in the UK but that we are also facing many structural, societal and financial problems which does not justify the current premium placed on home ownership that assumes it is a productive asset rather than a liability in which we make a home.
The UK has serious problems with those that will become the property buyers of the next two decades. There is excessive youth unemployment, an oversupply of graduates possessing a skills deficit for real world jobs, an all pervasive entitlement culture and an intergenerational rift where parents appear to have spent their children’s inheritance and priced them out of their future.
Many graduates have been led to believe that because they possess a degree they have a god given right to highly paid, highly engaging employment in the industry of their choice but alas we do not have need for 25,000 Photography graduates each year or the thousands of degrees in Forensics driven by a generation brought up on CSI Miami. Not every graduate in “International Business Studies” is going to end up working as Richard Bransons right hand man.
Ultimately, the generation under 30s seems incapable of affording to buy their parents house having struggled through the Great Recession are stymied with patchy work experience and often substantial student debt that must be addressed before home ownership or saving even considered. A further 5-10 years of painful deleveraging and scarce growth is not going to help ease these painful adjustments to a harsher reality of lowered expectations and bruised egos.
If you have a plan to sell your house then I think you should do it pretty quickly (I sold an investment property last year) and if you are considering buying then you should perhaps consider the timing or whether you buying for profit or as a home.
It wouldn’t surprise me at all to see house prices at the same level they are today in 5-10 years time, the greater question will be whether they merely stagnate or whether we see a fall of anywhere up to 40% allowing the market to clear and buyers to swoop in.
- Britain ranks 28th in the world for overall quality of its education system – behind Romania and Costa Rica – despite a doubling of spending since 2000.
- Only 55 per cent of young people get a C or better in GCSE English.
- The number of prescriptions written by NHS Doctors has risen 300% since 1997
- 2 million Brits regularly rely on prescription drugs to have sex.
- Britain ranks 89th in terms of regulatory burdens on business – behind Zambia, Saudi Arabia and Egypt.
- Public spending on Advanced Technologies relative to GDP puts us behind Angola and Rwanda
- The scale of our intractable tax system ranks 95th in the world behind Zimbabwe and Guatemala.
- 1.8m households (7% of total) are currently on the waiting list for government housing.
- www.emptyhomes.com estimates that in 2011 there were 930,000 empty homes across the UK.