Brexit – 9 (almost) inexorable consequences

Waving United Kingdom and European Union FlagLast Thursday British people decided to take their country away from the EU. No one knows (yet) how the economic relationship between those two areas will be shaped in the future – for those interested a governmental paper outlines the existing precedents in a very clear and interesting way.

In the meantime, looking at the market reaction, the situation has been seemingly well handled so far and stakeholders believe in a smooth transition rather than an abrupt ending. The CBOE Volatility Index, better known as ‘VIX’ or ‘fear index’, has reached levels which can be considered as modest relative to the ones witnessed in 2008 and is already on a downward trend. As I am writing those words the FTSE 100 is only 3.1% down compared with the 23/06 close and the pound has weakened but not collapsed against other major currencies.

Year-high levels reached by the VIX since 2000. Sources: Yahoo Finance, author analysis.
Year-high levels reached by the VIX since 2000. Sources: Yahoo Finance, author analysis.

In the long-term, however, the usual macroeconomic mechanisms will start acting – some of them are already noticeable. I do not have a crystal ball to tell you when and to which extent those trends will manifest themselves – and the ‘2-year window’ the UK benefits from after triggering article 50 adds to that uncertainty. Other future events could also change the course of action. This list of 9 items has therefore been prepared with the information made publicly available and the convictions I have at the time I write those lines. All in all, though, the picture looks relatively grim and one could fear that the UK is now sitting on a potential economic timebomb.

Credits: http://www.mattgoodwinlaw.com/
Credits: www.mattgoodwinlaw.com
  1. A weakened pound and potentially higher trade barriers will lift inflation. Goods and services from abroad will mechanically become more expensive once their price is translated into pounds – a phenomenon economists call ‘imported inflation’. On top of that, the UK has been enjoying non-existent or low trade barriers, both within and outside the EU,  and it is unlikely that it will be able to negotiate the same terms on its own. Higher trade barriers increase the ‘total cost of purchase’ and therefore inflation.
  2. Lower confidence will weight on growth. The uncertain period we are entering is reinforcing the anxiety-provoking environment in which the developed economies have been living in over the last few months. As a consequence, individuals are likely to save more and consume less and companies are tempted to defer non-essential investments. Thinner money flows ultimately impact GDP.
  3. Interest rates will rise, all other things remaining equal. The UK’s financial strength will decline as it leaves the EU – Standard & Poor’s has already downgraded the country’s credit rating to reflect this point. A weaker credit rating and creditworthiness translates into higher interest rates to reflect a higher probability of default (‘country risk’). I insist on the fact that this is the case all other things remaining equal since we will see later that the Bank of England is likely to have the final word through the benchmark rate.
  4. Rising trade barriers will mitigate the stimulating impact of currency devaluation. Usually, a currency devaluation means that exports are cheaper and therefore more in-demand all other things remaining equal. In our case nonetheless, and as highlighted in point 1, the devaluation comes jointly with an increase in trade barriers that will make exports ‘less more competitive’ than expected. As a result, it is possible that the currency devaluation triggers inflation (as pointed out in 1) without significantly reigniting the economic engine.
  5. There will be a few winners… Companies bearing costs in pounds but selling a large share of their products abroad will benefit from the currency devaluation. The Wall Street Journal mentions Diageo – whose product lines include Scottish whiskey – and pharma behemoths such as AstraZeneca and GSK – whose staff is largely headquartered in the UK while benefiting from a very global sales footprint. Again, this assumes no significant long-term change in the UK’s custom tariffs and policy.
  6. … but there will be many losers: Conversely companies manufacturing goods or providing services with a non-sterling cost base and then selling them in the UK will be negatively affected by the situation. Airlines are a typical example : costs are very often expressed in dollars but tickets are sold in local currencies. Banks got affected since they will not be able to enjoy their ‘passporting‘ right once the UK has exited the EU.
  7. Homeowners may have difficult nights ahead: After several years of continuous (and sometimes impressive) growth, housing prices are likely to flatten or even drop. Several corporations, primarily banks, are thinking about moving part of their operations outside of the UK. This move would impact the demand for housing and thus prices. On top of that, without Central Bank intervention, interest rates are likely to rise, negatively impacting the purchasing power of prospective buyers – and raising the burden on mortgage owners. Homeowners with recent mortgages living in areas where the drop in demand will be the most significant could end up in a ‘negative equity’ situation – a theoretical case where the sale of the house would not be enough to repay the mortgage.
  8. Mark Carney, Governor of the Bank of England
    Mark Carney, Governor of the Bank of England

    The situation will create monetary… We have seen that the Brexit could lead the UK into a period of ‘stagflation’, i.e. inflation with limited economic growth. The Bank of England could use monetary policy to either fight against inflation (by increasing benchmark rates) or stimulate growth (by decreasing the same rates). Whereas in the Eurozone the ECB has a clear mandate to focus solely on inflation (I am not saying that this is an optimal solution), the BoE has both growth and inflation management within its remit and will have to make a trade-off. The Telegraph indicates that growth may prevail as the market is not expecting any interest rate rise before 2020.

chart
Source: The Telegraph
George Osborne, (future ex?) Chancellor of the Exchequer
George Osborne, (future ex?) Chancellor of the Exchequer

9. … and fiscal dilemmas. Separately, the government will also have a difficult fiscal decision to make. With tax receipts dropping due to the lower activity, shall it aim for more austerity (and the political consequences attached) or for a fiscal stimulus? In any case, the fiscal and monetary policies will have to be fully aligned to avoid being trapped in the ‘worst of both worlds’ – a situation that some countries are currently facing.

Again, this is based on the assumptions that economic actors keep behaving rationally. Market volatility in the medium-term will indeed be driven less by the outcome of the negotiations than by the way they progress.

The 3 macroeconomic equations underpinning the theory behind this post's thinking.
The 3 macroeconomic equations underpinning the theory behind this post’s thinking. Sorry, couldn’t help myself.

The 5 economic trends that worry me (2/2)

[Continued from Tuesday]

3. The hype around FinTech

Last year the rise of Financial Technology (‘FinTech’) software and apps led some experts to predict the ‘disruption of traditional banking. The new providers of financial services would maximise the agility and cost efficiency provided by technology and as a result would kick the incumbents plagued by legacy systems and excessive layers of staff.

LendingClub_logoLendingClub, founded in 2006, was perceived as one of the standard-bearers of that shift. As a P2P lending company it offered to put individuals or small businesses directly in touch with lenders through an online platform – a mix of Uber and Match.com. LendingClub was claiming that it would enable small businesses to get easier access to funding while providing lenders with an investment offering a (relatively) decent return.  LendingClub was just taking a percentage of the loan as a one-off fee and therefore was not taking any risk.

In 2016 the picture is somewhat different, as Patrick Jenkins points out. Hedge funds and banks have replaced individuals and small businesses and have started securitising the loans – rings a bell? Poor credit risk assessment processes led to the first defaults, the departure of the CEO and a 25% share price drop. Compliance started to take its toll as the company grew. To command a technology startup valuation multiple, revenue growth requires LendingClub to accept an ever increasing volume of loans (new loans account for 90% of revenues), including riskier ones. And the company proved sensitive to credit cycles. As a solution, LendingClub started taking retail deposits to channel them towards its lending platform – basically what a traditional bank does, with a tiny bit of software on top. No quite disruptive any more.

Historical evolution of LendingClub's share price. A slow descent into hell... Sources: Yahoo Finance, author analysis
Historical evolution of LendingClub’s share price (in USD) since IPO. A slow descent into hell… Sources: Yahoo Finance, author analysis

In the meantime, regulators across the world are running behind and have not proposed a robust framework to monitor this new array of services yet – raising the risk to “systemic stability”.

 

4. Banks desperately looking for yield

Banks are by far the biggest losers of the negative interest rates policy implemented by Central Banks across the world. Their deposits do not generate any revenues any more. Worse, they are a source of cost. Given that very few banks have dared passing the cost through to the customer yet (i.e. charging current accounts), banks are now looking for more profitable investment to make up for the difference – notwithstanding the fact that banks have been massively streamlining their teams over the last 12 months. This implies taking more risks.

O&G companies for instance were granted higher quantums of debt at the time oil was getting close (or above) $150 a barrel – especially those involved in shale gas production. Those quantums backfired when the barrel dropped by more than 80% – shale gas then became almost unprofitable to produce. Despite the recent correction, the O&G industry has been suffering a series of bankruptcies as a result – 42 last year alone. In the US, car loans, student loans and credit cards balances and delinquency rates are also reaching abnormally high levels according to Le Figaro. By willing to invest at all cost, banks are becoming less and less concerned about the quality of their customers.

 

5. Housing market engineering is back in the game

I thought the 2008 mortgage subprime crisis would repel investors from the housing market for a while. I was wrong.

collapsinghouse
Credits: www.polizeros.com

According to TechCrunch, Opendoor, a company founded in 2014, “currently buys homes sight unseen when a home seller visits its site, asks for a quote, and accepts Opendoor’s bid, which the company comes up with based on public market information about historical home sales and its own proprietary data about market conditions”. Fortunately, the company selects its investments, not purchasing “any home built before 1960 [or] homes outside a $100k-$600k price range” – according to TechCrunch this still means that 90% of homes are eligible, so the criteria are not that drastic after all…

The startup’s balance sheet is currently worth “hundreds of millions of dollars”. Talking about profitability, its CEO “Opendoor isn’t focused on [profitability] just now”. Let us hope for them that the housing market does not decide to spiral down again.

 

Some hope: Investors seem to have learnt (part of) the lesson

After a euphoric 2015, investors seem to wake up (some of them hungover) and are becoming more realistic about the true potential of ‘disruptive’ investments.

First, raising equity has also proven increasingly difficult for startups since the beginning of the year, especially for those seeking very large cheques (greater than $100m). In Q1 2016 $25.5bn got invested in startups globally, an amount down 8% yoy. When they manage to do so, the financing package comes with increasing strings attached, even for well-established brand names. The bond Spotify issued in March contains an ‘bomb-ticking’ interest rate which strongly incentivises shareholders to look for an IPO in the short to medium-term – in substance, creditors are asking the company to become palatable for the stock market as a whole and not just a series of cherry-picked investors.

logoSecond, the ‘real’ value of existing investments is being re-assessed. BlackRock, for instance, decided to cut its valuation of DropBox by 20% last October. Rocket Internet, the controversial startup studio, lost 18.5% of its equity value in two days in April after it revised the valuation of some of its investments downwards. On a side note, Carl Icahn, the famous activist investor, recently revealed that his fund Icahn Enterprises had a net short position of 149%.

Donald_Trump_August_19,_2015_(cropped)Politics is also joining the party. In the US, the Presidential Election held later this year represents a clear source of uncertainty. Candidate Trump has already declared that “we [were] in a bubble right now” and has been criticising the role of the Fed in the construction of that bubble. The kind of mitigating action that Mr. Trump would implement to negate the bubble still remains unclear at this stage.

Credits: www.fineartamerica.com
Credits: www.fineartamerica.com

What’s next? Because of the excessive amount of liquidity in our economy, value destruction has reached a scale never witnessed before. This is clearly not sustainable. When the liquidity tap will stop flowing, there will be boats left stranded on the shore. But to which extent? Will we ever come back to a pre-crisis environment? I do not believe so either. As I mentioned in an earlier post, I think the answer is in-between: we need to give birth to a ‘new normal’. I fear, however, that the delivery will not be painless.

‘Irrational Exuberance’ striking again?

Prof. Robert Shiller
Prof. Robert Shiller

I thought today’s economic environment was perfect to reread Irrational Exuberance, the book written by Nobel Prize-winning Yale University professor Robert Shiller. Prof. Shiller made himself known to the general public by predicting the ‘dot-com’ bubble in the 2000s as well as the housing market collapse in 2007-2008. Coincidentally, no later than last year Prof. Shiller granted us with a third revised edition of his book which analyses the two aforementioned events to identify behavioural patterns leading to market instabilities.

Chapter Four, ‘Precipitating Factors: The Internet, the Capitalist Explosion, and Other Events‘, lists and discusses the triggering factors that were specific to the economic context at that time. The section entitled ‘Twelve Precipitating Factors That Propelled the Late Stages of the Millennium Boom, 1982–2000‘ resonates way too well in the light of the rise of ‘disruptive’ technologies and social media. Below are some quotes which I found particularly striking.

Because of the vivid and immediate personal impression the Internet makes, people find it plausible to assume that it also has great economic importance. It is much easier to imagine the consequences of advances in this technology than the consequences of, say, improved shipbuilding technology or new developments in materials science. [...] It could not have been the Internet that caused the growth in profits: the fledgling Internet companies were not making much of a profit yet. But the occurrence of profit growth coincident with the appearance of a new technology as dramatic as the Internet created an impression among the general public that the two events were somehow connected.

Do not get me wrong: some of the largest technology companies (by market capitalisation) completely justify their valuation because of the value they create. Nonetheless, one cannot help but think that some of the technology-related ventures created over the last couple of years (with a special attention to loss-making ‘unicorns’) were lifted by the abundance of liquidity in the market and the investors’ search for yield in a depressed environment.

New technology will always affect the market, but should it really raise the value of existing companies, given that those existing companies do not have a monopoly on the new technology? Should the advent of the Internet have raised the valuation of the Dow — which at the time contained no Internet stocks?

The impact of social media and ‘Uberisation’ still remains to be quantified, as the impact of the Internet was in the early 2000s. But here again caution is paramount. As an example, asset-light Fintech companies were expected to put the traditional banks out of business. We now see that those companies have benefited from an extremely favourable credit environment and struggle as soon as the tailwinds fade.

What matters for a stock market boom is not, however, the reality of the Internet revolution, which is hard to quantify, but rather the public impressions that the revolution has created. Public reaction is influenced by the intuitive plausibility of Internet lore, and this plausibility is ultimately influenced by the ease with which examples or arguments come to mind. If we are regularly spending time on the Internet, then these examples will come to mind very easily.

This sentence is very applicable to today’s trend. A vast majority of the successful emerging companies target the B2C market and actually very often make the ‘B’ closer to the ‘C’ by ousting intermediaries – think about Uber or Deliveroo. The change has settled in our everyday life, which makes the examples even easier to remember.

Anticipation of possible future capital gains tax cuts can have a favorable impact on the stock market, even when tax rates actually remain unchanged. From 1994 to 1997, investors were widely advised to hold on to their long-term capital gains, not to realize them, until after the capital gains tax cut.

Calls for a fiscal stimulus as a way to reinforce the already-implemented monetary ‘quantitative easing’ have been growing. Although in the UK the next budget will only affect the corporate tax rate, investors are right to believe that the fiscal burden may loosen soon on capital gains as well.

Although there is no doubt at least some truth to these theories of the Baby Boom’s effects on the stock market, it may be public perceptions of the Baby Boom and its presumed effects that were most responsible for the surge in the market.

Structural drivers such as demographics are indeed among the most popular discussion topics when it comes to predict the outlook of both the stock and the housing markets. Prof. Shiller nonetheless warns us that our (sometimes) self-fulfilling anticipations and expectations may actually be stronger than the real effect.

As further evidence that the media growth was boosting the stock market, we now know that after the peak in the market in 2000, business reporting took a major hit in reaction to declining public interest. Hip business magazines like Red Herring, the Industry Standard, and others went out of business.

As sole writer of this blog I have to plead guilty. As many other media, I have probably paid a disproportionate amount of interest to the evolution, past and future, of the housing market.

In a non-experimental setting, where people’s focus of attention is not controlled by an experimenter, the increased frequency of price observations may tend to increase the demand for stocks by attracting attention to them. [...] The rise of gambling institutions, and the increased frequency of actual gambling, had potentially important effects on our culture and on changed attitudes toward risk taking in other areas, such as investing in the stock market.

Our environment, including social media conversations, provides us with many opportunities to be part of the stock market ‘game’ and many platforms have leveraged the parallel with gambling, making their platforms increasingly entertaining.

In a survey of home buyers in 2004, Karl Case and I asked: “Do you worry that your (or your household’s) ability to earn as much income in future years as you expect might be in danger because of changes in the economy (someone in China competing for your job, a computer replacing your job, etc.)?” Nearly half of our 442 respondents (48%) said they were worried. Some of them said that one motivation for buying their house was the sense of security that home ownership provides in the face of the other insecurities. [...] One might call this a “life preservers on the Titanic theory.” When passengers on a ship think the vessel is in danger of sinking, a life preserver, a table, or anything that floats may suddenly become extremely valuable, and not because these assets have changed their physical attributes. Similarly, at a time when people are worried about the sustainability of their labor income, and there are not enough really good investment opportunities, they may tend to bid up prices of all manner of existing long-term assets in their efforts to save for the dangerous lean years seen ahead. They may not manage to save more in real terms. They may hold such assets even if they now believe the assets are overpriced and in danger of losing value in the future.

The sense of geopolitical and economic insecurity remains persistent – today a poll revealed that 86% of French people believed that the situation “had not improved for the French population in general”. In that context individuals tend to rely on ‘safe’ investments such as real estate and bonds, despite the very poor returns offered by the latter.

Sans titreWill we witness another 2000-type market crash in the short-term? I do not believe so. However, I do think that the Central Banks’ decision to open the liquidity tap to an extent never been witnessed before has led investors, i.e. the general public, to increasingly disconnect their thinking from the real fundamentals of our economy. The way the two converge again will tell us whether we are heading towards a ‘soft landing’ or a ‘bubble burst’.

Housing market update: testing the foundations

Credits: www.christart.com
Credits: www.christart.com

This post extends the series on the UK housing market which is one of my favourite topics, as you may have guessed by now. In earlier posts I discussed the impact of the stamp duty, clumsy real estate agent advertising and future house price trends in London. Today’s update brings a political flavour to the analysis, with Brexit as an obvious figurehead.

I think that a vast majority of industry experts would agree to state that the apparent uncertainty surrounding Brexit – although this uncertainty is largely a statistical artefact – has cooled down the real estate market. Although transaction volume is not officially monitored, this impression is supported by anecdotal evidence: estate agency Savills reported a 6.7% price drop in London’s prime residential areas compared with 2014, with more than half of homes being sold at a 10%+ discount. The momentum has started percolating to lower price layers, with inflation for homes in Central London costing £500k to £1m now standing at 3.4% over the last year. Commercial real estate is also affected, with investment in central London office buildings dropped 52% quarter-on-quarter. Some readers will recall that the market experienced similar turbulence in the weeks leading to the referendum on Scottish independence in 2014.

Nonetheless, the core of the market remains largely untouched. Prices throughout the UK in general, and in London in particular, still show vigorous growth, which tends to indicate that structural house undersupply largely remains a reality.

Mix-adjusted annual house price change by region as of Feb 2016. Source: ONS.
Mix-adjusted annual house price change by region as of Feb 2016. Source: ONS.

Brexit may come on top an artificial rush generated by the increase in stamp duty on buy-to-let and second homes, which led some investors to bring forward their purchase intent to Q1 2016, as demonstrated in an earlier post.

split_3540850b
Zac Goldsmith and Sadiq Khan. Credits: www.telegraph.co.uk.

On the supply side, political uncertainty also takes its toll. Brexit but more importantly London’s mayoral elections have strongly builders to ‘sit and wait’. The Financial Times reported that London boroughs approved 64% fewer homes in Q1 2016 compared with Q1 2015. This does not help.

On the investment side, strategies vary depending on the investor’s mandate. Property funds have been forced to partly withdraw from the market, sometimes crystallising losses, to face increasing outflows and form a sizable ‘war chest’ in case a major bank run happens post-Brexit – public trust in those funds took a hit when some of them had to forbid redemption during the darkest moments of the financial crisis. Conversely, more agile private investors are trying to take advantage from the current feebleness whereas more established institutional buyers’ field of action is restricted by their Boards.

1280px-Barclays_logo.svgFinally, in an environment where investment-grade bonds yield no (or even negative) interest and equity markets have struggled to find momentum, banks rely more than ever on the ‘power of the stone’ to generate satisfactory returns. Yesterday Barclays announced that it relaunched 100% mortgages, a product that got discontinued in the aftermath of the financial crisis, in a hunt for yield – fixed-rate mortgages start at 2.99%, not a bargain by today’s standards. Given that this mortgage can only be activated with a 10% deposit from a guardian, this mortgage is particularly aimed at younger buyers that recent price increases have excluded from the property ladder.

Share of borrowers under 25 within the first-time buyer population. Source: ONS.
Share of borrowers under 25 within the first-time buyer population. Source: ONS.

One cannot forget, however, that London remains one of the most expensive cities in the world, only trailing Hong Kong according to UBS’s well-named ‘Global Real Estate Bubble Index‘, which states in its 2015 edition that “the [London] housing market is in bubble-risk territory“.

Price-to-income benchmark for selected cities. Price-to-income is defined as "the number of years a skilled service worker needs to work to be able to buy a 60 sq. m. flat near the city center". Source: UBS Global Real Estate Bubble Index.
Price-to-income benchmark for selected cities. Price-to-income is defined as “the number of years a skilled service worker needs to work to be able to buy a 60 sq. m. flat near the city center”. Source: UBS Global Real Estate Bubble Index.

Monitoring house prices as the political dust settles will solve the conundrum. Only then will we indeed be able to understand if the London housing market has reached an inflection point or if the political milestones paving the first half of the year were mere bumps on the road to continuing inflation.

bubble204
Credits: http://fixingtheeconomists.wordpress.com

Stamping the housing market

Credit: www.thisismoney.co.uk
Credit: www.thisismoney.co.uk

Last week the Financial Times used the latest Office for National Statistics (ONS) housing price figures to assess the impact of the stamp duty raise on the housing market. Since the beginning of the month, purchasers of buy to let property and second homes indeed face a 3% stamp duty surcharge. Some experts believed that prospective second home buyers would rush to complete their transaction before the deadline and would thus generate an artificial and temporary price increase.

The FT article took the opposite view and concluded that “UK house price growth weakened slightly in the year to February, to 7.6 per cent […] meaning that a boost reported by mortgage lenders and estate agents ahead of stamp duty changes for buy-to-let investors is yet to show up in official data”. This statement surprised me and I decided to dig further into the data. My take is the following: although the statement may be true at a global level, by performing the analysis for each Government Office Region separately, one could conclude that the impact of the stamp duty reform was actually much more significant.

k12985080To perform this exercise, I used two publicly available sources of data:

  • ‘Number of residents with a second address in a region, who are usually resident outside of that region’ and ‘Number of usual residents in a region with a second address outside of that region’ as per the 2011 census;
  • ‘Mix-adjusted average house prices by region’ published monthly by the ONS.

First, we need to understand that all UK regions are not equal. The more second houses a given area hosts, the more impact the stamp duty reform should have had. The most recent information on the topic comes from the 2011 Census which gives us the number of residents elsewhere with a second address in a given region – e.g. in 2011 184,616 people had a second address in the South East.

Untitled
Number of usual residents elsewhere with a second address in the area (2011). Source: 2011 Census

Separately, the ONS data gives us the year-on-year house price evolution in each area from July 2015 to February 2016.

Year-on-year housing price evolution by region. Source: ONS
Year-on-year housing price evolution by region. Source: ONS

Nonetheless we are not interested in the price growth rate but by the increase of the growth rate as the stamp duty implementation deadline approaches. I have therefore compared the average housing price increase (in percentage points) in January and February 2016 with the one witnessed in July and August 2015 in each region – I have taken a two-month average to smooth out any shock. The analysis shows wide discrepancies between regions – for instance the growth rate increased by 5.0 percentage points in London over the period but actually decreased by 2.7 pts in Yorks & Humber.

Untitled
Increase in housing price growth rate by region, January-February 2016 vs. July-August 2015. Sources: ONS, author analysis

Finally, I look for a correlation between the number of second addresses and the increase in housing price growth rate.

Untitled
Correlation between housing price growth rate increase and number of second addresses

The correlation between the two variables is clear and we could therefore conclude that the stamp duty change has ‘warmed up’ the housing market in the regions with a high number of second addresses. The stamp duty effect was indeed pushing buyers to complete the transaction as fast as possible, even if it meant paying a higher price (up to 3% more actually). The surge in gross mortgage lending witnessed in March by the Council of Mortgage Lenders supports this conclusion. On a side note, this is another piece of evidence illustrating the fact that the UK housing market remains a ‘seller’s market’ – in a ‘buyer’s market’ you would have conversely seen a drop in prices as sellers try to get rid of their property before having to pay the surcharge.

Stamp_Duty_Paid_mark_for_British_cheques_from_1956It would be interesting to keep an eye on the market prices in the future. Given that purchasers have by definition a limited purchasing power, was the bump just bringing forward future increases (in that case the market should cool off for at least a few months) or will future sellers be able to maintain enough competitive tension to use the ‘overheated’ prices as the new normal?