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.

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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

Watch the step – Paradigm shift ahead

Have you fastened your seat belt?
Have you fastened your seat belt?

Last week the IMF downgraded its global growth forecast for 2016 to 3.4%. Among the developed economies, only the US and the UK show encouraging signs, with forecast growth of around 2.4% for this year. Growth remains limited despite abnormally low interest rates and a debt stock only seen in a WW2 context which low inflation cannot clear. Such a sequence of bad news could trigger only one question: is the ‘crisis’ back?

Advanced economies' debt amount as share of GDP. Source: Le Figaro.
Advanced economies’ debt amount as share of GDP. Source: Le Figaro.

The commodity price drop witnessed at the beginning of the year has taken its toll on the lending and bond side. 46 corporate borrowers have already defaulted on a total of $50bn of debt so far this year. According to the Financial Times, more than 80% of investors expect the default rate on junk-rated companies to reach at least 5% by year-end. This has already caused the liquidity on the bond markets to dry up, practically barring the weakest companies from accessing fresh capital inflows. Private equity sponsors, which are well known for making highly-leveraged acquisitions, have seen the default rate for their leveraged loans go from 0.88% on 31 January to 1.46% as of 31 March. Again, this tightness happens at a time of very affordable debt, which can make us fear the time when Central Banks will sketch a move back towards positive interest rates territory. At a country level, lending from the World Bank has reached its highest level since the aftermath of the 2008 financial crisis. “It is our highest lending in a non-crisis period ever” added the World Bank’s president. If we are not in a crisis then where are we?

What is certain is that the root causes have been identified for months: “sluggish capital investment, falling industrial production and declining business confidence” which partly feed themselves from geopolitical uncertainties (Brexit currently topping the agenda) and a lack of politically supported structural reforms – on the latter, we cannot blame politicians for favouring electorate-friendly measures over high-risk initiatives one year before reelection time.

Three leaders that put their job back in play in 2016 and 2017
Three leaders who will have put their job back in play by 2017

To solve these issues, all only have one word to say: ‘GROWTH’. The IMF estimates that one additional point of growth would enable the advanced economies to bring their indebtedness ratio to pre-crisis levels. But experts strongly diverge on practical ways to get hold of this extra growth.

Although many lights are red-flashing on the world economy dashboard, I agree with IMF’s Jose Vinals and I do not believe we are heading towards a ‘sudden’ crisis of the type we faced in 2007-2008. I nonetheless think that we are entering a world where low growth and low inflation will become the new norm –

Olivier Blanchard
Olivier Blanchard

former IMF Chief Economist Olivier Blanchard writes about a ‘weak recovery‘ situation. Once decision makers and Central Banks will have realised that achieving 2% of inflation annually is not realistic in a world where innovation builds on limited capital accumulation, where disruption takes place through not only better features but also lower prices and therefore drag inflation down (take the example of Airbnb or Uber) and where 5 out of 10 America’s fastest growing jobs pay less than $25k a year, the money tap will stop running, there will undoubtedly be a few winners but many more clear losers. And the interest rise wall can be closer than we think: in the video below, US Federal Reserve Chair Janet Yellen justified the December 2015 rate increase by the fact that labour statistics were positive – still the case as the US is experiencing its longest-ever streak of private sector job growth ever – and that “the Federal Reserve was feeling reasonably confident in the fact that inflation would move up over the medium-term back to 2%” – i.e. there is no need for inflation to reach 2% for rates to go up again.

The big question is now if the paradigm shift happens, how will it do so, and which target will Central Banks will be asked to go for. A brand new uncharted territory for the economic theory to discover.

A plan B for point C

Credits: www.edfenergy.com
Hinkley Point C (artist view). Credits: www.edfenergy.com

The debate about Hinkley Point C, although not new (the project has been on the table since 2008), has got passionate over the last few weeks, involving incessant decision adjournments, a CFO resignation, diverging positions from two engineering groups both operating within the same company as well as the usual high volume of well-intentioned statements from politicians sitting on both sides of the Channel. The current situation stakeholders are facing could appear surprising and complex; however, this tension could have been forecast from the beginning by simply paying attention to each one’s incentives.

For the UK government, for instance, the optimal behaviour is straightforward: they should keep championing the project, which features as a prominent part of their ‘cleaner’ energy strategy – the UK government intends to cut carbon emissions by 60% by 2030 – and acts as a strong relationship builder with China – which indirectly owns one third of the project. Furthermore, under the current contract terms, the UK government does not bear any financial risk linked with the construction of the plant – actually, the longer the delay, the higher the compensation penalties EDF will have to pay. The only itching point is the high purchase price promised to EDF for the electricity generated: £92.50/MWh, i.e. more than twice the current electricity wholesale price and the equivalent of $150 per oil barrel according to Deutsche Bank. That being said, the first bill will not come before 2025, which leaves room for 2 successive governments, including the current one, to put this point back on the table as (and if) the project moves forward.

FLA220-079
EPR project in Flamanville (France)

For EDF Energy’s employees, the situation is as straightforward, but in the opposite direction. Combined together, the size of EDF Energy’s initial financial commitment (£18bn), the back-and-forth movements the Hinkley Project has been subject to as well as the unproven nature of the European Pressurized Reactor (EPR) technology and the delays that the other projects using the same technology are facing throughout the world appear as great ingredients for a disaster recipe which could wipe out a significant portion of EDF Energy’s equity value – Areva_Logo.svgvalue which already got weakened by EDF Energy’s acquisition of Areva’s distressed nuclear reactor business in January. That is in substance the point Thomas Piquemal, EDF Energy’s CFO earlier this year, defended to the extreme by summarily resigning last month – pouring additional oil on the fire.

Delays and overruns of EDF's other 2 EPR projects. Source: Financial Times
Delays and overruns of EDF’s other 2 EPR projects. Source: Financial Times

China General NuclearDespite its strong financial interest in the project through General Nuclear Power Corporation, the Chinese government has stayed mum. At first sight, this is surprising. With hindsight, it clearly appears that the Chinese stakeholders do not need to make any effort or take any decision. Financially speaking, they are in the same boat as EDF Energy, which also needs to fight to defend its wallet. Politically speaking, the Centrica withdrawal has reinforced their minority investor position. As a first-of-a-kind cooperation in the nuclear energy sector between China, France and the UK, one can expect that the last two will do anything to keep the relationship afloat.

Dr-Jekyll-y-Mr-HydeThis leaves us with one torn – and sometimes schizophrenic – entity, namely the French government. The ‘Dr. Jekyll and Mr. Hyde’-type behaviour of the French State as shareholder is not news and already got criticised by the Cour des Comptes in 2008As a 85% equity holder in EDF Energy, it should depress the brake pedal. The project’s current estimated return on investment (9.2%) is not exceptional and relies on (i) the perfect completion of the project from now on and (ii) unchanged energy purchase prices from the UK government, two factors whose strength is not unquestionable and which have already been flagged by the Cour des Comptes, France’s state audit body. The government seems to have already forecast trouble ahead by indicating that it could inject fresh capital into the company. As a champion of French industrial excellence, it should push the accelerator. Hinkley Point C is a massive project that could showcase the French capabilities in last-generation nuclear power plant building, an increasingly competitive arena, while strengthening our ties with the ’emerging world’, whose energy needs will undoubtedly be called to further grow over the next decades. Last but not least, the government pushing for the project will not be the one paying for damages at completion – in 2025, President Hollande will not be in office any more. Unfortunately, any driver will know that pushing the brake pedal and the accelerator at the same time makes a car spin

Credits: www.autoracingf1.com
Credits: www.autoracingf1.com

So where do we go from here? The usual three options are envisaged: Hold, Drop and Change. The first one is the official line, championed by governments as well as EDF Energy’s CEO, and consists in keeping the project going as it is, despite all the risks previously highlighted. Others call for a full withdrawal of the project which would open the door for renewable energy and alternative nuclear power plant builders, although this would entail significant adverse consequences on UK’s future energetic independence, on the ability of France to remain a nuclear know-how pioneer and on the appetite for Chinese investors to support and collaborate on large projects in cutting-edge industries. Finally, the most reasonable option could involve a further delay to enable engineers to design an alternative solution, made of a number (4 to 6) smaller and thus more highly mastered plants. This would enable France to save face while minimising the risk of failure. The latter option seems to gain momentum following the publication of an internal white paper written by senior EDF engineers late last month.

27976819-Un-match-de-bras-de-fer-de-bande-dessin-e-avec-l-homme-mince-vaincre-l-homme-muscl--Banque-d'imagesThe Hinkley Point C project is an interesting example of apparent conflict between politic imperatives and economic logic. The next few weeks should indicate us which side (if any) takes over.

A budget for “the next genera(l elec)tion”?

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Credit: www.thisismoney.co.uk

On Wednesday the Chancellor of the Exchequer George Osborne announced the budget for the fiscal year 2016-2017, a “Budget that puts the next generation first”. The content and the form of this speech have been widely debated in the press already. Without repeating what has already been written, here are a few thoughts:

  1. Brexit has definitely taken its toll. This is the first budget speech since the overwhelming Tories victory in last year’s general elections. With the House of Commons under their control, the context was ideal to outline an ambitious budget instead of delaying the bulk of the government budget rebalancing effort to the end of the parliament – we are talking about a £32bn reduction in Public Sector Net Borrowing (PSNB) between 2018-2019 and 2019-2020. An interesting analysis compiled by Torsten Bell for NewStatesman and reproduced below shows that PSNB is only reduced the year after general elections, and tend to soar the year before. And yet, the next general election is planned for… 2020. Unfortunately, Mr. Osborne as well as the rest of the Tories establishment will bet their political future in 3 months’ time. If the UK gets out of the EU, this future will be rather short-lived. As a consequence, this budget speech was partly design with the intention of rallying the Eurosceptics, especially those living outside London – hence the focus on the importance of devolving power to “our nations” and the lengthy discussions on local issues such as “enhanced capital allowances to the enterprise zone in Coleraine” or the “upgrade [of] the A66 and A69”. The Chancellor made use of the carrot but resorted to the stick as well, warning that the Office for Budget Responsibility (OBR)’s growth forecasts, and ultimately the budget equilibrium, were based on the assumption that the ‘Remain’ vote would win in June.
Credit: NewStatesman
Source: NewStatesman.com

2. Raising a fiscal surplus – Mr. Osborne’s self-imposed mantra – is an unpredictable mission, especially when the goal is positioned in a distant future. According to the OBR, by 2019-2020, all the efforts outlined by the Chancellor will only offset the drop in fiscal receipts generated by the latest OBR’s GDP growth forecast reduction (0.5% p.a.).

Changes to public sector net borrowing in 2019-2020
Changes to public sector net borrowing in 2019-2020

Furthermore, there is a very high chance of seeing the forecast revised again multiple times over the next few years, making the target even harder to hit. Finally, history has demonstrated that a higher than expected growth rate does not always lead to lower borrowing.

3. Similarly, the PSNB will largely depend on the uncertain evolution of the Bank of England’s interest rate. Unemployment at a 40-year low and wages growing by 2.1% over the last 12 months could well translate into sustainably higher inflation in the medium-term – the Chancellor indicated that it was forecast to reach 1.6% next year -, which would ultimately force the Bank of England to raise the cost of money. With a debt to GDP ratio approaching 85%, public finances would obviously be significantly impacted by such a change.

4. For the reasons listed above, some aspects of this budget appear as slightly unexpected and Mr. Osborne could well hide a different political agenda. Two options come to mind immediately. The first is that Mr. Osborne will resort to the same tactics towards Brexit as the one he used last year in the aftermath of the general elections, by issuing a revised budget as soon as the vote outcome is known – although this could come at a possibly unbearable political cost. The second option is that, as hinted by George Eaton, Mr. Osborne is actually preparing the ground for an early election which could free his hands to achieve his massive PSNB reduction ambitions in 2019-2020.

You can watch the replay of the Budget Speech below: