Reiterate UK sell – prospects dimming fast 20220920

Since our 13^th May bearish call on UK property, things have not improved on any front, and in this report we update some important macro factors that have either added or worsened the property headwinds the UK is facing. We urge investors to speed up their disposals before it is too late to do so.

Several of the key factors impacting the outlook of UK, and in a sense Europe at large, continue to play out and the current lull (helped by both summer warmth and a temporary correction in energy prices) may reverse unexpectedly when winter arrives. Here are what could happen:

1. Energy starvation undermines livelihoods, triggers civil unrests?

The unfortunate situation Europeans find themselves in can best be described as  a combination of: a) political grandstanding in Ukraine where sanctions beget retaliations (energy & food shortage) from its biggest supplier (Chart 1), while b) the zealous embrace of fundamentalist ‘green’ energy policies without having backup plans worsens the hardship that can potentially explode on to the scene.

Chart 1: Nordstream gas turned off – is it lights out for Europe? Source: Nord Stream AG

Focusing just in the UK, our subject market, where 40% of electricity is generated from natural gas in 2021, the energy bills for households and businesses are going vertical (Chart 2). An outcome that would have been avoided if the UK did not gleefully hitch the joy ride that expansionist/hawkish US / Nato policies brought about when diplomatic solutions have been in place since 2014 (ie the Minsk Agreement brokered by France and Germany).

Chart 2: UK gas prices tripled vs a year ago

Chart 3: UK electricity price highest in Europe

Now European countries not only have to suffer manufacturing stoppages due to energy shortage, but also issue even more debt to relieve household energy hardships at a time when cost of funds are exploding (more below), all while spend unnecessarily on a costly arms race in an unnecessary war which benefits mostly foreign (ie US) energy and munitions producers. This is as close to a perfect storm as it gets, coming on the heels of devastating lockdowns that has destroyed the SME sector in the past three years and ushered in record high inflations (also expanded later, Chart 3) even before the war began…

Chart 4: UK inflation: tracking the the crazy 70s inflationary cycle?

2) Interest rates bursting out of CB control

As the Fed aggressively pursues neutralising rates after years of QE, the rest of the world is dragged along with it, with many EM countries flirting (if not already in) double digit interest rates territory. In the UK alone, it is widely expected now some 250bps of hike is on the cards by Q3 2023 (Chart 5), we fear that might appear mild if the sovereign debt crisis worsens.

This will force a repayment crisis for any home owner on high LTVs who will already be seeing their disposable income drop due to high inflation.

Chart 5: Central bank rates in the west projected to hike

Chart 6: rental yield lagging mortgage – negative for prices

As a result, property yields will have to rise either through big rental hikes (eg in Chart 6 above, c.60% if prices were to stay flat) or some meaningful price corrections heading into 2025. This hike in funding costs will hit even owner occupiers (who may be less concerned with yields discussed just now), as their repayment instalments have only just taken off, and could see multi-decade highs ahead, here is a taste of the rapid ascent and what it looks like:

Chart 7: UK mortgage rates by LTV levels - variously at new highs since 2002-2015

3) Economic shrinkage unavoidable? Unrest/war wildcards on top…

Given the set up of these very unpalatable cocktail, it is unsurprising that our sentiment momentum tracker is suggesting price drops into H2 2023 (Chart 8) and finance directors are getting more bearish (see Chart 9 – again, we expected weaknesses ahead back in May, but this may persist for a few more months to come), which can spell trouble for investments and consumption ahead.

Chart 8: Fast dropping PMI bodes ill for home prices

Chart 9: CFO survey – weak sentiments weakening further

To put all of these indicators on one consolidated view, it is helpful having our ‘stagflation chart’, which encapsulates both the expected weak (if not negative) household income growth and rising unemployment, we see a lot of downside risk indeed:

Chart 10: Stagflation flags point to real home price to fall in 2023-24

4) The weaker the GBP, the more imported inflation – a vicious cycle?

On top of the lacklustre macro picture overall, the currency headwinds are not to be overlooked either – as UK suffers the multiple disadvantages of wrong geopolitics and woke/green misadventures, less investment will head for the British shores, or if there were fleeing EU money, they may bypass the British Isles this time and head straight for the USA instead.

What this means is that, especially for foreign investors (which is everyone buying UK property from HK), more currency losses are possible on top of price drops in local currency terms. In fact latest falls in GBP has broken a long term support level that hs held since the 1980s:

Chart 11: GBP could fall another 25% by 2025 after piercing long term support

With this major technical breach, we could be looking at the pound reaching 80 cents on the dollar within the next two years, or another 25% devaluation. A familiar Christmas carol paints a serene scene like this:

In the bleak mid-winter
Frosty wind made moan;
Earth stood hard as iron,
Water like a stone;
Snow had fallen, snow on snow,
Snow on snow,
In the bleak mid-winter
Long ago.

Let’s hope this scenario does not come true this winter…and the politicians will have the wisdom to reverse so many bad policies that could result in just such a bleak mid winter indeed.

201401 - Outlook of UK property market amidst slow growth and tax crackdown

Below is the English translation of an article published in the January 2014 issue of HKEJ Monthly:


Outlook of UK Property amidst slow growth and tax crackdown

In recent months it seems, whichever direction one turns, from newspapers to letterboxes and even email inboxes, overseas property sales advertisement are omnipresent – be it familiar markets such as UK/US/Australia/Canada, or Singapore/Malaysia, even depressed Japan, or the sovereign debt troubled Spain/Portugal seem to be selling properties in Hong Kong.

However, buying property long distance already increases risks, let alone acquiring real estates located in places of different languages or unfamiliar commercial/legal cultures. Extra due diligence is therefore paramount to investment success. The writer tries to stick to markets which are easier to understand, and the one top of the list has to be UK. This article tries to look into various fundamental factors in an attempt to increase readers’ odds should they be looking at overseas property investing.

Where stands the UK property cycle?

The key advantages of investing in property are its long cycles, and the lack of market/insider manipulation like in investing in securities. As a result, one only needs to invest at turning points of these cycles to generate long term and repeated above-normal returns. Besides price cycles, another important indicator is affordability, below we look at the UK market from the point of view of valuation to determine if it still is a good time to take a plunge in this market.

Home price to income seem expensive, but mortgage affordability remain good

If left untouched, the free market would have allowed prices to rise and fall by the balance of forces between supply and demand, however, since the global financial crisis (GFC), all governments around the world seem to have taken on the role of God, trying all means at their disposal to prop up all sorts of asset markets. The result is the loss of the price discovery mechanism and a general loss of information content in whatever prices we see being transacted. In the case of the UK property market, what should have been a 50% fall in price seemed to have been arrested by the combination of zero-interest rate policy (ZIRP), quantitative easing (QE), and fiscal stimulus (such as Help to Buy), resulting in a rebound in prices after barely a 25% drop.

Currently, average home prices in the UK are equivalent to 4.67 years of the average full time worker’s income (Chart 1), and looks set to continue rebounding some 7% in the coming year, with a chance of breaching the bubble high levels last reached in 1988/9. This bounce in the national prices are too modest compared to London home prices, which helped by external demand (of which China/HK money rank amongst the top sources), safe haven effect (i.e. all European countries hit by tax hikes and banking crisis, such as France, Greece, Spain), has been rebounding strongly since back in late 2009, to have risen over 30% against income levels. London’s price to income multiple now stands at 6.06, and could well reach the top of the historic range around 2016 (Chart 2).

Exhibit 1: UK house price to earnings ratio

Exhibit 2: Greater London house price to earnings ratio

Whilst expensive in price-income multiple terms, housing valuation needs also to be viewed in the context of mortgage affordability (i.e. what proportion of monthly income is used towards mortgage repayments). In this measure, the central bank’s ZIRP has helped a great deal, and alongside recovering lending appetites amongst banks, mortgage costs have steadily fallen in the past year, leading to the UK mortgage affordability measure nearing historically low levels, and at almost one standard deviation below historic averages (Chart 3).Over in London, the stronger rises in prices have more than offset the magnitude of falling interest rates, resulting in the London mortgage affordability measure rising for two years in a row – even with another 16% rise in prices, the measure only just returns to the historic average line (Chart 4).

Exhibit 3: UK mortgage affordability

Exhibit 4: Greater London mortgage affordability

The above two sets of charts clearly illustrate that, without forceful administrative intervention, UK home prices had more to fall; however, with interventionism and political populist very much the mainstream philosophy, adding to that uncertain pace of economic recovery, government support for the property market will likely remain the main factor influencing home prices.

Home prices not attractive if income and rental yields are factored in the equation

In order to combine the income and interest sides of the analysis employed above to look at the whole picture, we can combine the key home price drivers – income, interest rates, and rental yields – into a ‘composite valuation index’ to reach a result akin to that shown in Chart 5. Unfortunately, despite recovering income and suppressed interest rates, rental yields have also fallen, resulting in the composite valuation index to reach levels similar to the 2007 top already!

Exhibit 5: Composite house price index: High

In a still low interest rate environment where government market support is unlikely to withdraw, we are afraid that the trend in the next two years will most likely be higher highs in the composite index, until around 2016 before a correction will be seen.

Tight supply also favorable to home prices

Besides affordability, another key factor driving home prices is supply. In this regards, the tight credit environment and slow economic growth has led to falling completions; this combined with household formation remaining at elevated levels, has pushed up UK occupancy rate back to the range seen in the 90s, or an occupancy rate of 96.6% (Chart 6) – this high occupancy rate will benefit rents and prices alike. Looking at the planning permission figures of the past three quarter, completions will likely stay low in the next six months, at an annual rate of around 150,000, which is significantly lower than the 200-220,000 levels before the GFC. Overall speaking, in the short term, UK supply will likely stay below demand.

Exhibit 6: Supply falls for 2 years, and occupancy rate increases

Exhibit 7: Completions for the 3 quarters will be low

Economic growth – not out of the woods yet 

The greatest challenge to home prices in the future remains low real income growth (Chart 8) which will restrain rental increases and therefore property prices. Further, fast paced economic growth seen in the UK since the 80s (i.e. the portion above the dotted line in the chart) may have coincided with financial sector deregulation (i.e. Big Bang) and the peaking global interest rates in 1980. Both these factors are now in reversal, with no prospects of improvements to help the economy outperform.

Whilst in the short term, low interest rates will continue to provide support, this remains an artificial ‘life support’ mechanism which will one day be taken away, adding to that the spectre of a Euro sovereign debt crisis, risks remain that home prices could mean revert towards income (Chart 9).

Exhibit 8: UK average real disposable income: no longer as strong as before

Exhibit 9: House price growth is higher than the growth of the economy and earnings

Besides troubles in Europe, it seems that the global economic growth engine that is the USA may weaken – after over three years of recovery, the initial jobless claims numbers may have reached a multi-decade low (red arrow in Chart 10). Whenever the initial claims numbers start to enter a rising cycle, stock market indices stagnate or even worse, enter bear markets. So, with the economies of two of UK’s most important trade partners entering a period of high uncertainty, risks also rise for UK’s economy and property market. The question remains of whether: governments allow markets to falter (arrow B in chart) or another round of QE saves the day (arrow A in chart)?

 

Exhibit 10: US job market recovery may be about to end

Fiscal difficulties + popularism = higher taxes have only begun

Another important factor that investors in UK properties need to increasingly take heed of is the implication of structural budget deficits (Chart 11) brought about by high welfare. When government debts are at the highest levels since the 60s (Chart 12), and when interest rates cannot fall further to reduce the debt financing costs, higher taxes may be the only way forward.

Exhibit 11: UK government has been in budget deficit since 1960s except for fiscal year 2000/2001

Exhibit 12: UK net debt will not decrease until 2015/2016 according to Treasury's optimistic prediction

Which sector is most attractive?As is common in many jurisdictions, the need to appease domestic voters will continue to increase as prices rise further, shutting out local potential home buyers. As a result, punitive taxes aimed at overseas owners/buyers (such as the Mansion Tax) will become more severe and more widespread – investors should be prepared for this trend unfolding in the next two years as elections loom.

By this stage, we hope to have highlighted the main pros and cons in investing in UK property. If you have already decided to put money into this market, you will certainly have heard all about buying location and quality (rather than cheap prices). However, it appears that quality and premium products are now reaching levels where the benefit no longer justify the cost – for example, West End prices have already outperformed Greater London by over 30%, and an even more substantial 100%+ when compared to national average prices (Chart 13).

With the rush of overseas buyers pushing prices to unreasonable levels, combined with the government targeting luxury homes (eg those over 2 million pounds), property prices in the more expensive districts have already started sliding, and looks set to continue in this trend to at least the middle of 2014 (Chart 14), if not as far as 2015/6.

Exhibit 13: West end house price increases faster than London and England & Wales

Exhibit 14: West end/London price ratio is high

Given this possible outcome, what you see in your letterboxes (most likely in the most expensive parts of London) will probably not be an outperforming asset in the near future. For good value sectors, office property outside of London may have better upside (Chart 15).

Exhibit 15: UK office price (excluding London) is still cheap

The author wishes to thank Mr Simon Zhu’s help in assisting in the collection and analysis of information used in this article.