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.

UK property – time to sell? [Article 1 of 2] 20220513

 

UK property – time to sell?

UK has been a good market for many HK investors, especially those who bought after the lows of GFC. Your writer has done even better by focusing on fringe markets which continued rising even when the prime central London sector crashed since its peak in 2014 – some popular development projects there having fallen by as much as 50% since:

Chart 1: prime central London underperformed by 14% since 2014 peak vs Greater London…

But with a plethora of negative factors now taking centre stage politically, economically, climatically, and on valuation grounds, we think the prospect of future rises, let alone outperformance, of the UK property market, is now much dimmed. Below is an extract of a longer piece we sent to clients, some key reasons for our cautious views are as follows:

1) Energy / food / hyperinflation => drop in real income, rise in civil unrest

2) Debt explosion + Rate surge undermining returns

3) Taxes must rise to service the rising rates, unsustainable welfare, and military spending

4) International wars cause capital flights (to US/Asia) and disrupt business

5) Chasing out the rich – the selling has just begun? e.g. Superman Li. The Saudis, Russians, and Chinese may not return if the seizure of private assets continue

6) Regulations Overload is becoming unbearable – for property investors

7) Positive immigration inflows may reverse after Brexit

Below we will look at all these factors in more detail.

1) Massive energy/food inflation drains disposable income, may trigger civil unrest?

The UK/EU construct, being heavily manufacturing and trade dependent, cannot afford to lose reliable and cheap energy imports, which was badly hit by supply shortages following covid lockdowns. This is now worsened as geopolitical tensions explode.

Just about every essential commodity, manufactured good, and service (eg imported labour) is now at critically low levels, stoking massive price hikes sometimes in triple digits. For example: reserves of arabica coffee, the higher-quality bean loved by espresso aficionados, have fallen to their lowest level in 22 years… prices on the ICE futures exchange rallied as high as 2.55 in Q1, up 140 per cent from 2020 lows:

Chart 2: Coffee inventory at multi-decade lows, and could worsen further as fertiliser/transport costs continue spiking

There has been widespread coverage of the energy shortage and price spikes so we will not go into detail here, one example being ominous The Telegraph warning on 18 Nov 2021 – well before even the Ukraine conflict broke out:

We are back to warnings of power rationing and industrial stoppage, a looming disaster for the European Commission and the British government alike

[Gas] Inventories are currently 52pc in Austria, 61pc in Holland, 69pc in Germany at a time of year when they should be near 100pc

Chart 3: UK less affected by Russian imports, but still can’t escape rallying global prices

UK is not as safe as the chart above suggests, as cross-Channel prices move in near lockstep, and the fact that the government allowed storage sites to close means the country may be nakedly exposed with just days of stock.

Further, the Hinkley Point C nuclear power station will not come on stream for another five years at best, and have banned, since 2019, fracking to extract easy oil resources.

Edging private sector to invest in fossil fuels is now more difficult than ever: ten years ago, the "cost of capital" for developing oil and gas was similar to renewable – at between 8% and 10%. Now, the threshold of projected return that can financially justify a new oil project >20% for long-cycle developments, vs renewables falling to 3%-5%, according to Goldman Sachs.

Chart 4: Cost of capital: very costly to start fossil fuels projects due to politics and ‘green imperative’ mentality

Why so high? Simple. Few want to lend to fossil fuel producers as stakeholder capitalism, ESG mandates, and identity politics infest corporate boards.

2) Debt explosion + Rate surge undermining returns

The West has sleep walked into a vicious cycle of:
(a) high welfare =>
(b) higher debt =>
(c) higher taxes when can’t borrow =>
(d) cut interest rates to -VE when can’t raise tax =>
(e) to buy political support, increase welfare (ie back (a))

This trick was easy to pull off from the early 80s when interest rates were as high as 15%, but now with EU at negative rates compounded by massive inflations every way you look, the game is OVER.

A slight increase in rates – when EM countries are now well equipped, after having gone through their own versions of debt crises (eg Asian Financial Crisis) – will cause the West into a painful reverse trade that threatens to rapidly unwind the past 40 years’ profligacy.

In the case of the UK, public debt has gone from 20% of GDP to 100% over 30 years (Chart 5), but all while interest payment fell from 10% of revenue to 3%. All of these are coming to a head now with collapse in confidence in public debt, triggered by govt mandated economic lockdowns, zealous push for green agenda, and now international wars:

Chart 5: UK public debt as post-war highs
Chart 6: Thanks to rate manipulation

The optimistic forecasts of OBR are probably based on low rates, low inflations, and strong growths after coming out of the lockdowns, but all of these assumptions are severely challenged, which could mean a debt explosion from the highest level since the 1960s to much higher levels than forecast below:

Chart 7: UK debt forecast likely too optimistic

Coupled to this the economy destroying zero-carbon ideology feverishly pursued by most of bureaucrats and politicians, the UK could see as much as 60ppts more in debt load in the next 30 years:

Chart 8: Climate change scenarios: public net debt impact by 2050-51

As international interest rates head higher, the ability of the slow growing OECD (mostly EU) to hold down their risk free rates will evaporate, as capital leaves seeking better returns elsewhere – all of this will lead to much higher finance costs for property very soon. The strong inflation backdrop (Chart 9) is also probably grossly under-estimated by the market, where low to mid single digit forecasts are still the norm, when we are already potentially looking at as high as 20%s levels (especially the 70s oil shock pattern repeats):

Chart 9: with war added to the mix of energy + food crisis, we fear UK inflation could reach double digits soon

Chart 10: Fed projected to hike 300+bps in next 1.5 years

If The Fed’s hike trajectory (300bps in 12 months) is anything to go by, given a weaker GBP (which means more imported inflation) plus higher energy uncertainties compared to continental USA, 400bps+ rate increases are a high probably outcome to us:

Chart 11: yield gap analysis suggests possible price falls

As a result, even modestly assuming 300bps mortgage rate hike (Chart 11), the low property yields of today will feel a lot of pressure to catch up. Expanding yields mean higher rental growths are needed (69% in above scenario) just to keep prices from falling!

3) Taxes must rise to serve the rising rates, unsustainable welfare, and military spending

Part of the problem of high inflation and high interest rates is the erosion of profits at the corporate level and take-home pays at the individual level. It is no wonder that the government’s own forecast project the highest tax-to-GDP level since WW2 (Chart 12), adding insult to injury after the first two drags on people’s income:

Chart 12: tax take as % of GDP up 8ppts from 80s lows

Chart 13: 2019/20 to 26/27 tax increase by factor

All of this is in addition to the economic rebound nearing its peak, when corporate expansion intensions are starting to reverse:

Chart 14: CFO expansion survey – growth may have peaked

As rates rise, and inflation and tax bite, people’s take-home pay will likely drop, leaving them less money to invest in property, and we expect the record high P/E ratio (home price to earnings) to also turn south (Chart 15), perhaps having first made a dash for new highs by as late as Q3 2022:

Chart 15: Home price to income ratio also may peak by Q3 22

Looking at the complex picture in one condensed chart, we factor in income growth and interest rises against real home prices (ie after inflation) below, we present two possible scenarios:

1)      optimistic outcome where home prices stay unchanged (blue solid line, Chart 16) - the combined effect of inflation and income growth will make home prices a lot more affordable by 2026 (red sold line);

Chart 16: yield gap analysis suggests possible price falls

2)      but what if the cycle we see in the red line repeats itself, and the red dotted line plays out by 2024 at the 700 reading on the real home valuation index? Such an outcome would require a home price drop of 37%, as represented by the blue dotted line.

The only possibility for home price drops not to happen is if income rises more than inflation (unlikely) and rate hikes are much less forceful than we forecast (also not high chance)…

Although our forecast contains a lot of forward assumptions, what we know for sure also is that the market has been too blasé about how the govts and central banks will be able to keep everything on a steady straight line (very typical mandarin thinking).

In the next instalment
Our discussion will continue in a second piece shortly, in which we will go back to more descriptive mode and go through some of the more real life examples of how and why owning and investing in property in the UK is now much more an uphill struggle compared to the ease it used to be barely 10 years ago... This aspect will very much weigh on the global collective sentiment towards this asset class going forward.

The author would like to thank Benson Kong Yu Chin of The Hong Kong Polytechnic University for assisting in data collection, analysis, and drafting of this article.