Investment
Comment
12th May 2023
SLO days
After successive bank holiday Mondays, the biggest question this week in the UK is what day do the bins go out? In the US the debate is less important, focusing on the government debt problem and growing signs that credit availability is falling.
In contrast, the equity market and high yield bond market appeared buoyed by elevated investor appetite despite the most anticipated recession still around the corner, albeit the corner has been spoken about and anticipated for the past few months and yet seems no closer. Indeed, even with the banking problems in the US, the state of the US economy appears resilient in the face of higher interest rates.
This week we saw the release of the Senior Loan Officer Survey (SLO). This highlights the credit conditions in the US banking system and lending conditions in the wider US economy. It measures the degree to which banks are changing covenants and borrowing terms. The recent SLO survey points to an increased level of tightening with a net balance of over 46% of banks who were tightening lending standards through the past three months. Tighter lending conditions will prove a challenge for the US economy.
One of the notable changes in this survey is the sharply lower appetite for borrowing. A net balance of 55.6% of lenders saw a decline in loan demand. Whilst this is grim for lending conditions, and typically results in slower economic activity, there was a pick-up in demand for residential mortgages. If the US housing market stabilises then this will be a bulwark against a deep recession.
Tighter lending standards typically lead to slower economic growth
Source: Artorius, Bloomberg
Demand for loans in the US has fallen sharply in recent months.
Source: Artorius, Bloomberg
Domestic issues: housing and inflation
The UK has a unique problem: very high inflation, even compared to our near neighbours who have endured the same energy price shock as the UK. This puts pressure on the Bank of England to tighten monetary policy to combat inflation and with the Bank raising rates again this creates challenges for the housing market and the wider economy.
Thursday’s report from the Royal Institution of Chartered Surveyors (RICS) highlights the drop in price expectations from surveyors. Typically, this extent of decline leads to falls in house prices. Without a recovery in house prices the UK consumer tends to borrow and spend less, which in turn should lead to lower inflation. This will help achieve the ambition of the Bank of England, but in the meantime a feel-good factor is likely to be lacking.
UK inflation remains higher than peer group nations
Source: Artorius, Bloomberg
UK house price expectations by surveyors is consistent with continued falling house prices
Source: Artorius, Bloomberg
Many mental models, and even mathematical models in spreadsheets used by economists, rely on historical patterns. When 80% of mortgages were variable rate, a change in the Bank of England base rate fed quickly through the system in predictable fashion. Now with 85% of mortgages in some type of fixed rate structure the impact of higher interest rates is harder to predict.
According to the Bank of England, although the rates being quoted on new mortgages have risen by around 3%, the effective rate on new lending has risen by less. The average effective rate on the existing stock of mortgages has only risen by 0.7% as many borrowers have yet to face higher interest rates.
Interest rates on the stock of mortgages have risen by much less than quoted rates on new mortgages, meaning that most borrowers have yet to feel the cost of higher interest rates
Source: Artorius, Bank of England
The timing of the economic reaction (in terms of falling household spending) is likely to be delayed until a certain percentage of mortgages get renewed at higher rates. Around 1.3 million households are expected to reach the end of their fixed-rate term between Q2 2023 and the end of 2023. For the average mortgagor within that group, monthly interest payments will increase by around £200 a month if their mortgage rate rises by 3% – the increase implied by quoted mortgage rates.
The risk is that in the meantime the Bank will be hitting the brakes harder, by raising interest rates higher, until they see a fall in inflation, as demand is curtailed. The risk of policy error is very high and a prolonged UK recession may result, especially in the face of higher taxes.
Gerard Lane Chief Investment Officer
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