Investment Comment
14th October 2022
‘Doing whatever it takes’ has become ‘whatever it breaks’
After the disastrous European Central Bank regime of Jean-Claude Trichet which resulted in a Euro crisis resolved only by Mario Draghi uttering the words ‘whatever it takes’, Andrew Bailey (the current Governor of the Bank of England) appears to be conducting a policy of ‘whatever it breaks’. In fairness to the Bank of England, the current bout of concern in the UK gilt market relates to the poor regulatory regime and an unfunded tax cut by the Conservative Government.
"Take away the ten days of mourning after the death of the beloved Queen, and Truss had seven days in control. That is the shelf-life of a lettuce." Anon MP
The Bank of England is stuck between its two mandates of promoting price stability (low inflation) and financial stability (a secure banking and financial system). An inflation target of 2%, which currently requires policy tightening in the form of interest rate increases, and financial stability, which appears to require additional injections of support from the Bank, are currently at odds. A Pushmi-Pullyu (of Dr Doolittle fame) is unlikely to result in coherent policy or stable market and economic conditions.
UK housing
Even before the new, 12-year-old, government’s fiscal mistake, which resulted in a spike in bond yields, the outlook for UK housing wasn’t great. Higher interest rates were filtering through the system and the typical household was looking forward to a winter with a sharp fall in real incomes as inflation outstripping wages increases.
With even higher interest rates and increased levels of uncertainty, the initial reaction of potential buyers is predictable. Zillow, an online Canadian and US based real estate company, is reporting a sharp drop in buyer activity in the UK and an increase in house sellers. Thursday’s report from the Royal Institution of Chartered Surveyors (RICS) highlights the drop-off in buyer activities in the UK against London house prices year on year (yoy). Typically this level of decline leads to falls in house prices.
Housing market activity changes in wake of the mini-budget…. fewer buyers and more sellers
Source: Zillow
A drop in buyer enquiries typically leads to a drop in house prices
Source: 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 80% of mortgages in some type of fixed rate structure the impact of higher interest rates is harder to predict.
Most mortgage holders are currently insulated (excuse the pun but we need insulation given the rise in energy costs) from the short-term rises in interest rates until their mortgages come to be renewed. At which time, those on fixed rates of say 2% will be facing interest rates of say 5-6%.
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. The risk is that in the meantime the Bank of England 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.
UK opportunity
Due to the speed of the gilt market move and the poor regulation which enabled pension funds to have leveraged asset positions to hedge pension liabilities, asset managers and pension funds appear to be offloading assets at indecent haste. When the funds sell the very large companies (such as Shell or Astrazeneca) are met with global investors willing to buy, so the share price declines are relatively subdued. However, in smaller companies and especially in the Investment Trust space, share price drops have been stark as international investors are not attracted, yet, to these investments.
Things to avoid? Just like post-2008 when banks were repeatedly fined one may see asset managers come under scrutiny for practices that may have contributed to the current state. Naturally politicians will be blameless and enter the public speaking gravy (or coulis) circuit.
Gerard Lane Chief Investment Officer
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FP 20221014001 Exp 25/11/22