This ties in with the low level of mortgage approvals – these totalled 47,643 in June; much higher than November 2008’s low of 27,000, but well below the average since 1993 of 91,859. Similarly, mortgage lending remains weak: June saw £0.7bn of net mortgage lending, versus the monthly average since 1993 of £4.3bn.[1]

 

So it seems that the rally in 2009 was triggered by a lack of supply (as discouraged home owners refused to accept lower valuations) coupled with pent up demand, which has since dissipated.  Does a collapse thus beckon?  The rise in house prices over the last decade does look exceptional against previous UK episodes and against international comparisons. Both the Barber and Lawson booms, which saw real house prices rise by some 70% and 100% respectively, were eclipsed by the 165% rise between 1996 and 2007. Yet since then real house prices fell only 15%, versus falls of 35% and 30% after the earlier episodes. Only Ireland saw a greater increase during the last boom; in the US, real prices rose 50% before falling 30% after their 2006 peak[2].

 

Moreover, when compared to average incomes, UK house prices still look expensive. The average house price is now 4.5 times average income; it peaked at 5.9 times and has averaged 4 times (1983-2010; Halifax).[3]

 

In short, UK house prices still look expensive. However, a mean reversion in real house prices is not necessarily appropriate. Financial market liberalisation has made mortgages more widely available, and low real interest rates have enabled households to take on bigger mortgages, thus low rates have been “capitalised” into valuations to balance supply and demand.    Underlying this, though, is the fact that supply has not risen to match demand. Between 2000 and 2006, growth in the number of households outstripped new housing completions by about 50,000 p.a.  The US response to increased demand is more building – which is not always an option here. Supply is still constrained: the house building sector was hit hard by the recession, so housing completions slumped to a post-war low of 118,000 in 2009 (versus the 2009 government target of 240,000[4] p.a. by 2016; the closest we have got to this figure in the last 20 years was 175,000 in 2007)[5].

 

It is primarily low rates that have put a floor under the housing market, and these are threatened by an inflation outlook that is worse in the UK than elsewhere. There are all sorts of special factors behind this, such as higher VAT and a weaker pound, and there has been much debate as to when rates should be raised, with the MPC reaching a consensus of ‘not yet’, but CPI inflation has exceeded the target of 2% every month since September 2009 [6]. The risk – recognised by the MPC – is that inflation expectations rise and with them, wage demands, which then feed back into inflation. So if rates were to rise, house prices could be hit hard. One excuse for not raising rates – that the coming fiscal squeeze (and cuts to the public sector) will keep a lid on inflation pressures – is not good for house prices either.  

 

But why do house prices matter? Because they are intimately linked to patterns of consumption, although not in the obvious sense of realizing capital gains to finance spending: homeowners cannot all simultaneously sell up; the gain to a last-time seller is a loss to a first-time buyer, who will also be a consumer. House prices and consumption may move together for various reasons: first, if consumers are optimistic about economic prospects, they are likely to increase their spending on housing and non-housing goods alike. Second, if house price increases are accompanied by an increase in housing transactions, these transactions may have a direct effect on consumption as people buy furniture, carpets, etc, for their new homes. Third, houses represent collateral for homeowners, and borrowing on a secured basis against housing collateral is generally cheaper than borrowing on an unsecured basis (for example, via credit cards). So an increase in house prices makes more collateral available to homeowners, which in turn may encourage them to borrow more, in the form of housing equity withdrawal (HEW), to finance desired levels of consumption and housing investment.

 

This was a key driver of economic growth during the Blair years; HEW was as much as £17.1bn back in the fourth quarter of 2003, or the equivalent of 8.5% of post-tax  income[7]. A strong economy creates higher house prices via rising incomes and falling unemployment; but in Britain, higher house prices themselves made the economy look even stronger.

 

This all works in reverse: individuals aren't borrowing money to spend; they are saving money and repaying what they can off their mortgages. They have injected £38.3bn back into housing equity since mid-2008 (when the HEW measure turned negative)[8]. Furthermore, falling house prices affect bank lending: if the value of the collateral underpinning the banks’ existing book of mortgage loans is undermined, then banks need to provide for potential losses, which means less capital available for lending, just at a time when the process of financial liberalisation has been stalled by the credit crunch.

 

James Codrington,Head of Charities, Baring Asset Management, London

 

The views and opinions expressed in this article are those of the author. They do not necessarily reflect the views and opinions of Baring Asset Management.

 

 

 

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Author: James Codrington

James Codrington heads the charities team at Barings and is a member of the targeted Return Group.

He joined Barings in 2002 and has 14 years' investment experience.

He has an MBA in Mordern History from Oxford University and is a regular speaker at charity events.

www.barings.com

Click here for other articles written by James Codrington

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