A look at housing affordability in the US and UK

In recent months we have blogged about the recovery in the US housing market that is currently underway. This is in contrast to the UK experience, where the housing market appears to be stuck in the mud. We thought a quick look under the bonnet could reveal the dynamics at play in both countries.

In order to do this, we have constructed a housing affordability index that captures the three main barometers of the health of the housing market; wages, house prices and mortgage rates. By combining average house prices and mortgage rates, we can estimate the typical payments facing a mortgage holder in either country. We have then divided the average wage in both countries by this number. We think that this enables us to get a pretty good read on how affordable housing is in the respective countries.


As the chart shows, owning a house has become considerably more affordable in the US relative to the UK since 2007. There are a number of reasons why this has occurred.

Firstly, US house buyers are feeling rate cuts to a greater extent than their UK counterparts. For example, at the end of 2012 30-year US fixed rate mortgages were 3.35% compared to an average UK fixed rate mortgage of 4.10%. As outlined earlier this month, UK building societies are finding it difficult to pass on any rate cuts because of the impact that such a move would have on their profits. Secondly, wage increases have also favoured potential American homeowners. In the US, wages have risen by nearly 16% compared to an increase of 12% in the UK.

The US has improved on two metrics relative to the UK, but the difference isn’t enough to explain the divergence in affordability between the two markets. The dominant affordability factor has been house prices.

US house prices saw a greater correction, falling by 30% from the peak to trough, while UK prices only fell by 18%. We have now seen US house prices generate solid returns for buyers, with prices now growing at over 10% year-on-year. This is likely to have a significant impact through the multiplier effect on consumption and GDP growth. In contrast, the UK housing market recovered relatively quickly, but since late 2010 house prices have been anaemic.


With the standard variable mortgage rate rising over the last 11 months, limited upward pressure on wages, and stable house prices it appears unlikely that the UK housing market is going to become more affordable for home buyers anytime soon. It is thus understandable that in order to assist potential homeowners, the government has launched its “Help-to-Buy” scheme (following the muted impact of its Funding for Lending scheme) which will come into effect in January next year.

Whether the scheme will work or not will continue to be debated amongst economists. The Help-to-Buy scheme should theoretically impact house prices in a positive way. But this could actually have a negative impact on those looking to buy and potential homeowners may end up borrowing more to purchase a house than they would if the scheme didn’t exist at all.


The fiscal cliff is bad news, but is likely to be resolved – so don’t ignore the extremely positive developments in the US housing market

There are some big risks to the US economy, but the potential for the US housing market to surprise on the upside, and deliver massive gains to US employment might well be the bigger story for 2013.

The real damage that the fiscal cliff is causing is mainly psychological at the moment, discouraging both capital investment and hiring. I’m not allowed to use the phrase that involves metal food containers being moved further along transport routes by means of the foot, as we have a “cliché box” at work, and saying it would cost me dearly – but that is both the obvious solution to the problem, and indeed the only solution. The size of the US debt is now too big for any politician to deal with decisively, and some sort of default (against bond holders if a default against the population’s pension or healthcare expectations isn’t possible) or devaluation (currency or inflation) sometime in the future will be likely.

The focus on the fiscal cliff has taken attention away from what we think are extremely positive developments elsewhere in the US economy – and particularly in the housing market, as alluded to in September. US housing became the centre of the global financial crisis from 2007 onwards, when the credit bubble burst as sub-prime mortgage loans started to go bad. Too many houses had been built, and the overhang of unsold inventory together with foreclosures and falling real incomes and unemployment led to a sharp fall in house prices. The banking system went bust, and a huge number of construction jobs were lost in the economy. From a peak of 7.7 million Americans employed in construction in 2006, by the start of 2010 the sector had lost 2.2 million jobs. But we’re now seeing a large number of positive signs in the US housing market, and just as the negative multiplier effects spread through the economy when the sector tanked, the reverse might be true next year.

The chart below was very important to us in 2007, when it led us to expect not just weak growth in the US, but an outright recession with huge damage to the banking sector. It showed that there had been so much overbuilding in US residential property that the supply of inventory had moved from about 4 months to over 7 months. This had historically been a leading indicator of recession. In fact unsold inventory moved much further than 7 months, hitting 1 year in 2008, presaging US GDP falling by 4% year on year. You can see that the available inventory of housing is now contracting sharply, to the extent that US growth should continue positive. It’s also at a level where house-building should resume – and the multiplier effect from that will be extremely powerful.

Other reasons to be cheerful about US housing? Well house prices have been rising, according to the S&P/Case-Shiller index, since March this year (but remain “cheap”, 30% below the peak in nominal terms, even weaker in real terms). So the negative sentiment around the sector will be fading somewhat – nobody wants to buy into a falling market. And the Federal Reserve has almost entirely moved its Quantitative Easing programme away from purchases of US Treasuries and towards the purchase of Mortgage Backed bonds. This should eventually help get the transmission mechanism working again. In theory American mortgage investors should be able to refinance existing mortgages at high rates into new lower rate loans. This hasn’t been happening – banks have dragged their heels on paperwork (the time from agreeing a loan to it closing has anecdotally risen from a month to three months for example), and lending standards for the new mortgages are often higher than they were for the outstanding stock of mortgages. So new 30 year mortgage rates are around 3.31%, (a record low). But as at 2011 (it’s probably lower now) 28 million Americans had outstanding mortgages with rates over 1% higher than the rate for new mortgages – in theory these are all refinanceable at lower levels. You could read this as bad news – but it represents a possible windfall gain for consumers if the transmission mechanism does start working again (lower interest payments equals more spending power). And the Fed is now focused on making the transmission mechanism work – it will get better.

So if the price of US housing is attractive, and mortgage rates have fallen, and there’s an increasing level of demand relative to low supply, how powerful can this be? Well we saw how powerful the negative impact was post 2007 – the multipliers involved with housing construction and household formation (people starting households for the first time, as a result of population growth and immigration, or moving out of a parental home) are very strong. A new housing construction project might result in a contractor hiring more workers, who buy pick-up trucks and power drills, and have wages to spend in their neighbourhoods. They buy cement (from Cemex hopefully, a high yield company we like!) and wood. And the people who move in buy carpets, chairs and flat screen TVs (is it time to stop saying flat screen when it comes to TVs? Probably). The Australian Bureau of Statistics calculated construction multipliers back in 2002 (the link is here). They found that there was an initial effect (the employment of construction workers and what they produce), a first round effect (the output and employment of those that produce the goods and services to the construction industry needs), an industrial support effect (the extra output impact on the suppliers to that first round effect), and a consumption induced effect (increased spending resulting from the wages resulting from all of those efforts). The ABS calculated that every US$1 million spent on construction output results in US$2.9 million of output in the economy as a whole. And, better still, gives rise to 13.5 jobs in construction and 55.5 jobs in the economy as a whole (I’ve pro-rated the jobs upwards from the Australian example, as their original calculations were using the Aussie $). The ABS did warn about the multiplier being overstated from the theory to the actuality, and Australia is obviously not America – but the numbers show the power of housing and construction, and could make you very bullish on the US economy over the next couple of years.

Which brings me on to my final, and tenuously related point – I had a coffee with George Trefgarne last week, the former economics editor of the Daily Telegraph, and the author of Metroboom, a paper about Britain’s recovery from the 1930s slump. We can debate about whether it was austerity or currency devaluation that got the UK out of depression – but house building was certainly part of the solution. Between 1931 and 1939 we were building from 200,000 to (in 1936) over 350,000 new houses per year. Compare that to the UK today, where despite the much bigger population, we’re building under 150,000 houses per year, whilst rents rise and affordability remains very poor for most. In some ways we are lucky – we have a potential solution to the UK’s weak growth – allow house building to take off (by loosening planning restrictions, incentivising house builders to release land banks). If you are Spain, and you have a huge glut of housing, this is not a way out of the ongoing crisis – but for the UK, or the US, building homes could be the answer.



Arizona research trip: US high yield in times of the fiscal cliff

James recently returned from a research trip to the US. He attended the Deutsche Bank Leveraged Finance Conference in Arizona, gaining insights into US market sentiment ahead of the presidential elections and the arising fiscal cliff. Following his latest research trip to Chicago, James had further meetings with a considerable number of US high yield issuers and discussed their outlook for 2013. The conference also created an excellent framework to share market views amongst fellow investors. Most of the talks with both issuers and investors were centred on the fiscal cliff. Therefore, the speeches of George W. Bush and Bill Clinton, guest speakers at the conference, proved to be quite valuable. Have a look at this short video from his trip in which James summarises his main observations and conclusions just before the Election Day for you.


The US: living in a lower population growth environment

The 2000s were the slowest decade of population growth in the US since the Great Depression. The first set of state population counts for 2011 revealed that there has been no change to this trend. The US experienced the lowest annual population growth rate in 2010-11 since 1945.

William H. Frey concludes that the weak labour market in the US appears to have slowed down immigration to the US and to have led to a decline in birth rates. What is more, the baby boomers have passed their prime years for childbearing, affecting the natural increase of population. He has also observed a slow down of internal migration within the US as a consequence of fewer job opportunities across the country. Furthermore, the housing sector in the US is still under water. It remains difficult for a large share of the population to sell houses and raise capital. That makes it unaffordable for many Americans to pursue job opportunities elsewhere in the country.

What could follow economically from this demographic trend? Lower population growth will lead to an increase in the dependency ratio. More people will live on state pensions, and government spending on health care will increase. At the same time fewer workers will pay taxes and, consequently, negatively affect government revenues. The talent pool of skilled workers will shrink which might decrease economic competitiveness. Companies might have to pay higher wages due to lesser competition in the labour market. In the end, it could incentivise companies to look into outsourcing production or relocating business, which would also decrease government revenues.

It is fair to say though that this demographic trend of lower population growth might turn out to be only a relatively short episode in US history, just like after the Great Depression. The US economy might also prove to be able to maintain its high level of competitiveness and to continue to sufficiently attract talent as well as to improve productivity.

If not, government spending and/or tax benefits might need to be increased to support the economy and to maintain the current standard of living. Costs for social security and healthcare will inflate significantly at the same time. The negative impact on the US debt dynamics is striking. According to an estimate from 2007 that was available to us, mandatory spending composed of contributions to Medicare, Medicaid and social security as well interest payments will exceed government revenues between 2030 and 2040. This estimate stems from a time before the financial and sovereign debt crises corrupted US politics as well as the economic prospects of many US citizens.

What we also have to bear in mind is that potential GDP growth is traditionally considered being a function of population growth and productivity growth. I leave it open for debate how likely it is that future productivity growth will offset the lower population growth. In a gloomy scenario, lower population growth could prove to be not only the consequence of economic struggle, but also its future catalyst.


UK housing market flashing amber

The July RICS survey continued the worrying trend of weaker UK data that has been in evidence since the preliminary UK Q2 GDP data release on July 23rd.  It seems that the economic slowdown that has been evident in the US in the past few months is no longer contained to the US alone. The survey showed that UK surveyors are on balance seeing house price falls rather than rises, the first time this has been the case since July 2009, and signs of both weakening demand and greater supply meant that future price expectations turned more negative. 

We’ve focused on the UK and US housing markets on this blog a lot over the years, and forward looking indicators such as sales/stocks ratios or mortgage approvals played a primary role in shaping our exceptionally gloomy view on the UK and US housing markets (and hence financial markets) in 2008.  The correlations between the variables has changed, as correlations always do, but you can definitely get a feel for which way the UK housing market is headed by eyeballing this updated chart, which plots UK house prices against the RICS sales/stocks ratio (ie the number of sales that estate agents have made over a rolling 3 months divided by the total number of properties that estate agents have on their books).  A low ratio implies a glut of supply and/or poor demand, while a high number suggests houses are flying off estate agents’ books. 

The RICS sales/stocks ratio doesn’t suggest that the UK housing market is about to fall off a cliff, but it does suggest that the short term outlook is for flat or slightly negative prices.  This isn’t necessarily surprising considering that UK house prices moved sideways in the aftermath of the last housing crash in 1993-1995.  But the concern is that the enormous monetary and fiscal stimulus of the past two years has only served to temporarily halt the decline in house prices, and house prices in the UK in particular still look very overvalued relative to average earnings.  Another leg of house price declines will place significant strain on the already vulnerable banking sector, which would leave us looking more and more like Japan

Returning to the recent trends in global economic data, some of the US slowdown may simply be because the economic benefit of the huge monetary stimulus at the end of 2008 has now worked its way out of the system (monetary policy operates with about an 18 month lag, as suggested in last week’s blog).  The Bank of England didn’t move quite as rapidly as the Fed, with the final rate cut taking place in March 2009.  The UK is only now starting to face a slowdown, which will likely be highlighted in the Bank of England’s quarterly inflation report released tomorrow.  European data remains remarkably strong, although this may be partly because the ECB was slower and less forceful in implementing monetary policy (the final rate cut didn’t occur until May 2009).  There have of course been numerous additional monetary and fiscal responses around the world since May of last year, but the beneficial effect of the ECB’s rate cuts will cease to be felt over the next few months and I’d expect European economic data to begin to weaken.


US housing crash now worse than during the Great Depression

US data released last week showed that US house prices fell by 14.4% in the year to the end of March (this is the S&P/Case-Shiller Composite-20 Index, which the market tends to focus more on – the S&P/Case-Shiller Composite-10 Index was down 15.3%). The track record of these indices is not very long though – the composite-20 index goes back to 2000, while the composite-10 index began in 1987. So Robert Shiller, who is the cofounder of the index, has calculated the change in both nominal and real US house prices going back to 1890 (see the second bullet point in this link for the data). As shown on our chart and reported in this week’s Economist (see here), US house prices are now falling faster than the -10.5% rate witnessed in 1932. Given the month-on-month declines of more than 2% that we’re currently seeing, it should only be a few more months until the year-on-year record of -16.1% is broken, which dates back to 1901.

US nominal house price falls are bad enough, but the picture is even worse in real terms (ie adjusted for inflation). Real US house prices are currently falling by 16.6%, which is easily the worst figure on record. In 1932 for example, the US economy was experiencing deflation of 10.1%, so real house prices were only falling by 0.4%. The US housing market doesn’t appear to be anywhere nearer reaching the bottom either – the supply of houses on the market is very close to all time records, and house prices will have to continue falling until this is cleared.

The UK housing market looks like it is rapidly following the path set by the US. Nationwide have UK house prices falling by 4.4% in the year to the end of May, while HBOS today reported that house prices are down 3.8% over the same period. Taking the last three months of the Nationwide index and annualising it shows that UK house prices are dropping at an annual rate of 17.0%. HBOS’s index has registered monthly falls of -2.5% in March, -1.5% in April and -2.4% in May, which equates to an annualised rate of -25.1%. And unfortunately, UK house prices are set to fall a lot further. We’ve charted the progress of mortgage approvals over the past 18 months (see here for Richard’s comment at the end of April), and as you can see from our updated chart, our adjusted mortgage approvals number is predicting a year on year house price decline of 15% by the end of 2008.

The central banks’ inflationary concerns are preventing interest rates from coming down as fast as they otherwise would do. This, combined with banks’ unwillingness to lend, means that demand for houses continues to wane, and a rebound in house prices is exceptionally unlikely in the foreseeable future. A collapsing housing market will inevitably have a severe knock on effect for the wider economy.


US housing downturn worst since Great Depression – and getting worse

Investors are almost becoming blasé to dire US housing market data releases, but the reality is that things are getting worse and worse.

The monthly S&P/Case-Shiller figures that came out on Tuesday showed that the US housing market downturn is now more severe than the one that led to the US recession in 1991. As the chart shows (click the chart to enlarge), the S&P/Case-Shiller Index Composite-10 Index fell by 9.8% in the year to the end of December. In Q4, the index fell by 21.0% on an annualised basis. This index starts in 1987 – for a longer history, you need to look at indices such as the catchily-named ‘US New One Family Houses Sold Annual Median Year Over Year Price Change’. This index fell 15.1% in the year to the end of January, the biggest fall since records began in 1964.

The excess supply of houses in the market suggest US house prices will continue deflating. The number of US homes for sale rose 5.5% to 4.2 million in January – at the reported sales pace, this represents 10.3 months’ supply, just below the record set last October. The months’ supply of new homes on the market rose to 9.9, representing the largest housing stock overhang in the US since 1981. US house prices will continue falling until this overhang is significantly reduced.

This chart (click the chart to enlarge) shows that the months’ supply of new homes is a very good predictor of US recessions. When the months’ supply of new homes breaks above 7 months (as shown by the yellow line, inverted on the right hand axis), the economy goes into recession (blue line, left hand axis). A figure of around 10 months’ supply suggests the US is about to head into a nasty recession – worse than what we saw in 1991, more akin to 1974-5.

Ben Bernanke yesterday stated that US real GDP has ‘slowed sharply since the third quarter’, US consumer spending has ‘slowed significantly’ since the end of 2007, and that labour market conditions have ‘softened’. Furthermore, ‘the risks to this outlook remain to the downside…the housing market or labour market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further’. This is a clear indication that the Federal Reserve is prepared to lower interest rates further. The Bank of England now needs to act in a similar manner.


Housing market : Down down, deeper and down

The US housing market is getting worse and worse, and the UK looks set to follow it.

Yesterday saw the monthly update on the disaster that is the US housing market. Figures showed that the downturn is accelerating – the S&P/Case-Shiller Composite-20 Index showed that the US house prices fell 7.7% in the year to the end of last November. The S&P/Case-Shiller Composite-10 Index (which covers the 10 main US metropolitan markets and has a longer history – see graph) showed that house prices fell 8.4% in the year to the end of last November, the steepest fall since the index began in 1987. This is bad enough, but digging below the headline year-on-year numbers reveal a startling trend in the house prices. Taking the quarterly house price change, and annualising it, shows that the Composite-20 index fell 16.2%, while the composite-10 index fell 16.6%, which shows that the downward trend is quickly accelerating.

Then today we had the UK release of what I believe is perhaps the most important UK economic indicator, the number of mortgage approvals. We have discussed mortgage approvals numerous times on this blog (see here for our last comment), but it’s worth a brief recap. The housing market is the transmission mechanism for monetary policy – when the housing market is strong, the Bank of England increases interest rates to stop the economy from overheating. Higher interest rates slow the housing market, then consumer spending and economic growth both slow (both with a lag), then inflation falls (with a further lag), and finally unemployment starts rising as companies react to weaker growth by cutting costs. Any predictor of what’s happening to the housing market is therefore worth its weight in gold to figuring out what’s going to happen to the broader economy.

As you can see from this chart (click the chart to enlarge), today’s mortgage approvals number was shockingly bad. Since we last wrote about mortgage approvals we’ve made a slight adjustment to mortgage approvals, where we now adjust for the fact that the total UK housing stock has gradually increased over time. This makes recent mortgage approval data much more comparable to historical data, and improves the predictive powers of the mortgage approvals on the housing market. As you can see from the chart, the dramatic slump in mortgage approvals spells woe for UK home owners, and UK house prices look set to fall further over the next six months. The graph suggests that by the summer we’ll be seeing a year-on-year decline of around 5%.

What does a collapsing housing market mean for the central banks? It means that economic growth is set to fall very sharply. The US Federal Reserve is acutely aware of the risks, as a falling US housing market has always historically resulted in or coincided with recession. The Federal Reserve is being very active in slashing interest rates but the Bank of England has been slower to react, having cut rates only once so far. With UK rates at 5.5%, many rate cuts will surely follow. The Bank of England will not be maintaining the status quo.


Letter from New York

Stefan and I had a research trip to see our New York counterparties at the end of last week. Two key themes emerged. Firstly, when we were there a year ago, many of the Wall Street strategists were cautious on high yield and investment grade bonds. But after a year of strong returns from credit – and especially risky credit – capitulation appears to be the order of the day. Not one strategist was anything but positive on the asset class. There are a couple of reasons why – the high yield default rate continues to stay around 1%, and the demand for corporate bonds from structured credit vehicles like CDOs (and CPDOs, see our earlier post) remains incredibly high. This strikes me as a little complacent, after all since I was last in NY the US growth rate has collapsed. GDP growth was over 5% in the first quarter of 2006, but is likely to be running at around a 2% rate in Q4 – and according to some indicators like the ISM manufacturing survey, the industrial sector may well be approaching recession. This can’t be good for credit fundamentals, and we continue to think that it’s time to rotate out of riskier corporate bonds into more conservative issuers.


Secondly, the Wall Street economists on the whole think that 2007 will see a continued US slowdown rather than a recession. A couple of people we saw even thought that US rates would end the year at their current level (5.25%) or higher. There were a couple of outliers however. Both Merrill Lynch’s David Rosenberg and BNP’s Richard Iley see the US housing market weakness tipping US growth over a cliff next year. The US corporate savings rate is currently extremely high (companies are very cash rich and can’t find opprtunities to invest in the US, which in itself is quite bearish – has the US economy gone “ex-growth”?) – what happens if the US consumer weakens further and starts to save rather than spend? As a result Rosenberg sees the Fed cutting to 3.75% by year end, and Iley to an even more punchy 3% – both moves implying that the US is getting a hard landing rather than the consensus soft landing.

Elsewhere we learned that basketball is a mediocre spectator sport, and that the New York Knicks can’t buy a home win at the minute; and that the Gramercy Park Hotel’s Rose Bar is the hippest place in the universe right now – even if I did have to ask Stefan who exactly any of the celebrities were (Misha Barton?)…