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.
Emails from wine merchants are starting to pop into my inbox with offerings of en primeur wine from the 2005 Burgundy vintage. Thanks – probably – to global warming, pretty much every vintage, from every wine growing region of the world, is at least acceptable nowadays, and the years where the hype declares it to be “the vintage of the century” are increasing. For example, we’ve had three “vintages of the century” already (2000, 2003, 2005). I’m telling you this because if you’re looking for inflation protected assets for your portfolio, fine wine has historically done a very good job. Manesh Kumar’s recent book (Wine Investment for Portfolio Diversification) shows that classic Bordeaux wines returned an average 12.3% over the 20 years to 2002, versus 9.2% from the FTSE 100 – volatility adjusted the advantage was bigger still. The last couple of years have seen even greater outperformance thanks to strong global economic growth, and the emergence of new super-wealthy classes in India, China and Russia.
Growers and producers have put their prices up year after year. Wine critic Jancis Robinson has tracked prices of first release Burgundy over the past few years. 12 bottles of Jean Grivot Clos de Vougeot (a Grand Cru vineyard near the village of Vosne Romanee in the Cote de Nuits) would have cost as follows:
2005 – £600 (i.e. about £60 a bottle once tax and duty is added)
2004 – £480
2003 – £594
2002 – £498
2001 – £408
2000 – £402
1999 – £402
A rise of nearly 50% over the period, compared with an increase of under 20% in the UK RPI.
Given the tiny size of the Burgundian vineyards (some make just a couple of thousand bottles a year) supply can’t rise to meet demand, as it would do in a widget factory. So if you believe that rise of the middle classes and super rich in the emerging economies is a trend that can only continue, buying scarce, trophy wines would seem to be a good long term bet. The problem is that this market – like that for art – is sentiment and confidence driven, and years when growers get too greedy and confidence falls (like the 1997 vintage in Bordeaux) are followed by long hangovers. Art prices are still 5% below their 1990 boom level. You also need to account for the cost of carry – ie the interest foregone on your wine purchase over the holding period of say a decade or two, and storage costs at about £10 a year per case. In contrast to a boring equity however you can always get drunk on the asset if it falls in price.
PS Talking of the finer things in life, I happen to know that a keen reader of this blog (who for obvious reasons needs to remain anonymous) is in the market for a diamond at the moment. Here’s the Antwerp Diamond Price Index. The good news is that despite the rise in commodity prices in recent years, 1/2 carat diamond prices are actually 4% lower than they were in 1995.
More choice is a sign of greater prosperity, right? That tall skinny soya cappuccino extra hot (without chocolate on top) was just what you wanted, wasn’t it? It might not be. It turns out that the more choice you give people, the less satisfied they will be. It used to be the case that if you didn’t like the coffee from the shop it was the shop’s fault for only selling an instant brand. Now, it is your fault for choosing a skinny milk when full fat milk gives the longer lasting foam. The blame shifts to you because you were given so much choice and you made the wrong one. This is the one of the ideas in the book “The Paradox of Choice: Why More Is Less” by Barry Schwartz.
And the relevance to investment? More choices also paralyse decision making. A study found that the participation rate of a pension plan fell 10% when the number of funds on offer went from 5 to 50. You think that you are going to make the wrong choice, as the one you choose probably won’t be the best performer. Even though this will probably be outweighed by the fact that the employer will match your contribution, people avoid the choice.
I watched Prof Schwartz on iTunes as part of the Ted Conference series. This is a series of short presentations by interesting people. You can also watch them online (click here for Prof Schwartz’s presentation) or download to your ipod. Other presenters include Freakonomics author Steven Levitt and Tipping Point author Malcolm Gladwell.
The ‘founder’ of the High Yield market, Michael Milken, was in town yesterday at a conference I attended. Mike is the guy who restarted the High Yield market in the 1980’s (high yield bonds were around during the great depression) when he saw great returns available on fallen angels. Mike served 22 months and paid almost a billion dollars in fines for securities fraud after making a fortune at Drexel Burnham Lambert. He has since won a battle with prostate cancer and has become best friends with the guy who put him behind bars, Rudy Giuliani.
His talk was on the subject of change and how the world will be different over the coming decades. The main themes were the rise of the BRIC economies and the value of human capital. Both his charitable work and for-profit enterprises are focused on healthcare and education which he believes will be the source of economic growth in the future.
Interesting article in the Times this morning (see here) discussing the increases in fixed rate mortgages over the past week as borrowers scrambled to fix their home loans. Typical 2 year fixed rate mortgages have increased by around 0.4% over the week, to around 5.39%. This is bad news for the 100,000 to 150,000 borrowers whose much lower fixed rate deals come to an end over the course of the next month – it could end up costing them an additional £60 a month on a £150,000 mortgage. It’s still interesting though that competition in the mortgage market is so intense that the new rates don’t look expensive compared to money market rates – for example, the two year swap rate is 5.72% right now, which is a good proxy for where banks and building societies can borrow wholesale cash. So if they are then lending it out again at 5.34% (Portman Building Society) or 5.39% (Yorkshire Building Society) they are having to make up the difference somewhere else. This might be in high initial arrangement fees, or by selling additional products such as buildings insurance or redundancy protection insurance. In any case, higher home loan costs, in addition to lower real wages (average earnings growth came in at +4.1% this morning, versus headline inflation at +4.4%, in other words a real pay cut) should slow the consumer in 2007.
CPI inflation in the UK hit 3% in December. Anything higher than this and the Bank’s Governor Mervyn King will have to write a letter to Gordon Brown explaining why inflation is so high. It probably won’t read “Dear Gordon, the reason inflation has busted out of the target you set for us is that we’ve kept real interest rates at exceptionally low levels for too long. Yours, Mervyn.” – but it probably should.
The inflation rise was driven by higher transport costs (train and tube fares), furniture and household goods, and recreation and culture. Most worrying was the rise in headline RPI to 4.4%, from 3.9% previously. The latest survey from IDS, a pay consultancy, suggests that in the most recent wage settlements, the benchmark has been the RPI number, rather than the lower CPI number. Higher and higher wage increases could cause inflation to start getting out of control. The most important job the Bank now has to do is to control inflation expectations – this will partly be down to words, with strong anti-inflationary speeches required; but it also requires action, and that includes a further rate hike in the next couple of months.
Elsewhere, commodity prices are worth a comment. The major commodity indices have fallen back a decent way over the past year (CRB down over 15%), largely driven by the setback in the oil price, but also in some recent falls in metals like copper. All good news for inflation, but while there’s good news in these “hard” commodity prices, the “soft” commodities have seen some impressive rises of late. In particular the price of corn has just jumped to a 10 year high (to $4.165 a bushel) on the back of falling stockpiles. Demand from ethanol producers has driven this shortage, and the dramatic rises in corn prices is causing some social unrest in some emerging economies where it’s a staple food. Worth watching.
In an article that appeared in the Daily Telegraph on January 13th (view article here), I argue that the Bank of England has to drive interest rates higher. Structural changes in the UK mortgage market mean that the transmission mechanism between UK interest rates and the UK economy is weakening. UK inflation is the highest it’s been in more than a decade, and real interest rates (which are what really matter) are still very low. The Bank of England’s raison d’etre is to control inflation, so control inflation it will, even if it means risking an economic slowdown. Rates will therefore have to climb higher.
Here’s the link to the Office of National Statistics new Personal Inflation Calculator that was widely covered in the weekend press. Not that we can get it to work, and we have no idea what an SVG file is, or how to download one. But it’s a great idea. Let us know if you can get it working and whether your personal inflation rate is above the national average (likely if you like to eat out a lot and send your kids to public school) or below it (if you have a shoe buying addiction and are looking for a flat screen TV). Incidently, for all the talk of higher council taxes feeding through into inflation, my local council, Hammersmith & Fulham, has just announced a fall in bills of 3% for the next fiscal year (the first fall in over a decade), so it’s not all one way.
With all eyes on tomorrow’s inflation data (will Mervyn be forced to write a somewhat embarrassing letter explaining why inflation has breached its upper target ?) a report from the Virgin Money Group show football fans are suffering more than most. The Football Fans Price Index shows that the cost of attending games has risen 8.3% in the last three months and a whopping 17.1% in the last twelve. According to the survey it now costs a massive £91.29 to attend a Premiership game once you account for tickets, travel and other expenses. Having attended most of Liverpool’s away fixtures this season I cant say I’m surprised to learn that England tops the league for the most expensive average match ticket in Europe; what a shame we can’t transform that supremacy onto the pitch!
I thought it would be useful to explain the key positions in the new M&G Optimal Income Fund and how I am making use of the “wider powers”, so that readers can get a better understanding of my strategy for international bond (and indeed equity) markets.
A prevailing view over the past 18 months has been that the market’s expectations of interest rates have continually been too low, and my long-only bond funds have been very short duration since summer 2005. Back in August 2005, the Bank of England had just cut rates from 4.75% to 4.5%, and the market was pricing in one interest rate cut. How wrong the market was – yesterday’s rate hike was the third since August 2005 and there are very likely to be more on the way. This duration call turned out to be spot on and the M&G Corporate Bond Fund achieved top quartile performance in 2005 and 2006, although frustratingly, the fund only just succeeded in breaking even last year. In a long-only bond fund you are always a victim to market conditions.
I believe there are likely to be at least two more rate rises in the UK, and the bond portion of Optimal Income has an exceptionally short duration of just 3 years. On top of this, I sold a significant amount of sterling interest rate futures in December and the beginning of January, which has added to performance since launch (particularly yesterday)
With wider powers, I am now able to accurately express my yield curve view for the first time. I believe global investors are being too conservative on their interest rate forecasts and expect short dated bond yields to continue rising as interest rates go up. Long dated bonds should fare much better, thanks to ongoing support from pension funds. In the US and Europe, I have sold short and medium-dated bond futures, and have bought long dated bond futures. In the UK, long dated bond futures do not exist so I have sold 10 year gilt futures and bought 30 year gilts, which still accurately reflects this view.
As for asset allocation, investment grade corporate bonds form just over 50% of the portfolio. High yield bond valuations are not overly enticing on the whole, and high yield forms 30% of the fund. This is only slightly above the 20% minimum that must be held in high yield corporate bonds in order for the Fund to qualify for the IMA UK Other Bond sector.
Equity exposure stands at just over 10%, and I expect to build this up closer to the maximum 20% limit as opportunities become available. Equity markets still look relatively cheap versus bond markets (and very cheap versus high yield bonds). The equity holdings in the fund are all where a company’s earnings yield looks very attractive versus that company’s bond yield. Equity selection is made in close consultation with M&G’s Equity fund managers and analysts, particularly with the Global Equity team.