The House Of Cards About To Collapse
June 3, 2022
Today we take a deep dive into the UK property market.
All the commentary at the moment is about inflation. It is high, unsustainably high, but the headline figure only tells part of the story; raising interest rates won’t solve the problem, but it could create another one.
The first question to answer is why we think raising rates will do little to curb inflation.
The UK and the Eurozone are in similar situations.
Euro-zone inflation accelerated to an all-time high, with consumer prices jumping 8.1% from a year earlier in May, exceeding the 7.8% median estimate in a Bloomberg survey.
The acceleration was driven by food and energy after Russia’s invasion of Ukraine sent commodity prices soaring. A gauge that excludes volatile items like those rose 3.8%.
When oil prices increase, it costs more for everything to where it’s going. That makes everything more expensive. That is the inflation we’re seeing right now.
While price growth should peak this quarter, it will still average more than the central banks 2% target next year. A European Commission survey this week showed inflation concerns among consumers retreating, though remaining double the average level since 2000.
Russia’s attack on its neighbour -- and the response it’s prompted -- remains the biggest risk to the economy.
Manufacturing has slowed amid soaring input prices and renewed supply-chain snarls. An EU ban on Russian oil, meanwhile, risks further stoking pressure on prices, which are rising partly as the war disrupts wheat and fertilizer supplies.
The reason to increase interest rates is to raise the cost of borrowing and encourage people to borrow and spend less. This drives down inflation………in theory.
From the chart above, the problem is clear: soring energy prices and disruption to the supply chain, particularly with regards to food such as wheat. Interest rates are more or less irrelevant.
If this is the problem, how will raising interest rates solve it?
In short, it won’t, but raising rates is the only thing central banks can do to lower inflation. They are under a massive amount of pressure to do so, and so they will. It might do a little, but it won’t touch the sides so what’s the point given what the consequences could be?
If they move too much, or too fast, what will happen next is, will be a disaster on two fronts.
The cost of government debt will increase to levels the country can’t realistically afford to pay.
Government debt has now reached £2.22 trillion. It is increasing at around £5,170 per second. By increasing interest rates and tapering (reducing quantitative easing), this number will start to increase even faster.
It’s a terrifying fact that nobody seems to care about. We are beyond being able to fix it and so it will forever increase. The more we borrow, the worse it gets, and it will only keep on increasing until one day, it’s so big, we can’t pay the interest.
As a nation, right now we are borrowing money, just to pay the interest on the money we already owe. To put it in a way we can understand, if our government borrowing were a mortgage, we are borrowing more money just to pay the interest on the mortgage.
This isn’t paying back the mortgage, this is borrowing to pay the interest only on the mortgage, and the mortgage is getting bigger by £5,170 per SECOND. We can’t afford to pay for the interest ALONE, so we borrow more, to cover the cost.
We can’t solve this problem, and maybe it’s for the government to worry about. One day that problem will be so big, we default. But that is a long way off yet, as we can always………you guessed it, borrow more money.
SO, let me bring the same problem much closer to home. In fact, into your home.
We are currently panicking over the price increase of food.
The ONS released data stating that UK inflation hit 9% in April. This has us all in a flap. The cost of food and drink has gone up 6.7% year on year as of April 2022.
Bread and cereals are up 3.4%, fruit is up 6.2%, vegetables and potatoes are 4.6% higher.
We don’t want to make light of this issue, but the average household spends around 10% of their income on food. If food is 6.7% higher, then the average person needs to spend 0.67% more of their income on food.
Average wages this year were up 5.4%. Every household might be slightly different, but as statisticians, we must generalise and look at the numbers not the individuals.
People are earning more, and life is costing more. This is not a crisis – yet. As we saw from the chart above, the real cause for inflation, is energy. Food is costing more to get to the shelves; therefore it costs more to buy. Fix the first problem, and the second will fix itself.
If we can bring down the cost of oil and gas, the inflation issue will gradually dissipate.
HOWEVER, if we combat this problem by raising rates, then another consequence of this is that mortgages will increase and this will really affect the cost of living.
The average household spends 20% of their income on their mortgage, and on the back of decades worth of cheap borrowing , we have built a house of cards.
In 1979, the Bank of England base rate was 17%. To borrow money was expensive, buying a house was expensive, and not done with the flippant carefree attitude of today’s buyer.
Since then, interest rates have been getting lower, and lower, and borrowing has been getting cheaper and cheaper.
If the average buyer, can borrow twice as much money for the same annual cost, then they will and this in turn will inflate prices.
By 1993, the Bank of England base rate was 5.37%. This is a third of what they were in the late 70’s and house prices in this time increase by around 250%. People were borrowing 3x as much money, and house prices increased by roughly the same amount.
In 2009 UK interest rates were lowered to 0.5%. This is an absurd level, making borrowing so cheap, the average UK 5 year fixed mortgage rate is currently 1.79%. In 2008, the average was still 6.4% (5 year). Is it any wonder house prices have done nothing but fly.
And what goes up, must come down.
BUT, WHAT HAPPENS NEXT?
In our lifetime, interest rates have only really ever gone down, but that’s about to change and it’s going to shock a lot of people.
Interest rates are going to rise. This hasn’t happened for a long time. The consequences might not be immediate, but they will come.
You may remember last year when Technology based markets like the Nasdaq and the S&P were flying high, and our analysis revealed that the valuations were extremely out of sync with the fundamentals. We called a 'sell off', and since then- we've witnessed exactly that.
Right now, we have a very similar belief with the UK property market. Don't say you weren't warned.
Regardless of what happens in the property market, here at TPP we'll be looking to take advantage of it. Whether it's selling a stock market full of house builders, or buying other markets that will profit as people migrate from property- TPP will continue to guide our clients successfully through the uncertainty. If you'd like to discuss your options- contact our team here.
“TPP might just be about to revolutionise investment for the retail market.”
- London Stock Exchange 2020