“Notice I didn’t specify what kind of doom, so no matter what happens, I predicted it. How very wise of me.” – Christopher Paolini (author), Eldest
Welcome to the last supplement of 2022, of note. Don’t panic – there WILL be one on Christmas Day, but it will be an annual roundup with a light-hearted tone (I’ll try to keep the Dad jokes to a minimum, with no promises). I won’t expect you to read it on the day of course, but there will be a Quiz on Boxing Day night! (I’m half joking, of course).
Time is arbitrary
I come from an interestingly miserable school of thought around days, weeks, months and years – these constructs of time are somewhat arbitrary although mostly make sense in terms of seasons and the like. If I buy a big chunk of property in December 2020, rather than January 2021 (true story) – does it mean that 2020 was a great year and 2021 lesser so? Technically, yes – but does it matter? Is it really meaningful? I would argue no, no it isn’t.
However, we do need some way of dividing efforts and tasks, and measuring progress – and for that, months can be useful as can quarters and years in terms of property. This is because the nature of the beast is that the asset is slow-moving – although there are those that have had success in shortening this time window, particularly property traders, there is still an extent to which the asset will always remain slow-moving.
Markets look wrong
This has been an interesting week, as is so often the case when the Central Banks of note in the Western World have a policy meeting (or similar terminology). This was a great week to try and read between the lines, and a week where I feel that the outlook of the markets, overall, as I see them right now, are not correct. These moments seem (to me) to be the most important to write and talk about.
Start with the USA
We kicked off with the Federal Reserve meeting for the US interest rate. The rate had been moving upwards at a very swift rate, 0.75% for 4 meetings in a row – and this trend was broken with “only” a 0.5% rise. This was on the back of an inflation “print” as the industry calls it that was once again below expectations, 7.1% versus 7.3% for November 2022. This was great news as far as stocks saw it, shooting upwards on this news. Commentators are now predicting with certainty that the peak in inflation has been passed, and was likely dealt with back in June. Indeed, the 2022 inflation curve in the US really appears quite orderly, almost like a normal distribution (depending on how you plot the scale on the y-axis).
This was, however, accompanied by some pretty hawkish chat. The hawks want to move the rates up (or keep them up) to control inflation in the most direct fashion. The Fed has a fairly cool piece of information that it publishes, that is called the “dot plot”. This sees the members of the committee anonymously publishing their idea of the expected rate in the future – in this case, at the end of 2023. In a nutshell – the rate at the end of 2023 according to the dot plot looks like something around 5-5.25%.
This 5% number is significant. The USA has so much debt, in relation to tax receipts, versus welfare and defence spending, that this is a fairly major threat – or at the very least a significant fiscal drag. It isn’t “commercially viable” for the Fed to sit up at this rate for a long time, just based solely on the debt figures.
This isn’t based solely on the debt figures though, of course. Inflation is very important. It looks to me as if the message “inflation has peaked” has been confused with the message “inflation is headed back to, or under, target of 2%”. The second one is by no means a locked-in certainty. Inflation inspired by the end of cheap energy from Russia (the largest cheap energy producer in the world, when you aggregate this across Oil, Gas and other raw material exports), and the “transitory” nature of the Covid-inspired inflation; sure – at some point it works its way through, leaving an element of permanent scarring. This is not the only fruit after the pandemic – or indeed after any pandemic. The labour market remains incredibly tight which passes power in wage negotiations to workers; labour forces still remain too small to fill available jobs, particularly in the USA.
What if inflation starts to look much more persistent when it does drop to 5%, or 4%, or whatever figure, in the US? Then, rates don’t necessarily need to go up more (especially if they are sitting above inflation at that point), but they do need to remain high and there is very little in terms of an effective argument for dropping rates at that point. I don’t see an answer to this at the moment – and I think the market is missing this very important distinction.
The US frontruns the UK
Why do we care? Well, the US gives us some good insight into what’s going to happen here in the UK next year. Not because the Bank of England “copies” what happens in the USA – that notion is nonsense, in my experience. There are of course similar macro pressures that affect both economies, so some element of congruence between policy rates is sensible. The USA can influence UK policy a lot more than the other way around, as well, of course – simply because of their size. However, the Bank has been committed this year, from what I’ve seen, to trying to do the right thing, and haven’t done a terrible job by any means.
More rate rises
The Bank this week raised the base rate by another 0.5% – I’m sure you saw it! That puts us at 3.5% now, with a likely path to 4 or a shade higher next year. The smart money is betting on 0.25% being the rise at the next meeting (3rd Feb who feel that these meetings come around far too quickly for everyone’s liking). This is always meaningful – but we also perhaps should revise just how meaningful it is, because I do see a lot of confusion in the property community about exactly what’s going on and why it matters so much.
The individual votes – disagreement
Before I undertake that task however, I would like to go down into the detail a little more; this is always a good way to attempt to read between the lines. The Bank doesn’t do a “dot plot” – the committee is overall far smaller of course in number, because we aren’t talking state representation considerations as there are in the USA – instead we attempt to get the people and most independent people that we can, in general, from all around the world.
No dot plot – but we do have the individual voting records of those committee members to consider, which is published, transparently. Each member does have a chance to comment alongside their vote, and whilst all members of the Monetary Policy Committee need to be careful exactly what they say to the press for the fear of markets reacting, we do not live in a regime where they would be fearful of speaking out.
At the last meeting, we noted that the rise by 0.75% was only disagreed with by 2 members – one preferring 0.5% and one preferring 0.25%. At the time, this was the largest amount of disagreement that we had seen for some years in terms of the vote (in terms of the gap with one member being 0.5% “off the pace”, if you like, compared to the consensus). This meeting saw even more disagreement – with 2 members (both who voted for lower increases last time out) voting for no increase at all (so they are both 0.5% “off the pace”), and one member voting for a 0.75% increase rather than a 0.5% one – which was the majority. So, only 6 of 9 were on the same page.
Two believe that we have done enough for the moment to head off inflation, or would like to know some more information, before raising rates any further anyway. One feels we need more extreme, federal-reserve type action (I choose my words carefully, because she is a well-respected American banker and economist who seems to believe that following the lead of the federal reserve, and hiking aggressively, is the way forward). 3 members thus have a 0.75% difference, as I write this, in where they feel the base rate should be. That’s fairly significant – and also speaks to just how difficult the task of being on the monetary policy committee is, at the moment.
Raging inflation but below expectations
Now we head more towards my personal view. The smart money would bet on an increase of 0.25% in February 2023 and another 0.25% in March 2023, without any changes of significance before then. Our inflation “print” for November was 10.7% from expectations of 10.9%, which was significantly our first “undershoot”, our first indication that inflation may have peaked just as it did in the USA in June this year. As discussed throughout the year, our cycle does appear to be around 6 months behind, so we will expect an element of dropoff, although we have a guaranteed increase in domestic energy bills of around 20% in April 2023 thanks to the price cap and what has been proposed in terms of governmental support. We also have the oil price having moved fairly sharply downwards, breaking below $75 for a barrel of crude for the first time in nearly a year – which is helpful. The near-term market is expecting a slowdown due to global recession, and that being more relevant than a stilted (and somewhat forced by domestic pressures) reopening of China. We will see how that pans out as global supply capacity still looks under pressure versus the need pre-covid – as I’ve said before, I’m not an oil trader or a bond trader, so I am often confounded by the short term moves in these markets.
We have exactly the same problem as laid out above, however, in terms of how much of the inflation was and is transitory, versus what is secular and will remain in the system, “sticky” or persistent, we will have a different path going forwards compared to the USA. We have historically “ran hotter” than the USA, with higher organic inflation – sometimes driven by not being anywhere near independent on the energy front, where the USA has produced much more in percentage terms of its own energy demand within its own borders. In terms of the impact of rate rises and the likes, we will only be seeing things really bite in quarter 2 of 2023 and beyond – so peak rates are likely to be arrived at around about this time, or the first meeting where rates do NOT go up is likely to be around the middle of 2023, all else being equal.
Time at the higher rates
Where I differ from the market, and where I would be more on the side of the “dot plot” in the UK if we had one, is that I am expecting a much longer duration of base rate up at the 4% level or so. A lot of this will depend on the first time the inflation print is above expectations on the way down, because currently inflation is being deemed to nearly crash in mid-2023, whereas I would be surprised if it was a crash – more of a drop, for some mathematical reasons, but not a crash. The USA will experience a similar phenomenon, for different reasons – in terms of inflation, they were faster than the UK to the problem because their economic cycle has been faster overall post-pandemic (often the case as they have a more laissez-faire attitude overall), and are faster to the solution as discussed. However, the USA looks headed for a 5% rate which could well be dropped and can ill be afforded by an indebted government – the UK is more headed for 4% or thereabouts, especially if the Bank of England MPC members are to be believed, and this leads to (as often) a strange quandary.
The higher high versus the duration
US inflation has not peaked at such a high level, and doesn’t have as much organic “heat” in it, historically, as the UK. Bank rate at 5%, when the Fed gets there which does look inevitable, might well be above inflation at that time, since the US has only got to get down from 7% to 5%. UK inflation is still double digits, and if we are only reaching 4% or so, it is highly unlikely that inflation will be below 4% by that point (although if the inflation crash does happen, we will be). This looks like a narrative crafted to fit a situation rather than a likelihood, to me.
It isn’t critical that the base rate is above the non-transitory rate of inflation (that’s the first time I’ve formalised it in that way), but there is historical precedent to suggest that persistent inflation won’t be controlled by interest rates below the non-transitory rate. This would mean rates either up a bit more than the Bank wants or forecasts, or a long duration of higher base rates. The expectation of getting base rate back down to 3% or so by the end of 2023 as yet looks unlikely to me.
Jobs jobs jobs
This, however, is predicated on a number of things. One of them is the tightness in the labour market. For all the doom and gloom, for all the yield curves indicating a clear recession in the USA (there has already been a technical recession there in 2022), for all the mathematical certainty that the UK is currently in a recession (but without the economic engine to pull out of it as the USA has done in this cycle), the job market does not look too miserable. There is still one job for every one vacancy on the latest UK data, and around 1.6 jobs for every 1 vacancy in the USA.
The UK still has net migration of over 500,000 this year, and now has a record number of jobs compared to ever on record, and still huge shortages in so many sectors (the NHS being a notable one in the news at this time!). This ultimately empowers the Bank to be more aggressive than they would otherwise be on rate rises, but their appetite to spend much time about 4% is very questionable having listened to and consumed a lot of their minutes, webinars and other content in 2022.
Is it “all about the base”?
We do need to revise the fact that base rate is not the only fruit, however. Regular readers should now know with confidence that the 5-year limited company mortgage rate, or the investment rate as we should come to call it, is based on 5-year SONIA swaps (primarily), and those 5-year swaps are based on the 5 year UK Gilt yield. Those yields fell a little on Thursday after the Bank’s announcement, and are now sitting below the base rate for the first time on the 5-year UK Gilt, for many years. Friday’s trading saw them come right back up to end the week above where they were at the meeting on Thursday, which, for what it is worth, looks more realistic to me.
The current state of play sees the 5-year gilt have a bit of a floor around 3%, for the first half of 2022 anyway. Add the swap premium (the swaps tend to trade above the 5 year gilt) of around 0.25%-0.5%, and then lender margin, and that sees rates around 5.25-5.5% (this is the pay rate). There are already lower rates available – some may shout – and indeed there are if you are prepared to pay 4-5% arrangement fees. The only way to compare these products is to compare their APR as that is your best estimate of the cost of capital – lower rates and higher fees are one way to ensure you take as much money as possible out of any property you are remortgaging, but the likely landscape looks to me like many of these are only going to make meaningful money for the bank in the next 5 years, rather than the investor. Without really significant discount or value add, AND a relatively high net yield after operational costs, the case for buying stock is weak at this time.
Reasons to be cheerful
On the other hand, we are pricing in significant rental growth – and I am nowhere near as bearish on capital values for 2023 as many others are. Firstly, many seem to be missing the point that the market is likely already around 4-5% off its peak. At the same time, inflation is still ravaging away and has moved forwards another 2-3% – so in real terms, property is already around 8% cheaper than it was before the change of prime minister in early September 2022.
Relatively cheaper or absolutely cheaper?
I think the knife has a little further to slip, rather than fall – perhaps another 3-5% in early 2023 as we approach max bearishness, but would not be in any way surprised to see a healthy market in the latter half of 2023 with prices rising again. With an average inflation rate next year of around 7.5% on my predictions, if we got to December 2023 with nominal prices where they are today, having gone down and up, then prices would be more like 15% cheaper in real terms than August ‘22.
This offers significant opportunity. We will be, I hope, seeing the green shoots of recovery when others around are still being very bearish indeed. Already, deals are happening at our end that just would not have been there in Q2 2021 – Q3 2022 – a long period of difficult trading. We are cherrypicking – because I don’t expect to be right about everything, at all, and there is downside risk to pricing here – I’m not stupid or tone-deaf enough to simply ignore what the experts are saying, but I am happy to predict that they will be incorrect. Let’s see – because the record will reflect, and to the victor will go the spoils. I have more skin in the game than the average predictor who is doing this because it is their paid job – if I get it wrong, I pay, I don’t get paid!
Active Asset Management
I have been outlining over the past few months to Partners in Property members my advice around tackling 2023. Active asset management strategies – rents must go up to reflect the massive increase in the costs of holding and operating stock that have been realised in 2022; some single lets are simply no longer viable unless run as HMO, SA, or leased to an operator who is willing to pay above-market guaranteed rent. As the months go on in 2023, fixed rate deals will be dropping off and stock is guaranteed to come to market as there are no choices for those who have not predicted the future very well, and some debt pressure will no doubt be upon us. The debt on a business level, thanks to BBLs and CBILSs loans, is similar to the weight of the debt on the governments of both the UK and the USA.
Keep hold of your assets
Remember the number one job – keep hold of existing assets. But they must be assets – if they no longer have positive cashflow, you will need to reassess whether they are assets or liabilities, at some point. Selling is still by no means a terrible strategy – as at January 2023, I think we will be in a buyers’ market, but just about. Certainly not a 2009 style market. The relative difference between the white-hot and red-hot markets of most of the last 21 months or so is massive, but the reality is that there are still willing buyers who can buy with similar stress tests as those that have been faced for the past 10 years or more. The saving in buying versus renting has somewhat disappeared, and that incentivizes renters to continue renting to an extent – or at least affects the attractiveness of buying, somewhat. The problem will continue to be saving a deposit, primarily.
With all of that in mind – and with a tough market ahead, but filled with opportunities, I hope you approach 2023 with trepidation but are prepared, and fill your respective boots with low-risk moves which have strong returns! Health and wealth wished to all!