Inflation? Yes, really

Oct 23, 2022

“The trick is this: keep your eye on the ball. Even when you can’t see the ball.” – Tom Robbins, American novelist


Welcome to another supplement at the end of another unbelievable week. I’m going to refrain from commenting too much on the departure of the weakest PM for some time, I’m going to leaf out the comments around comparison to vegetables (sorry not sorry), and I’m going to sidestep what could be an even bigger mistake in terms of the potential return of Boris Johnson, and simply hope that those in positions of power can, for once, make a half decent decision which would see economic stability return to the UK. We will find out by the time next week’s supplement is published!


What’s been concerning me this week while all this mayhem has been playing out is the things that we’ve stopped talking about because there have been, temporarily, bigger fish to fry. There have been the obligatory 40-year high headlines around inflation, as it ticked back over 10% in September on official figures, but they quickly faded into the background of political turmoil. My bigger concern is that this wave is still not being taken seriously enough.



To understand the primary issue the world has faced since covid – which of course prompted incredible levels of stimulus into economies which can only ever be inflationary in nature – we need to remember that in the post-covid world, where demand is larger than pre-covid, supply has been the major issue. This has been massively exacerbated by the war in Ukraine – where energy supply, or the supply of the raw materials to be converted into useable energy, has been a significant problem.


There’s a factor which I’ve not spoken about at any great detail which is waiting in the wings to have a significant impact – and that’s the Chinese approach towards their zero-covid policy. President Xi is moving into an unprecedented third term, and thus an overall change of direction in a hurry is unlikely – however, at some point as and when China is back “fully online”, monstrous consumer of energy and raw materials that it is, supply shortages will be felt ever further. This in itself will have an impact on global inflation, and it will mean further upward pressure. 


Strategic Petroleum Reserve

The USA has been deploying its strategic petroleum reserve for the past year or so, with around 280 million barrels of their full reserve capacity of 714 million barrels being drawn down. This puts the SPR at its lowest level for the past, well, ever (since it started being filled above this level in the 1980s). This has helped to control the price of gasoline at the US petrol pumps and made a significant difference to inflation in the USA, which has taken a different shape to the UK inflation and has (before recent months) had more core (non-food, non-energy) inflation issues than the UK has had, although the UK core inflation has recently overtaken the US. 


This significant drawdown, in a time before China is back online, could be very damaging indeed. The cushion has already been used – and a significant impact of Chinese inflation now has a much smaller safety net behind it. The plan is to wait for oil’s price to drop before filling the reserve – the problem with this tactic being that crude prices are likely to jump significantly as and when China needs far more of it to get its economy back to full speed. 


All this represents yet another uncontrollable source of inflation for the UK. We’ve seen the primary mandate of the central bank – inflation control – take a back seat thanks to the political instability of the past few weeks. The central bank has had to perform an even more important role – to stabilise the UK’s position as a significant borrower of monies from the international money markets – in the past month or so. 


Opportunity to right some wrongs

This had provided an opportunity to shoehorn in a significant rise in the base rate at the next monetary policy meeting (November 3). This opportunity looks to be slipping through the hands of the bank, as they insist that the rates will not be climbing as high as the markets expect. The more I look at the governance and ability at the very top of the Bank, the less I am impressed at the moment; there seems to be no obvious reason why bank rates can top out lower than the markets think, and indeed I still think that the inflation risks are understated, not overstated, which means higher rates than anyone thinks; not lower.


The alternative to raising rates until it breaks

There is a relatively simple disinflationary path that doesn’t just involve raising interest rates until things break because mortgages (and rents) simply become so much more expensive. We were, quite happily, on that path under the Chancellorship of Sunak – tax increases. The logic is fairly simple – take money out of people’s pockets in tax, it leaves less money to consume, which calms demand. Even better, it funds public services rather than borrowing money to do so. No entrepreneur likes to see higher taxes (in fact, no-one does!) but this is (or was) a far better way to address the current situation and the gigantic wealth transfer from the government to the households that was achieved in 2020, than simply raising rates until the cost of living crushes the bottom 20-40% of society.


The complete reversal of this, which was attempted by Lettuce Truss/KK, was rightly shunned as total and utter economic idiocy, and as discussed has now been mostly reversed. The Sunak 1.25% rise in national insurance would have been better preserved, but the 1% drop in income tax which has now been cancelled has also helped to prove to international markets that fiscal responsibility is still the number one priority of the UK Treasury. 


Will we see that approach come back? Either way it looks like Hunt remains as Chancellor, at the moment, and that is a comparative rarity – the incoming PM will need to work with him; his removal would cause too many jitters in the bond markets which have come back to functionality, at least temporarily!


We must turn our attention though into what this actually means for UK property and how we, as investors, attempt to navigate the upcoming choppy seas and continue to take our portfolios forwards.


I’ve made no secret of my thoughts on the interest rate and the direction of travel over the past 9 months or so. Be philosophical about early repayment charges – a cost of doing business sometimes. Fix low, enjoy stability and cashflow for the next 5 years+. That’s fine if you’ve taken action, but if not – or if looking to still expand your portfolio – then what now?


Evasive action on rates

Some quarters seem to be suggesting moving onto variable rates – and some more attractive variable rates seem to be out there, with larger product fees – but there’s significant risk inherent in this strategy. If the fiscal policy “calming” approach doesn’t work as well – and taxes can’t be raised much further, whoever is in power – then we still have interest rates moving up to a level that the central bank doesn’t want to countenance or accept. Loans subject to that base rate could spend some time, longer than expected if I’m on the right lines, at levels that look like bridging loan rates or even higher. With commitment periods, arrangement fees, legals and repayment charges it could potentially be cheaper to be on a bridge at a fixed rate, especially as bridging loans have as yet remained insulated from the rate rises that have ripped through the rest of the industry. If base moves to 7 or above, for any sustained period – it will be that feeling of being near the peak but also not knowing just how high things could go – and at those sort of levels, every 0.25% would have a significant impact on capital values.


I still prefer fixing at the higher rates, if cashflow can be achieved and you have rent coverage. No-one should really need more than 60% LTV on existing stock at this time, after a 25%+ bump in capital values over the past 2 years – this keeps cost and risk down somewhat. New stock needs to have significant cashflow to offer protection against the current environment.


How do I buy? What do I buy?

How is this cashflow achieved? In one of the following ways – bigger deposits/more equity in deals – unpopular but it works. More layers of service/operations on each tenancy – i.e. HMO, or serviced accommodation. More work for the same cashflow as was being achieved 12 months ago? Sure, but we cannot benchmark to 12 months ago. Higher yielding property? Yes – but ensure you are looking at net yields after all costs, not attractive looking gross yields. Don’t go miles away from home without a robust management strategy in place. There are some excellent commercial yields out there at this time where some safety might be achieved – but put the work in beforehand, before jumping at them.


Do what? Really?

It might be time for those who have sacked the boss to take a look at a temporary return into the labour market, also. Consultancy, on a remote and/or part-time basis, at today’s inflated rates, is not the worst place you could get your next deposit from. It seems like a good time to sweat your human capital if you are not yet 100% free of all financial obligations. 


Some of this will feel like “taking cover” somewhat, which it is. There’s no guarantee of a drop in prices over the next couple of years – especially if inflation keeps ripping through the economy, as I’m suggesting it will. I certainly wouldn’t be on the sidelines waiting for the crash, although a price adjustment post-covid wouldn’t surprise too many people – the definition of the word “crash” would be important, for example we’ve seen relatively large adjustments to the stock and bond markets in 2022 without hearing the word “crash” particularly mentioned – it could be quite a soft decay in pricing. However, if employment stays high, and the labour market remains tight – wages still rise, and people still want houses – with an insufficient supply of both rental houses and houses to buy. 


Opportunity is knocking

There’s going to be little else we can do, for the moment – but we need to stay alert, stay liquid, and watch for opportunities. I’ve already seen around 5 to 10 times the volume of potential deals in the past fortnight than I’ve been seeing for the past couple of years – not too much of interest, but this looks like the start of a great time to buy, if you can work out how to hold on to the assets and at least break even for the next couple of years if you are buying at a significant discount. 


The key, as so often, will be to keep your head while all around you are losing theirs. Expect the unexpected – we are still only entering event 3 of this decathlon, most of the past year has simply been a warmup. Keep calm and work on making the right decisions (not buy high, sell low!).