Inflation, you say?

Sep 18, 2022

“The only thing that should surprise us is that there are still some things that can surprise us.” – Francois de La Rochefoucauld (French author)


Welcome to the supplement in “hiatus week”. With many institutions on hold or deferring major decisions (like the Bank of England) for example in light of the passing of Queen Elizabeth II, the news has been somewhat thin on the ground. The timing of two of the major announcements last week, the “cap on the cap” of energy prices in the UK, and the eviction moratorium and rent freeze north of the border in Scotland, were fortuitous given the timing of the Queen’s passing. In comparison, this week has been somewhat thin on the ground – finally a date for the “fiscal event” or emergency mini-budget as some are preferring to call it, that’s next Friday on 23rd September. The day before will see the Bank of England raise rates by at least 0.5%, and possibly 0.75% – my money is saying 75% 0.5%, 25% 0.75%, for what it is worth. The dovish nature overall of the MPC is likely to take over, knowing that large hikes are more likely to cause large problems. The expectation in every camp that I speak to at the moment is upwards, in the next few months, although many are, in my view, still reading this whole situation incorrectly.


Markets don’t stop though – certainly worldwide markets. The US and UK stock markets have taken a bath this week as the bears have taken over – and indeed, the expectation on the currency trading front is a prolonged and difficult recession in the UK. Sterling has hit an all-time low against the Swiss Franc, with £1 only buying 1.10 CHF (bouncing back to 1.11 on Friday), compared to 3.82 CHF 40 years ago today (that’s the effect of being a former global reserve currency, right there – although the Swiss have also stayed strong and stable, generally speaking, throughout).


I’ve spoken and written about my overall feeling that, whilst I saw no particularly viable option to capping the energy cap (to be clear – I mean that “in the moment” – the alternative was to have a proper energy strategy, invest in it and deliver it – alongside far better regulation of the sector – neither of which we have seen, and neither of which we will see, under this administration in my view), controlling something as volatile and as uncontrollable as the energy price feels a little bit like the Bank of England buying sterling in the events leading up to 16th September 1992 (passing its 30th anniversary with no commentary this week) – when the UK left the ERM, the exchange rate mechanism, one of John Major’s weakest hours in charge and only 5 months into a new parliament. 

The moral of the story – governments can control markets until they can’t, and when they can’t, the fallout is really significant. Our strategy then went from “have a strong currency and take advantage of pegging to the ever-mighty Deutschmark (as it was at the time)” to “a weaker currency will make us more competitive in export markets as it will make our goods and services cheaper” (or, TINA – there is no alternative – so we might as well suck it up). Many a headline and a commentator focuses on the money, because everyone loves to moan about the money without even conceptualising what £100bn (and we all know the bill will likely be more, here) even means. The economic engine generates £2 trillion per year roughly, and the governmental receipts were £915 billion in the previous financial year – that puts into context just how significant that number is, but 1/9th of receipts (or a little under a month and a half) to avoid a financial meltdown and many deaths seems a reasonable investment given the complete strategic failure that has led to this position.


We also aren’t at “full ERM”/the mercy of George Soros or equivalent intelligent hedge fund traders here. Sensible contract negotiations at fixed prices from nuclear and renewable energy sources have been negotiated – so we have at least controlled what we can control. One of the problems, if you’ve never heard, is that wind power is so variable that there have been days where the UK has been entirely powered by renewables – there have also been days where wind has provided less than 4% of our energy requirements. Offshore wind is more reliable than onshore, for reference (and many would I’m sure prefer the wind turbines to be out of sight, out of mind – personally I don’t find them particularly offensive on the eye). 


Still, it feels like the pause button has been pressed after this momentous decision – and there will no doubt have been a 30 day impact plan for Truss, and a 90 day plan, and the disruption means 7 working days of that has simply evaporated. There’s a lot to do, and don’t forget – the party faithful that have fallen for someone who looks like the most ideological traditional conservative for some years, are expecting her to win an election in relatively short order too. So, she needs to win over the people – those who lent their vote to Boris, the old red wall, and any floating voters tempted to defect to her old party, the Liberal Democrats, of course.


I want to spend some time focusing on the stock market movements temporarily. This week’s quote is meaningful – because I have spent most of this year being surprised about quite how well the markets have been doing (yes, I know they are down by a reasonable amount at this point in the US, -17.3% YTD S&P 500 from a pretty bloated new year valuation – less than 5% down in the UK seems too bullish to me compared to the bad news that has developed since what we knew on 1/1/22). An awful lot of this has come down to 95%+ of the rest of the world having a much more bullish view on inflation control than I have done. I first wrote about inflation being a secular problem (one difficult to control, and long lasting) in February 2021 – at the same time as the Bank of England talking about negative interest rates. I’m still surprised that the stock and financial markets in general are seeing what looks like it is relatively obvious, to me.


The talk of transitory inflation has evaporated, but not for a switch of position to where I, and some other select economic commentators have been, for that period mentioned. From transitory to “somewhat secular” I would describe the market’s prevailing opinion. The reality is, this is ever more clearly secular than it was in Feb 2021 when it was an idea, a theory, a possible and probable course of action – core inflation, for a start (no food, no energy taken into account) has been well above a comfortable level (say 4%) for months and months in the US, and is now there in the UK too at over 6%. That’s where the goods and services that have not been directly affected by the energy crisis (this will, when it comes to the history books, be one of the defining features of the decade after the pandemic, and is likely to run on for longer than the pandemic, in my view) have nevertheless started inflating. Wage demands going upwards puts prices up of everything, wage demands need to happen to even attempt to stay in the same place on the basic costs of living – but then inflation in home improvements and maintenance, alongside increasing interest rates, massively raise the price of shelter in general. 


For property investors that filters through more into rents (the bigger your portfolio, the better off, nominally at least, you are) than it does to their own cost of living – for 1 or 2 property landlords it perhaps balances out. But where does the cycle stop? I’m afraid there’s only one realistic answer to that. Recession. Demand destruction by raising interest rates too high, too fast. A little history is also desperately needed here to put that statement into context.


“I remember the 1970s. I remember when mortgage rates were 18% in the 1990s.” Heard it many times, or more likely read it on social media. But I have one question – Do you? Do you ACTUALLY remember what FACTUALLY happened? The answer, almost every time, is no. No, not at all. And that shouldn’t really be a surprise. Some of us (myself included) can’t remember everything that happened last week, so events of 30, 40 and 50 years ago – even if we are old enough…..should we really expect to remember them? The order of play? Which event triggered what other event? Unless you are an economic historian, I would say no. Unless you wrote a macroeconomic journal throughout those periods, I would say no (if you did, or you know anyone who did, I would absolutely love to read it, or interview you, as an aside!).


The most pertinent example of this would be the aforementioned strategic “pivot” (read – desperation play) that followed upon Britain crashing out of the ERM. Rates at 15% (announced for an afternoon, changed by the next morning, and by the next week back down below 60% of that value, below 9% – which in context of the time, was not unusual) were never even historically enshrined by the Bank of England at 15%.  the official base rate turned into a graphic – I started the data from when I was born, in order not to cherrypick – and finished it once the early 90s recession had played out. Note the difference (and the absence of a 15% rate in 1992).

What actually happened? Well, the Treasury realised that 15% rates meant far too many homeowners, having bought homes and also taken advantage of massively rising prices and MIRAS (Mortgage Interest Relief at Source – yes, you used to get tax relief for mortgage payments folks if you aren’t lucky enough to remember it) – and regeared, because this is how the middle class exploded in the deregulation era of the 1980s – could not possibly afford their mortgage payments. So the plan was aborted – and indeed, with the lunatics in charge of the asylum, it became a key part of the next election campaign, with one of the manifesto commitments of the opposition (who won a resounding victory on the back of this and other screwups), being to make the Bank of England independent. 


So, a lesson, if it were needed, in truth and rose tinted spectacles. Two other lessons, however, in that graph. With double digit inflation for most of the 1970s (with a peak at 25%), we came into 1980 with a rate above 15%. That wasn’t as scary as it sounds at the time, as it was a couple of percent above inflation – it was also the winter of discontent, of course, in ‘79 and as usual, as inflation looked somewhat under control the rate dropped like a stone. It’s also clear that the average in the period was over 10%, but that that period started and ended not far away from 5% (the long term average over the 300+ year history of base rates is closer to 6%). That drop in the rate from the late 80s to 1994 saw in a huge boom in property prices, before a stutter around the millennium and another massive boom in the early noughties, leading up to the global financial crisis of course.


One last lesson though – when mortgages looked in danger, other methods were found to change the path of fate. I still believe we can easily see rates over and above 5% in the coming 6 – 9 months, but am not doing the readership the service that it deserves here. The peak is distracting us all – even some commentators who are usually level headed – but we need to learn from the bond market here.


The peak is just that. A peak. The theoretical early 90s “peak” of 15%, as discussed, is a complete ghost. What was important was duration, back then, and it still is now. If inflation is stronger, for longer (and that’s the definition of secular inflation) – then when the market FINALLY does catch on to that, there will be a further reaction upwards in rates. Why? Because stronger rates for longer are needed to calm that demand down and keep the economy under control. 


There are “soft landing” alternatives that have been managed historically in around 10-15% of these situations –  but they don’t involve the central bank going into every meeting it has (and you could level this at the Bank of England, the ECB, The Fed – all of them) not really knowing exactly what they will do over the next 6 months. I quoted him some months back – Ben Bernanke in 2015 said monetary policy is 98% talk, 2% action – at the moment it is not quite 98% action, 2% talk – but the talk is definitely less than the action. The talk is lessened because the direction of travel simply isn’t clear. In the absence of a proper tactical plan, I see the soft landing option as a 5% probability or lower. With an idealogue as a prime minister, that 5% evaporates yet further, to be honest.


So how long until inflation is back under the target? My feeling – around 3 years at this point. And so we go to the number one mistake that I am hearing over and over again. In the US they call this the “Fed pivot”, related to the “Fed Put” where once the stock market goes below xx level, the Fed intervenes and cuts rates. This whole chat misses something very fundamental – inflation.


None of the recent pivots and puts have been done in an environment of 8%+ inflation (10%+ in the UK, of course). Getting inflation under control is the SOLE mandate of the central banks, with secondary leans towards employment figures, and a stable economy. Even if we go into a deep recession next year in the UK, which has a 25-30% probability in my book (this would be defined by GDP going down more than 1% over the course of the year, in real terms), rates will not be able to be cut. Instead, they will still be increasing. Demand destruction will occur, and people who do still have disposable income will start to hoard it, which of course makes the situation worse, calms down the money multiplier (the number of times £1 travels through the economy, being taxed at most points of course, when it has been earned), which also helps to deflate the economy (often at the worst time, naturally). 


As often, we are quite lucky. I follow the “The US sneezes and the world catches a cold” analogy – but in reality, this has a specific meaning in the UK. So many of our listed companies have revenues denominated in dollars – 77% of the FTSE 100’s revenues, at the last count. That’s a massive dependency on the performance of the dollar (incredibly strong, at the moment). Our currency’s strength defines how much our plethora of imports cost us. We import more than we export, and so a weak currency is, you guessed it, inflationary. More bad news, more petrol on the fire. 


The US has moved first, it was more brutal with its economic handling of the pandemic – it also stimulated much more aggressively, so we have been able to observe the fallout of that fact. It has possibly seen its inflation peak (although I would suggest more than a 50% chance that the peak is yet to come) but we will see its duration play out some months ahead of our own. Unfortunately for us, as above I believe this plays out over years not months, so it is not a massive help; but it is a help nonetheless. The market now expects a potential 100 basis point – one whole percent – rise at the next Federal Reserve meeting – in order to really get on top of this inflation situation, before it becomes entrenched.


The fallout of that is the impact on bond yields and that’s where we get to talking turkey in terms of the mortgage rates. We may, as investors, all be sitting sweating the 5 year limited company fixed rate – but this is not the rate that has by any means the most impact on the residential mortgage market and thus the pricing of residential property overall. The most important rate is the 2 year (or 5 year – whichever the cheaper – 90%+ of the time that will be the 2 year) fix for residential mortgages that is widely available – in the UK. If the 5 year is below 5.5%, the affordability side is no different to what it has been since 2012 – since this was the test that was applied, regardless of if you were lucky enough to get 5 year fixes at 0.99% or below last year on your own residential property.


In the US they fix for a lot longer, and the 30-year rate is the valid one, most often used. That rate is at its highest since 2008, and that simply has to destroy demand for first time buyers, and second steppers to an extent. If you can port a mortgage, that changes that of course – but a second stepper usually has to sell their house to a first time buyer (unless they have the cash to retain it, of course). 


If and as we go above 5.5% 5-year residential pay rates, then we will see the same impact as what’s about to play out in the US over the next few months – demand destruction (depending on how far above 5.5% we go). Now, the bond market is smart (but still hasn’t seen this inflation for what it is, for what it’s worth, in my view) – and so it doesn’t just jump up when the rates jump up. The likely path of the rate as the financial markets currently see it is what is baked in. What I’m saying, hopefully clearly, is that this path is too low at this time. 


This has, unfortunately, put us in a bit of a spot for onward purchasing. Those who’ve listened or read with any regularity in the past 6 months have, I hope, fixed their mortgages. I’ve had many readers reach out and say they have – and thank you for the messages, I really do appreciate every single one of them. However, none of us can control what’s going on for expansion purposes. Purchases that were no brainers 6 months ago now need another 5% off the price to make it worthwhile – or are not even worthwhile holding, they might as well be flipped. So how do we make this add up?

Well, a few things. 1) In your 5 year numbers, bake in a rent increase. 3.5% per year or similar. That’s what I’m doing – because I believe it is accurate or even conservative. If inflation is rife, rent inflation is rife. 2) In your 6 months mortgage rate numbers, if you are using a momentum or (aaaarrrrgh) BRRR “strategy”, then use around 5.25% for a 5y fix at this time. 3) Use 5-year fixes, but don’t let everything drop off at the same time. Yes, some 7 year or 10 year are even cheaper – very little cashflow once on term, with rent increases, and a good capital uplift via redevelopment, buying keenly, or both – will still stack up. 4) Attempt to use vendor finance loans on larger deals, at rates that are above the bond yield but below the mortgage rates. That can help things to stack up. 


Don’t deploy all the cash you have just because of inflation. Don’t overcommit. Don’t buy because you are bored, or have itchy feet. You need extreme concentration and there might be a whole raft of deals next year. There might not be though – so if that gift horse comes along now, take it. Don’t expect it giftwrapped though – we are working as hard as we’ve ever worked for our deals, and are taking solid, long-term, income generating properties. Now isn’t the time to buy at 4-5% yield, and I really would urge you to consider HMO minus bills net yields, not gross yields, at this time. That exposure could be deadly, especially if you already have a number of HMOs.


And as always – the last piece of advice – Keep calm and carry on, back next week with no doubt a 2 ton truck to report about on the back of the “fiscal event”, plus the Bank’s biggest decision for some time on interest rates.