Sunday Supplement – “Economics is everywhere, and understanding economics can help you make better decisions and lead a happier life.” – Tyler Cowen

Mar 13, 2022

Economics is everywhere, and understanding economics can help you make better decisions and lead a happier life.” – Tyler Cowen
Welcome to the Sunday Supplement – today’s efforts concentrate on some of the reality of the economics of the current times, and what it means for us as property investors or those exposed to the UK property market.
Today’s society at the coal face of social media looks more divided than ever, even though a sensible look at history would quickly show us that that statement is ridiculous. The key part of the sentence is “looks” – a small number of people on one or other side of a particular spectrum make a lot of noise and that’s interpreted as “popular opinion”, when it is anything but. The “silent majority” have never been so important, but on the other hand, they’ve never been so silent either!
Brexit or remain, Republican or Democrat, Conservative or Labour. It just isn’t that simple in reality. We have to revisit, once again, the inflation situation. The supplements of early last year spent an awful lot of time covering the arguments around inflation, and the guaranteed presence of it – with the real argument being whether it would be transitory or secular – would last a short time or a long time. Again, that’s reduced to a binary argument which is incorrect – there isn’t a day after 3 years 4 months of inflation, for example, that “transitory” becomes “secular” – and it will be judged one day in the rear view mirror of course. We need to deal with what’s actually happening now – and what’s happening is inflation already spiralling out of control and hitting the consumer in the pocket, with a further black swan event of a hot war in Europe which risks overspilling or heating up further.
A further benchmark has been passed this week, in the US anyway. The official figure has nearly reached 8% inflation – but that’s not the point. The expectations were that the number would be at least 8% if not higher; so the expectations were missed. This is the first time this has happened since the inflation breakout happened. The direction of travel is still in the wrong direction – it is going upwards not downwards – but not as fast as expectations had thought. This could be an anomaly, so waiting for next month’s number is the best tactic before getting too carried away – but it could be good news for the high point. The war is impacting the US with oil prices being at a record and the price at the pumps is a more important factor in the US compared to the UK, although remote working will be a help to an extent (but only applies to around 40% of jobs even potentially, in the US economy).
The US is a couple of months ahead of the UK in the cycle, perhaps three – although the UK is of course about 2.5% behind the US number and has been well below it for some time. UK inflation has run hotter than the US numbers, even though the US growth in productivity and the resultant impact on GDP has been greater than in the UK since world war 2 – this is because of a longer term trend as money has rotated out of sterling from the times when the pound was the world’s reserve currency, and into the dollar as it became the world’s reserve currency, so there’s been a long-term shadow there – as people want more of your currency there is a deflationary impact, because your currency gets stronger and your imports get cheaper (this does of course need you to be a net importer of goods). The reverse has happened in the UK.
The immediate point versus this long-term viewpoint is that the oil price has moved to a place around 40% above expectations just this week. It was a brief dalliance at nearly $140 for a barrel of Brent Crude on Monday morning, coming back to just under $113 at the close of trading on Friday. The backdrop of this is headlines around the highest prices on record – nominally true, but never put into real terms context. In real terms prices have been higher, once they are adjusted for inflation then the 2008 peaks for example would need to see Brent above $220 a barrel to be as expensive in real terms. Sadly, this isn’t completely out of the question – some scenarios would see Brent above $250 a barrel, but they would be quite extreme – Russia refuses to export any oil for example. Permanent infrastructure damage in Russia and/or the Ukraine. Nuclear war….but if we are there, we have bigger problems than $250/barrel for Brent Crude.
We are already at a place with the inflation numbers such that a smaller shock (when already at 5.5%+) is much more damaging than a larger shock (e.g. a surprise referendum result) when the number is low, at or below the long term target of 2% – in May 2016, inflation was at 0.7% and post-referendum relatively quickly climbed to 4% – not all the referendum result, but a significant amount was, and mostly because of currency devaluation as the pound got weaker in the eyes of the world. Inflation expectations are completely underreported – the market is, as I write this, not seeing inflation under 3% in the next FORTY years, using the difference between nominal gilts and index-linked bonds. Real yields (after inflation) on bonds are between minus 3% and minus 1.5% for the same time period. Mindblowing.
So what does inflation mean for us as property investors, in our economic ecosystems? Inflation sees consumers bring purchases forwards, all else remaining equal – high inflation also erodes the confidence in the monetary system which is a more significant risk of course. However, on the back of the shadow of the pandemic, households have more savings and are wired, at this time, to be in a more defensive mood. Consumer confidence was at its lowest in February 2022 for 13 months, with consumers in the benchmark survey looking particularly bearish about the next 12 months economic performance as well. So the first port of call – increased consumer spending – is not playing out anytime soon. There are 2 considerations here of course – people spending more solely because prices are going up, so spending more in nominal terms – and people spending more because optional, high ticket or luxury purchases, are perceived to be going up and now is the time to buy – this is the part that is not firing at the moment.
There are two things we need to look at as investors. Firstly, how is our asset class performing in real terms? Can we beat inflation and earn a crust from the risks that we take? This question at the moment is difficult to answer. If we look at the purchasing power of money, and we take significant leverage on an interest-only basis, we are happy with a healthy rate of inflation. Indeed I’d suggest that 3-4% suits us down to the ground, just as it does the government after the significant debt mountain built up over the past couple of years under the pressures (and dare I say opportunity) provided by the pandemic. On the basis that wages move upwards, and credit stays available or gets even more available (in a sustainable fashion), that debt inflates away and our asset price increases. This would be “functioning high inflation” and there’s a reason why the target is set at 2% – this is a lovely thing to wish for but unlikely in practice. However, with rates remaining low, we do have a chance to benefit as we can borrow and in real terms get paid for that privilege. If we can beat the rate of that debt, we are better off than if we are not borrowing.
That leads on to the second point. What else can we do with the money? We can always liquidate investments and consume it, of course. The holiday of a lifetime, the dream car, etc. etc. This is the gratification that so many do delay – but once it is gone, it is gone, naturally. Keeping our investor hat on, we look for other opportunities – where can we earn better returns? Indeed, as was in the 1970s, we risk a situation at the moment where the game becomes “who can lose the least money in real terms?”. There are always winners of course, in every market – the savers have no chance of being in that camp at this time. The borrowers are the likely winners, but they must invest wisely and buy assets that will perform.
The energy market obviously has a significant correlation to inflation, although it is not the only driver of inflation of course. The prices already referred to in the above, and the effect of the current geopolitical events taking place, have multiple implications. Heating your homes – winter is over, and for the first time the weather forecast sees every day next week above 10 degrees celsius in the UK at its peak – is on the back burner until October when the next fuel rise bites. We will need to get used to paying a lot more for our electricity – disastrous for some households, those on fixed incomes specifically – anyone heavily reliant on the benefits system, the 17% of households who rely on the Local Housing Allowance element of housing benefit or universal credit, but also those drawing their state pension – which in itself is a significant issue for the incumbent government as the pensioners represent the strongest lobby in the country when it comes to voting, without ever taking to the streets to protest!
It isn’t just heating and electricity of course. Anything that goes from A to B needs transportation and transportation costs have already ballooned in the past couple of years. The input price of the commodity is only one factor, but if significant increases to the cost of living mean staff demand higher wages, in a very tight labour market – are vacancies up or down, the last ONS number nearly a month ago was 1,143,000 vacancies – the highest on record. So again, what is the direction of travel? It has only been upwards since June 2020 when there were fewer vacancies than at any point in the 20 years before the pandemic. Companies are not stupid – although they might easily be quite distracted at the moment – minimum wage is up 6.6% in less than a month’s time, and so that in itself will be inflationary but force some to shed a few jobs if they cannot successfully pass price rises onto customers. Price rises are never 100% passed on to the consumer in a functioning market – so margins get squeezed as a percentage.
Higher energy prices mean higher food prices from both of those angles – the energy bill of the retail outlet, the fuel costs of transportation – and could add a further 1.5 to 2% to inflation. This is why I feel 10% is now odds on to be published as an inflation number this year at some point within a few months – unless we get what will now be a surprise stop to the conflict in Ukraine.
So back to the micro level – what does this mean for us as investors? Our own cost of living, of course, hit on all levels. Once again the “who can lose the least?” question – flights going up by a rate of knots, as kerosene costs soar, but staycation again (and didn’t fancy a ‘plane this year anyway? The global covid situation is quite different to the UK situation after all) and expect the higher running costs of those units to filter through, at least in those that are run professionally.
And that is the point – if you are an operator of furnished holiday lets or serviced accommodation – have you tweaked your pricing to reflect higher bills coming down the pipe this year? Have you looked at solar PV systems or other green systems to invest some money in order to get payback, because payback on solar PV has changed dramatically in the past several months? You can increase your EPC at the same time by doing this of course, which has further implications which I will move on to.
What about HMO? The increase in bills is just inevitable, with rises of 50% or more, especially if you are coming off a cheap tariff onto a naturally more expensive variable one and struggle to fix. I’ve heard some clever solutions though from our Partners in Property community, as I would expect – a real drive to save energy with renewed vigour, and even incentivizing tenants – the difficulty around maintaining fair use clauses in your contracts for HMO owners rears back to the front of mind here, with a larger incentive to try and get this right for the asset owner. Once again solar PV and other green solutions need re-examining.
And single lets – no-one is safe of course. If your tenant type has a fixed income and relies on LHA, there’s a double bubble problem in the pipe here. Come 1 April, minimum wage is up significantly – housing benefit is up 0. Other benefits are set to increase by 3.1%, pension and universal credit – less than half of the working increase set by the minimum wage, a little under the average wage rise this year, and well under the rate of inflation. On top of that your voids will cost more money with some standing charges doubling or more, and 51% increases in the price cap. Affordability is down, and for new tenancies we are looking at a bit of extra room in that affordability calculation, keeping affordability down to more like 25% than the nationwide 33% that is accepted. The average ex-London tenancy is at 29%, but percentages hide certain things – there is a collar to the cost of living and the lower the income, the more you will feel it.
Potential problems include rent arrears and the inability to raise rents to reflect far higher costs of maintenance, and compliance. We could also see some of what we saw in the pandemic which is what the economists call the substitution effect – more people moving back in with parents, not leaving home as early or having to save more for their first property, and of course at the market level first time buyers getting yet older. This affected HMO more significantly than anything – but also during the pandemic there was an incentive and a drive to get much more space, and break up the household. This trend could reverse, and with fewer household starts/new household creations, the demand and need for new build property could subside somewhat.
That’s the glass about nine-tenths empty – the realistic worst case scenario is that that effect is nowhere near enough to temper the overall attractiveness of the UK as an immigration destination, and the housing shortage is so deep and we are so many millions behind that this is a ripple of an impact worth a few basis points on housing market capital growth. So don’t worry too much! But there’s fragility to some models – the more exposure you have to the bills directly, the worse, but HMO could also become more attractive because the “bills included” model makes the gap between a one bed flat and an HMO room much bigger, and so purely on affordability HMO becomes a lot more attractive than the self-contained unit.
There’s one major stakeholder omitted from the above, of course. Social housing. Those providing support services and paying bills will have their business models put under pressure. The demands on the local authority to increase rates will be significant, but the money won’t necessarily be there to do so. Or council tax bills will be up another 5% or more in 2023, as the new bills start to bite from the beginning of next month.
On balance, in conclusion – this sort of environment is not ideal for ANY asset class, but suits a hard asset like property very well. Review your financial arrangements, even considering breaking existing mortgages and swallowing the early repayment charges because liquidity will be everything at some point in the next few years. There’s a few hares running which could lead to panic – note, panic, not crash – but panic brings serious opportunity. The beauty of being in a market where you provide a staple good is that you are always needed, and your role in the market has a significant value. If you sell luxury goods and there’s a recession – or you fall out of fashion – your business is in trouble and could even be over. If you sell housing……on a rental basis……the last couple of recessions haven’t been too unkind. Keep on your toes, review your assets, consider high gearing if you can deploy the money safely and stay liquid (it is a really hard time to sit with significant funds in the bank because of the inflationary effect on those funds). Stick with it – the rewards are there and despite continual slings and arrows, the decade’s prospects still look bright for UK residential property. Until next week!