Welcome to the Sunday Supplement – please can I ask that you like, share and comment on this post? It helps the reach of this – in fact, the reach of this is totally dependent on you liking, sharing and commenting on it! Thank you in advance.
This week I want to focus on clarifying a few things. After several conversations, message exchanges and emails with several supplement regular readers, it’s clear to me that I need to do this with clarity because I know that some people do take what I say quite seriously (a phenomenon that I still don’t understand or get used to at any point!).
There’s a few threads to draw together. I put a Facebook post out this week that drew quite a significant reaction (no, not the one where the bloke called me a naughty name…..) – around interest rates and more specifically bond yields and the resultant swap rates. It was calling people who use significant amounts of leverage (like me) to action, and telling them to sit up and pay attention. I had another exchange in my relatively limited social media time on a very typical post about investment – the age old question, should I invest now or should I wait – and I wanted to talk about that in some more detail. In summary, I then wanted to talk about what to do if you do follow some or all of what I say and think I have a reasonable handle on upcoming events – and most importantly what YOU should do about what’s potentially on the horizon in your own personal investment situation.
Firstly – let’s cover off a few dictionary definitions. A recession (and can I say at this stage, I am the first to joke about people predicting 9 of the last 3 recessions and things like that, and can’t stand the clickbait doomsayers doing things just to get reactions) is currently a 50/50 chance over the next 18 months, on my numbers.
So – what’s a recession? It is 2 quarters of negative economic growth (measured by the gross domestic product of the country, the GDP). Like all measures – beware. What about if there are two quarters in a row where the growth is -0.1%? Is that a recession? Technically, yes it is. Should we worry about the sky falling? No, you’d think not – although only a fool would ignore an economy that is clearly struggling that much in order that that becomes the case.
One problem, in the post-financial crisis world (let alone the post-covid world) is that growth was “rattling” along at between 1.25 and nearly 3% per year, on average, between 2010 and 2019. The average was under 2%. Quarterly, this is under 0.5% on average of course. Fairly fragile situation to start from, I’m sure you will agree. This is why in real terms (after inflation) some household incomes were lower over that decade – the growth simply wasn’t there in aggregate to lift (nearly) all boats in the rising tide.
So you start from a low base, and what then happens? Any shocks hurt more. But, even more importantly – so what? What if there IS a recession? Well, we all associate recessions with losing jobs and higher unemployment, struggles to make ends meet, fewer luxuries, business and bank failures. That’s certainly one framing of the situation.
There are alternatives. You can see why (and this is why I have used it as today’s image) there were predictions made around huge property crashes in 2020 – mostly because analysis was done by people who don’t understand black swans or what a statistician might call a 3 or 4 sigma event (being so far from the typical “average” that the numbers break down somewhat). GDP and the housing market in the UK do correlate, to an extent.
There’s a few things to say about the graph, too. The graph uses the MSCI (an index provider and research firm, Morgan Stanley Capital International) all property total returns, year on year, and plots them against GDP growth with a very different scale on both axes, to make things look about as correlated as they can. As always, the devil is in the detail. This isn’t UK residential property – it is all property in the UK. Commercial property in recessions is much more cyclical.
What’s hard to find is a graphical representation of UK nominal house prices versus GDP growth. Why nominal? Because your debt is denominated in nominal terms. So what am I saying here – that if there is inflation (often linked to a recession, naturally, but not 100% correlated) then we could easily see a situation where you gain nominal house value but house prices are down in real terms.
Let’s bring that example to life a little. House, worth 200k. Inflation 10%. House price goes up 5%. All over the course of a year, from 1 Jan 2022.1 Jan 2022: House worth 200k in real and nominal terms.
1 Jan 2023: House worth 210k in nominal terms, but take off 10% inflation – house worth 189k in real terms. Real equity -11k or -5.5%.
Introduce the leverage, a vanilla 75% LTV interest-only mortgage (ignore frictional costs for the purposes of the exercise):
1 Jan 2022: House worth 200k in real and nominal terms. Mortgage 150k in real and nominal terms. Equity 50k in real and nominal terms.
1 Jan 2023: House worth 210k in nominal terms, but 189k in real terms. Mortgage 150k in nominal terms, but 135k in real terms. Nominal equity now 60k. Real equity now 54k.
So…….real house prices are down 5% in that example. But you manage a real equity growth of 8%, even though house prices didn’t keep pace with inflation. Something very, very worthwhile thinking about and the power of leverage in a “down” market in real terms. Also note, if wages are up 10% (this depends where you are in an inflation cycle of course), then houses are also more affordable – which is why all of the media circus and hype around nominal house prices is absolute rubbish, most of the time (and why the market doesn’t look like the 2007 market right now, if you take inflation into account).
Worth pointing out when you consider there is a strong correlation between GDP growth and real house prices (strong, but not guaranteed). It is worth repeating that 58% of the UK in terms of households did not see a real terms growth in their properties’ prices in the entire decade of the 2010s.
So that’s why portfolio holders can and likely still are making money even if house price growth doesn’t keep up with inflation. The leverage is very important as you can see.
So recession combined with inflation (inflation first, typically, and then recession slows down inflation because demand drops and unemployment rises, pushing consumption down) has happened a number of times in the recent past of the UK. There was limited inflation in 2011 after the financial crisis – inflation was not the driver nor a major part of the 2008 conversation. The early 90s market will give some readers shivers – although it does need to be remembered that the interest rate behaviour was largely forced by the ERM bloodbath (and was a big driver in creating the independent central bank later that decade). A repeat of that seems unlikely. For the record books, annual inflation was 9.5% in 1990, 5.9% in 1991, 3.7% in 1992. and 1.6% in 1993 – which says something about the staying power of inflation and what secular inflation might look like in the next few years.
In fact, it is also worth revising the actual property price movements in the 90s. Even those who lived through it at the coal face normally cite “15% interest rates” – pedantry of the highest order, of course, but interest rates never actually reached 15%, the highest was 14 and seven eighths per cent – and that was October 1989, not September 1992 (where the rate went from 10, or 9.875 actually, to 12, to 15, all in theory and was never an official bank rate change – in fact, often missed is that the bank rate dropped to 8.875% 6 days after Black Wednesday, which in the context of the 70s and 80s was a “low rate” of interest (get your head around that if you don’t remember the detail well or are too young to have been in the game!)
The often-recalled “bloodbath” in the property market back then, in nominal terms, found its year-on-year bottom from Oct-Dec 1992 – at minus 7.3%. Between July and September 1988 it had found a top at +33% year on year in nominal terms – yes you are reading that right. Now – in a world of 10% bank base rates (although you need to remember – the margin in those days was largely loaded on the savings side, offering 5% which outstripped inflation – sometimes – and left a fat margin in it for the banks to lend at, or close, or below the base rate – indeed some will remember the discount tracker mortgages that still existed in 2007, the highest discount to the base rate that I heard was 2%, which got very interesting indeed when base dropped to 0.5% in 2009). It was of course a different world back then. But you’d like to think that had the supplement been around in 1988, it might well have been pointing out that this sunshine couldn’t continue forever in the midst of a +33% YOY bull run.
Indeed, what 1990 did bring was some sense of reality. “Things couldn’t go up forever”. The graph post Jan-1990 comes back to something realistic – a bit like the graph after 2008. These were major, cataclysmic events that shaped entire schools of economic thought – we aren’t there yet. We have the Modern Monetary Theorists pushing for Universal Basic Income – not of the sort that even Friedman would have supported, where it is basically getting rid of the bureaucracy and inefficiency around allocating benefits – but the sort that has potentially dangerous consequences on the incentive to go to work (I offer you some evidence in the form of the 550 thousand people who are out of the job market, voluntarily, after covid, despite being fit and able to work – I support the individuals who have discovered themselves and found there is “more to life”, but I doubt those 550k can truly afford to retire at a younger age and be a part of the “great resignation” – the next couple of years, and inflation, will tell). I have published before my analysis on furlough and what a spectacular policy it was – at the time – but I have a feeling there will be a 2023/4/5 update on the longer-term effects of furlough (and indeed the hangover of the government policies of the pandemic as well, of course).
None of these lessons from the past – and I’m a huge fan of economic history – sound too scary. Particularly for the sensibly leveraged. I feel obligated to just stay on that note for a moment – the sensibly leveraged. Now is an absolutely fantastic time to fix debt – rates ARE going up. They’ve already gone up. You’ve got a few weeks. The number at the moment is only 0.25% or so – but this could be the first of several gaps up in the bond yields and swap markets over the next 12-18 months, so you might be hedging against a 2%+ increase in your interest rates. There’s no guarantee of that last bit – that’s a possible situation with a probability of around 40% in my book – a big old risk of a big rate rise.
You’ve got 12-18 months to reorganise portfolios or possibly longer before any music stops. But we could easily have a nominal price bull run that goes on for years in UK resi property. If next year we have an average inflation rate of 6% (perfectly possible) and property goes up 3%, do you want to be in or out? What else will you do with the money? Stock market investments at the moment are punting that the central banks will bail them out once again at some point (which they might do, but in a smaller way than the past decade, and they will exercise those “options” at a lower market rate than has been speculated, in my view). Bonds (as in government bonds) are not for supplement readers, generally, although your financial advisors might disagree – and I read a really interesting theory this week that basically says there’s so much money in the world now, that institutions are accepting bonds as performance drags in real terms just because they are so safe. Real returns from bonds, or the expectation of that, is largely a thing of the past (it definitely is over the next 3 years, in my view, and that has been the case depending on country and bond type since 2009).
I want to be very clear in conclusion.
I feel there is a 50% chance of a recession in the coming 18 months.
I feel the most likely outcome is a property market rising in nominal terms, and losing ground after inflation – but primarily because inflation is so high.This is a 75% likely scenario for me.
I believe that property still encapsulates the very best opportunity to take advantage of inflation, due to the nominal debt situation that is at our disposal. The example of that, simply, is above.
I believe that even if you cashed up today, the alternative (other than spending it) is very weak – you will be taking significant risks in things you don’t truly understand. Gold – good luck. Could be a great buy.
But it still looks relatively historically expensive (it won’t when inflation really bites). But it yields nothing.
Crypto, which is interesting, but rammed with speculators. Some of those, many of them, will be better traders than you are. There are still thousands of scams out there too – so be careful.
The stock market, which has overperformed extensively over the past 12-13 years in a world that hasn’t gone anywhere near as far forward as we would like, from a productivity perspective. If anything the markets look fair value, there may be undervalue companies (there always are) – but again serious devotion, skills and expertise are needed.
Spend it – well, if you have an inheritance tax problem and too much but not enough to start using very fancy structures – you may as well spend it before things get more expensive. Whilst that’s an investment in your mental well-being and experience, it isn’t a real investment so we can’t take that too seriously.
What you need to do is protect yourself against INFLATION, not recessions. I talk about them because this is my subject, this is my thing, I’m passionate about economics. It helps me second guess what governments and central banks might do. It helps me run my group of companies.
Time IN the market, not TIMING the market. Uncle Warren. He always provides in these situations, and now is no different. There are deals out there – I’ve just completed one of the biggest and best I’ve ever done, with my partners. Since we agreed the price, because it was a complex purchase, the market is up over 5% in that area. Rents are up more than 10% from when we started discussing the deal. That’s a hell of a free option and that’s what is going on at the moment. DO NOT SIT AND WAIT FOR A CRASH IN THE PROPERTY MARKET. Thank me, or vilify me, later.
This is of course my own opinion and shouldn’t be considered investment advice. The bigger the bat you swing, the more important your professional services team, peer network, advisors, and your own health – from a mental, physical, and mindset point of view. There’s loads more choppy seas to come which are partially covid-related, somewhat brexit-related, and determined by external factors like Russia and Ukraine (as one example).
Keep calm and carry on – until next week, folks. The puzzle continues to form; fascinate; and surely this is better than Eastenders, right?
