Welcome to the supplement. Bam – just like that we are halfway through the year. Or 26 supplements in, as I prefer to look at it. Q2 is ending and we don’t really have all the data I’d like to see about Q1, just yet. As always, though, the world moves faster and real time is very important at the moment. Markets volatile – with bull traps, potentially, as things look fairly bleak for the next year, particularly for some economies outside the UK.
Markets recovered this week though as the question that’s really being asked is “Can the central banks really raise these rates at this pace?”. The answer that comes fairly easily to most analysts’ lips is simply “No”. But, they can, they are, and something will break. The question we really need to be digging into is “what will happen when things DO break?”. I.e. Will rate rises just stop?
Well, unsurprisingly, that’s almost all on inflation. The raising of the interest rate is the wrong tool – it almost always is. Tightening, this time round (the raising of rates raises the price of credit, and when the price of something rises – all else being equal – less is demanded, of course) is an inevitable effect of too much loosening. At a really simple level, we got tunnel vision during the pandemic. Of course we did. It gripped every bit of attention that we had. Some of us had an eye on the after-effects, of course, but it would have taken a superhuman to ignore the pandemic and only focus on the future.
The longer-term effects were of concern. We had a massive recession – and the public as a whole barely noticed. Instead they were paid to stay at home, in many circumstances. They were then forced not to consume their usual entertainment and services, and instead turned to goods – hot tubs; cars; peloton bikes; property purchases with bounceback loans. Sound familiar? Lunch was free – and as you know, lunch is never free.
Our tunnel vision then turned to letting the economy recover. There were lone voices at the Bank of England calling for rates to rise more quickly than they did. Andy Haldane, former chief economist, got something very right and something quite wrong, from what I recall of most of his soundbites and interviews last year. Right – the economy would be on the up and rates could start going up sooner. Wrong – the household savings would provide a massive boost to consumption in 2021. It’s taken longer than that to filter through, and today their primary use is to deal with a world where prices are up 10% on average. We all know there are pretty horrific outliers going into that average – 60% on energy, 75% on fuel right now, construction inflation is certainly double-digit. There was too much fear to take the foot off the gas before we had completed the V-shaped recovery.
This was ultimately pretty stupid. Our chance of a soft landing – where we come out of this without a recession – is sitting with most economists at 10% or so right now. I would say it is lower than that – technical recession is now basically mathematically guaranteed. Demand would have to come off a cliff very fast, and THEN recover, for that not to happen. We have 2 months of negative growth, confirmed, in the books (March and April ‘22). Remember a technical recession is 2 quarters, consecutively, of negative growth – and whilst March was down, thanks to Covid recovery January and February were positive, so Q1 2022 was a positive one. We won’t officially see the R word in the papers for many months yet – even if we ARE in a decline – we don’t see May’s provisional figures until 13th July, and even then, that’s the rolling quarter rather than the calendar quarter.
We also have a whole raft of excuses of course. In April it was the removal of free testing from the end of March – a very large drop in that particular part of the economy. We’ve already heard that in June, retail confidence is on the floor and sales are “well below what’s expected for this time of year”. Anecdotally, people are tightening belts. But there’s a bigger reason why recession is, in my book, utterly nailed on.
It gets forgotten again and again, but these conversations are about REAL GDP. Adjusted for inflation. So when inflation is nearly 1% a month (it has been over, some months), then you are losing 1% from the nominal GDP figure from last month before you even start! Obviously, inflation does grow some goods and services very organically – but as the price races up, demand goes down, unless supply becomes particularly constrained (and of course, there are factors that fit into both sides of that supply and demand relationship – many outside of anyone’s control, such as the weather). This, however, is an example of the self-fulfilling prophecy.
I was sitting in one of our PIP meetings this week and had a conversation which I’ve had in different formats in different places several times this year. The people involved in the conversation would, honestly, comfortably be in the middle class and above, household income several times the national average. Everyone had assessed their outgoings, cancelled streaming services that weren’t being used, other spurious memberships, various “big tech” bolt-ons or monthly premiums (think Amazon Music, Spotify, YouTube Premium, etc.) and lots of things alongside and everyone had savings in the “over £100 a month” category. This is anecdotal but it’s unlikely that many people aren’t thinking in the same way. It is a mindset, not a matter of need, for those in the top 40% (let’s say) – when need is driving, I’m sure the cuts are more aggressive in percentage terms. One issue is always that those at the bottom have nothing left to cut, and more are being dragged into that bottom by the maelstrom of inflation – and they feel the rises in the commoditised parts of life (energy, fuel, food) harder than the others do.
So, on 13th July we are highly likely to have our first rolling quarter of negative growth. It works on calendar quarters rather than a “March, April, May” quarter – so then we see if Q2 is negative. Again, it is highly likely to be. That’s us halfway to a recession, and the word spreads, and the prophecy starts to fulfil itself.
I always feel obligated to remind the property investors reading this. This is not supposed to be particularly bearish or bullish – it is supposed to be factual. My thoughts on what’s coming around the corner. I have a very good strike rate over the past 18 months of talking about what is going to happen – although when I’ve swung and missed, I’ve missed spectacularly – for example, I didn’t think the interest rate could go up as quickly as it has done. However, thanks to the time afforded to us in property, I’ve been able to react fast.
What we need to cogitate on is not how high inflation is, or even the direction of travel (although it is handy to know, as it will influence behaviour) – we need to consider how good or bad inflation is for us. Or how to make it work for us. There are still massive opportunities for cheap fixed debt at the moment that are evaporating with every week I write these articles. Rates are going up at some lenders another 0.35% in this coming week. In fact, there’s a double bubble situation where sensible lenders increase other fees/their margins overall, by increasing arrangement fees (or other fees), because they feel that there is more volatility and more risk – and indeed, there is.
To give readers a rough idea, in the group we are recalculating remortgages that will be applied for in 6-7 months time on new purchases at 4.375% or so in our current analysis spreadsheets. That’s our call for the mortgage rate in Dec ‘22/Jan ‘23. (5 year fixed, limited company). There’s more variables than you might think in that calculation – but they can be saved for future weeks and months as this situation continues to unfold.
How will inflation work – and how will the recession work, for us, as investors, then?
I’ve banged this drum time and again over the past several months, but the real tool we have access to – the real privilege of the property investor, is fixed-price, and therefore nominal, debt. A lot of investors don’t even consider the alternative – floating-rate debt – but it is a box that the banks try to put you in as you grow a portfolio, commercialise, etc. At the much bigger scale, you are then allowed or more accurately encouraged to fix your debt again, using interest rate swaps. The cost of fixing at the high street bank at the “mid” level (which covers about £1m – £15m in loan size) comes at a premium – currently looking at low/mid 5s, to go to high 5s next week no doubt (again, ltd co, 5 yr fix). This starts to put many supposed investment properties underwater or provides negative gearing, and would see properties sucking cashflow each month rather than throwing it off.
I’ve done the maths before, some weeks back – a fixed nominal mortgage can turn a wealth-destruction situation (inflation at 11%+) into a real-terms return situation, even in a market that is flat or only going up nominally at a few per cent per year – my current best estimate for capital growth over the next 12 months is 1-2% (nominal terms, so a massive drop in real terms).
So – we turn inflation to our favour by using sensible leverage. Our benefit of the wage-price spiral that is currently a pitch battle between unions, our government, and businesses/operators in the private sector, is that as wages go up, affordability goes up. Rents go up. There is a lag that exists of course – in the group we don’t raise rents above 7% in any year, which is in line with the fair rents guidance – and show much more clemency for great tenants. That is perhaps not particularly commercial at a time like this, but overall is the right thing to do, even though margins are compressing on existing tenancies due to maintenance costs going through the roof, alongside anything else.
The rent gap is realised on a new tenancy – we have seen £470 go to £750 on a turnaround (a 60% increase), and similar rises, in the past 12 months. There is quite literally no stock within a mile in some areas and we still get 50 enquiries. There’s no shortage of those with the affordability to take the tenancy at £750, although plenty of the 50 enquiries just can’t afford it. The pressure on LHA-supported tenancies, by the time April 2023 comes around, will be absolutely incredible and this government, with limited opposition to it, will try to short-change the LHA rates as much as possible just to keep the housing benefit bill down, even though the overall economic impact of doing so will be much more expensive.
Margin squeeze on cost of debt is huge as well though. We are simply trading capital growth for certainty for 5 years at the moment, and paying break costs left right and centre. Your eyes would truly water if you knew the early repayment charges bill for this year, but looking at it in percentage terms – I’m afraid it all makes sense. Not that there is any guarantee – it is simply time to buy that insurance, and the insurance is, in my view, cheap.
What will recession mean, then, since inflation certainly isn’t all bad – and nowhere near as bad for us as it is for the rest of the population? It is, when viewed correctly, a giant wealth transfer opportunity. You just need to get your head around that. The issue at the moment is that stock is for sale at a high price. Supply still isn’t back although it has improved considerably. The jungle drums in the auction market are indicating weak sales, and that famous leading indicator is suggesting a fairly significant summer slowdown, to me.
This means opportunity with a capital O. If you’ve found it hard to buy over the past 2 years, it is about to get easier. But your numbers need to include those inflated mortgage rates, and the vendors need to get their head around the coming recession (which, by the way, could be low and slow, or deep and requiring stimulus from the central bank…….) – there will be plenty who are already significantly bearish. Imagine if you’ve just come off a 5-year fix and are risk averse and are surprised to see you are at an SVR of 6% (some will be right now, more will be, very soon). Fairly motivating with the next BoE meeting being another absolutely nailed-on interest rate rise, right?
So the moral of the story, today, is simple. Back to our quote. Fix the roof when the sun is shining. Never has that metaphor been more appropriate in property. Come Q4, and winter, with energy prices potentially spiralling even further out of control, if Russia is still in Ukraine (90%+ probability in my book), real problems will abound. Sort your financial structure out, and do it TODAY. Get going. Prepare for the deals. Until next week……keep calm and carry on!