Welcome to the supplement, as we inflate our way through the year, it seems. Numbers for April 2022 are out – 9% official figure – no surprise at all. The surprise was that it was exactly 9%, which is where many were predicting – and indeed the consensus was 0.1% higher. Nothing to party about, but rather be hitting numbers below consensus than above consensus, which is what we have been doing for the past 10-11 months or so.
This week I wanted to provide some actionable coaching, advice, guidance or whatever you would like to call it. Of course, this is not regulated financial advice – just my thoughts, my stream of consciousness as we work our way through these strange post-pandemic economic times, seemingly struggling onward in the face of the largest inflationary environment for 40 years now. It will be of limited surprise to those who read the supplement regularly, and/or watch any of the video content that we produce live on Facebook or LinkedIn at 10am on a Sunday morning, that I’m going to start this mini-series – because this will take more than just one supplement – with a healthy and hopefully comprehensive discussion of risk. That’s the particularly prevalent risks in the current environment – for the record. Spiralling energy prices, interest rates on a path upwards, inflation at a dangerous level for 2 reasons – one, it is 4.5 times the government set target figure, and two, it has not yet reached its peak, and until it peaks, there is still significant upside risk. Also, on a personal and an investment level, the cost of living squeeze of course.
After that – we will move on to the “so what” – what do we do about these things, how do we navigate this – and ultimately, as investors, how do we try to ensure we give ourselves the best chance of falling on the right side of the line, and staying out of the red and into the black.
So – onto the risks as I see them at the moment, in some more detail. Firstly – inflation itself. As above, both extremely high by historical standards, damagingly and dangerously high – but also not at its peak yet. What’s beyond inflation – well, hyperinflation. A very dangerous phenomenon indeed. We are nowhere near that yet, but as a near-zero probability event, every time the rate moves up, every time that near zero moves up to “a touch nearer material”. Hyperinflation is when prices really are out of control – rather than going up 10% per year, it would be at least 10% per month, and perhaps more like 50% per month.
That’s the doomsday scenario which still isn’t much more than a speck on the horizon as I write this. However, the much more likely scenario which is still damaging is the upwards tornado effect of inflation. Why did the Bank of England governor, Andrew Bailey, say something about wage increases that drew him so much criticism some weeks ago (for those who didn’t see the headlines – he told people, effectively, not to be going in asking for huge pay increases, which was then translated in the media as he told everyone to eat cake and survive on the same wages as last year). He might have mis-stepped as far as the media went, but his intentions were good, of course. Wages are not going up at the current rate of inflation (neither are fixed incomes like benefits, pensions, etc. of course). The only chance you have of your wage matching inflation this year is to get a new and better-paid job, or to get a promotion. This might represent around 25% of people in the workforce (the number is quite hard to pin down, so this is part data, part speculation on my part). The majority will be worse off, and worse off by a few per cent in real terms.
The worst hit group will be 5-7% worse off, those whose fixed incomes have moved up by 3%, but their cost of living has moved up at least 10%. The worst hit individuals will of course be much worse off than that.
Why aren’t wages just put up by the rate of inflation? Well, in a normal year the hope is that wages go up more than the rate of inflation. In times of austerity, post-2008, wages in the public sector have of course not kept pace with inflation. That’s still happening, and why there are lots of sad stories about public sector workers not being able to feed their children or fill their cars up. They were 10% worse off, after inflation, last decade, going INTO the decade of black swans, this pandemic environment. The private sector, a much larger sector of society in terms of employment, have not been as badly treated – but have not made many steps forward as a whole since 2008. It took until mid-2018 for wages to really start outpacing inflation in real terms – nearly, a lost decade, from the workers point of view (whereas those exposed to the stock market, for example, made some healthy money thanks to the easy money policies of the 2010s).
Private sector pay increase is still well above the public sector, but is around 5% on current numbers – 55% of the current inflation number, or just over half. This is why the Bank of England sees households on average down, in terms of living standards and household incomes, by just under 2% this year. On aggregate. The worst year for many years.
If wages did just go up at inflation, then there would be no need to temper consumption. Prices would follow (as suppliers pass the wage increases on to their consumers), and then as prices follow, wage demands go up to keep with the new prices, and at the basic level this is the upwards tornado. This is where that phrase comes from; “the best cure for high prices is high prices” – i.e. people can’t afford things, demand for those things goes down, the price then has to come down which is one of the phenomena observed in a recession, or leading up to a recession.
Wages are also linked to social unrest, of course. Highly unionised workforces and particularly union leaders, who, in fairness, exist to maximise the pay of their members, see a very compelling case to push very hard for high single figure or even double figure pay rises. The alternative if they don’t get a reasonable settlement is industrial action – this is very much the blueprint of industrial action in the 1970s. The economic cost of that is significant, depending on the industry – it also feeds inflation even further if critical supplies are withheld, not delivered, etc. as prices go up even more when supply is even scarcer.
The next upside risk at the moment is the interest rate. Rates are moving, faster than they have done for many years. Yes, they’ve started incredibly low – and yes, affordability for residential mortgages is done on a pay rate of around 5.5%, so repossession in swathes is not yet anywhere near a major risk. Rate expectations are topping at 2.75% in Q3 2023, according to the markets, at the moment. The risk is that the runaway train hasn’t stopped, and indeed the raising of the rate doesn’t fix the problems leading to inflation, and that the economy comes off the boil (and really, it has only been simmering since 2008, it has never got to boiling – apart from in the v-shaped recovery from the false lows of a locked-down economy). That could lead to a recession of one flavour or another – and high rates, without inflation under control, will mean no or negative growth for sure.
There is a reasonable expectation that energy prices will work themselves out, but with the Russia/Ukraine conflict having a potentially very long way to run, it is hard to see how the world’s dependency (which ultimately sets the prices in the global markets) on Russia ebbs away any time soon. Renewable and other solutions will take years to make the dent they already should have done since 2010 (or arguably 2000, or before). Pipelines from more stable and less hostile nations can be faster solutions, of course, but there’s still a precipice if Putin did decide to cut off Germany (as an example) – although it needs to be noted that Russia’s GDP still expanded 3.5% in Q1 2022, but forecasts are 8% down for 2022 as a whole as sanctions bite. Such a strong move would see those forecasts come down significantly more, I believe, as Russia would not be seen as a trading partner than much of the world could trust for many years to come, and serious economic collapse could follow. That doesn’t mean it won’t happen, of course.
If you are still with me, and not reaching for the happy pills just yet, then we need to work out what we should do about all of this. There are some fairly clear steps we can take, as property investors, to protect ourselves and our assets throughout these choppy times.
Firstly – at the risk of the broken record scenario – fixed rate debt. This is the beauty of property. It moves slowly. Fixed rate, 5-year fix, limited company mortgages at 3% simply SHOULD NOT be around right now. You should be wiping them out at the first chance you get. This is an opportunity which we won’t see again, unless we have a deep recession, for the next 5 years and perhaps beyond. This is super cheap. What do you need to ensure:
1) That you are not exposed to onerous early repayment charges
2) That your time horizon is 5 years or longer (really it should be 10 years+ if you are a new entrant into the investment property market)
3) That all your products (if you have a portfolio or are going to build one) do not drop off on the same day, month or year
4) That you comply with the terms of the loan and that the loan suits your circumstances, of course
5) That you have a cash reserve, backup plan, and run your property business prudently (always!)
Secondly – understand real versus nominal. We could easily see a situation this year where the market is up 6%, inflation is 10%, and rent is up 3%. If you have no property and 100k in the bank, you lose 10% of the purchasing power of that 100k (10k). You can buy only 94% of the property you could with the same money at the end of that period (you lost 6% because the market gained 6%). If you have a portfolio, with fixed rate debt, you lost 10% on your cash reserves, you gained 6% on your portfolio, and you gained 10% via the depreciation on your fixed debt. And your rents went up 3% as well (so at least the percentage spent on the fixed debt went down).
The game in the 1970s was to lose as little as possible in real terms, or at least that was the joke in investment circles. When inflation is 25% or near offer, you can understand that I’m sure! Investment property, thanks to fixed price, nominal debt, depreciating against inflation, offers you that protection that you need and crave as an investor.
The scenario I describe above is actually a very typical scenario in a high inflation environment. Let’s strip out all the noise – wages are up 5%. IF interest rates stayed the same (and yes, they aren’t – BUT affordability calculations aren’t changing yet) then that 5% rise makes houses more affordable, in nominal terms, for people. But I can also draw you a graph in the above scenario or write you a headline that says “HOUSE PRICES DOWN 4% AFTER INFLATION”, “BUBBLE BURSTS”, “HERE COMES THE MELTDOWN” etc. (no job offers from the daily express, please) even though prices went up in real terms. You really need to make a lot of effort to get your head around this in an inflationary environment. This is one of the most misunderstood things about the current environment that we are in (no debate). Those numbers will change, of course, but the fundamentals are likely not far off for 2022.
Next week I want to talk about the money supply and inflation in property, what stagflation looks like for the property market, inflation in maintenance and refurbishment/conversion/development, and what to do about all of that! But until then – keep calm and fix your mortgages. And try to enjoy the ride – not many will have that privilege – I’ll be thinking about this 24/7/365 until we get back to “normal” (got that pencilled in for 2026, when of course Fred Harrison has got us pencilled in for a crash – so let’s see what happens!)