Supplement 01 Oct 23 – Q4 begins….

Oct 1, 2023

If you are going to be a great investor, you have to fit the style to who you are.”

 – Dr Michael Burry, American investor and hedge fund manager.


Welcome to the Supplement everyone. You know it must be a bearish week when I reach for a Michael Burry quote – for those who haven’t seen “The Big Short” – it is a must watch. Burry, played by Christian Bale, is an unbelievable character. There’s so much learning in this film – I honestly can’t recommend it enough and I rarely even consider watching a film, let alone re-watching one – but in the past 10 years I’ve seen it at least 10 times, and just writing or talking about it makes me want to watch it again.


Burry had taken a large short position against the S&P stock market in Q2 this year, revealed by his mandatory SEC filings. The news of this broke in August, shortly after the deadline for the Q2 filings. We don’t get to follow this in real time, although you can always take a look at the twitter/X account @burrytracker for more news (I also recommend @buffettracker, even though there should really be 3 ts in the middle of that!). Dr B also sometimes shares some pearls through his own twitter/X account if that’s your thing. 


Why the shoutout to the master of shorting? Well, because there do seem to be some parallels with the 2008 scenario, in a way. Dramatic changes to the price of credit, rather than the availability of it – over a much, much longer timeframe than 2008 – but nonetheless likely to have a similar, but more muted effect. If you factor in inflation, and believe the most bearish of indices (Halifax/Nationwide), then you could argue this has already happened.


That isn’t the main thrust for me though. I’m more interested in what has happened versus what probably should have happened. Or, arguably, what we are all glad HASN’T happened and that’s why we are entrenched within property rather than crypto, or stock trading – although I know more than a few Supplement readers will have or still do dabble, or take a keen interest.


Before we get into that, however, I just wanted to do the macro roundup. Firstly, the calm in the bond markets hit a rocky patch this week as gilt and swap rates surged midweek after the conclusion that oil prices are not getting where they “should” be because the expectation is that inflation means that interest rates will remain higher for longer in developed nations. The 5-year gilt was trading happily in a tight range between 4.1 and 4.2% until Wednesday afternoon when it broke out, to reach 4.4%+ on Thursday at one point – a fairly significant move in one day.


In plain English, that’s 0.25% on the mortgage rates. More accurately, it is 0.25% “not off”, rather than on. The lenders have been slow to come down from the highs (which were more like nearly 5% on the 5-year gilts) and so can still be a bit trimmer than a month ago, but these unsettling days where things move more than a quarter of a percent don’t go down well (I know it doesn’t sound like a lot, but we are talking markets where many, many millions are traded daily, in what’s supposed to be ultra-low risk assets).


Some better looking deals did start to rear their head this week, but product heads may well wait and see for next week before getting back to the table.


UK car production was down nearly 10% year-on-year, which was a surprise as the expectation was positive. However, 12 months ago the number was up 31.6%, although as always, beware the base year effects (the pandemic would definitely have made a difference to that figure).


Friday contained the most interesting macro stats this week, including finalised (they are never really finalised) growth figures for Q2 2023. The mortgage and credit figures were also out for August and they made for interesting reading.


GDP growth rates for Q2 were ahead of expectations, and it turned out to be a pretty good quarter by today’s standards as inflation ebbed away a little. Sad to say but 0.6% annualised growth is the best we’ve seen for some time. Remember that is in real terms, so ahead of inflation – not to be sniffed at, in the face of the interest rate rises. The forecast was 0.4%, so an outperformance compared to that.


Mortgage lending was also about a billion pounds more than expected, and there was a net mortgage balance increase of around £1.25 billion. Nothing in the grand scheme of things, but the expectation was no real increase in mortgage balances, so again – a positive move as expanding credit means a more expansive market as a whole.


Consumer credit was also about a third of a billion more than expected – the consensus is starting to be that pandemic savings have run out, and people borrowed a little more to enjoy their first truly covid-free summer in terms of restrictions (although after the recent spate, masks have started to appear again of course) – but overall, this was the first set of data for a while that suggests that the economy isn’t on life support, but has been doing OK against the odds (and against some of the incompetence that has plagued the past 18 months, particularly before the current iteration of PM/Chancellor were at the helm!).


Back to Burry – what feels like the most pertinent part of economic history, and the film, is the way that he spotted things early – very early. In March 2007 when the financial world was still going great guns (as was the property market) he was starting to build significant short positions against what he’d identified as the impending mortgage price crash. He first mentioned post-pandemic inflation in April 2020, which was a fantastic call and earlier than anyone else I’m aware of (I didn’t see it at the time – sadly!). 


If you could criticise the great man, it would be that he sees the angle, but doesn’t necessarily see the timing of the angle. That’s incredibly difficult, of course – as the great Uncle Warren would say – “Time in the market, not timing the market”. Burry has proved to be a fantastic directional predictor, but struggled with the timing of it.


He isn’t right every time, either, of course. He is obviously very good at what he does – having traded his way to billionaire status. He annoyed and ostracised many with his singularity leading up to the 2008 crash – and his dramatised character is seen bemoaning just how the big banks and investment houses manage to keep the music going when the writing is on the wall, for just long enough to unload or reverse the massive positions that most had taken in the subprime mortgage markets onto unsuspecting punters.


This is where I’m most interested at the moment. Of course if you say the stock market is going to come off the top at some point in the next few years – in many instances, you’d be right. So, that isn’t that helpful. However, to go around buying put options – the right to sell shares at a price even if that price has collapsed (you wouldn’t want to exercise those options if the prices had risen, because that would be a losing trade) – you need to be confident that you are going in at a level that is overvalued, and your options have an expiry date on them of course. If they expire – and Burry has tended to use relatively short expiry dates in the past on similar trades – then you need to buy them again “until you get it right”.


This week, the market hit a 3-month low – although perhaps not enough to make a profit. It seems, though, from his recent “breadcrumbs” clues that he tends to leave, that he is expecting a significant downturn. He tweeted (back when it was still twitter, I think) in January one simple word: “sell”.


Let’s also remember; he’s a professional short-seller. A bubble spotter. All of his form is in seeing the angle when stocks are priced too high, in an unsustainable way. He’s only ever going to do 2 things – 1) Stay silent (which he does the vast, vast majority of the time) or 2) Act/speak expecting negative things to happen. 


The implication – although interviews with him are as rare as hen’s teeth – is that he feels the economy can’t cope with the current level of interest rates. He’s of course talking about the US – a stronger and much larger economy than the UK – but one with a base rate of interest at 5.25% – very familiar. The Fed have been within 1% of that rate for 12 months, now, however – the UK are a fair way behind as only the hapless Truss forced a 0.75% rise out of the Bank of England, whereas the Fed scattered them around like confetti at the start of this hiking cycle, showing that they mean business from day one. 


We have to go back to before this current cycle kicked off. I personally definitely did not have clarity of thought when it came to how speedy the hikes might be, thinking back to early 2022. Ukraine also took me somewhat by surprise, until we were only a few weeks away from the conflict. I was in line with a lot of other economic commentators – not around inflation, where I was very vocal that it was happening – but around whether the economy could withstand a significant hike in interest rates.


What we are hearing, left, right and centre (in the data – rather than the speculation) is that rates haven’t had the effect they usually would. For all the furore over the mortgage “crisis”, the average homeowner with a mortgage (28% of the households in the UK) is seeing a rise of £250 a month. That’s £250 out of disposable income, sure, but disposable income is also up over £100 per month assuming a 5% pay rise, at PAYE rates of tax, in this year, which at least partially mitigates that (based on an average owner-occupier-with-mortgage household). Doesn’t help those households increase their consumption spend though, of course – they have to cut down, or borrow.


Much more sensitive are the 2m encumbered buy-to-let properties, which data suggests includes about 1m on old floating-rate mortgages. Those are much more at risk, since they are interest only – likely to have increased by a similar amount, but given much higher costs of maintenance, insurance and also the section 24 tax that the majority of those landlords will be paying – putting much more pressure on the rent of households which have a much lower average income than the average owner-occupier with mortgage. So you might be talking more like £300 per month, but a £75 per month pay rise after tax. Much harder to deal with (these figures are only my own, as no quality data exists to this level, sadly – or none that I’m aware of anyway). 


We know that a lot of corporations fixed debt in early 2022, when their well-remunerated financial controllers saw the writing on the wall and went for some very long-term debt – the average bond issue was for 17 years in the big companies, compared to only 10 years in 2023’s issues). This is all fine, but still many listed companies have bond issues dropping off next year, and have a difficult decision to make on the debt – pay a coupon approximately 2.5 times larger, or pay the debt off with retained earnings, if they have it (or raise it via equity, of course, affecting the share price, earnings per share, etc. etc.). 


This isn’t really the strangler though. If you followed what I was belting out last year, you likely had a very good think about fixing your mortgages for 5 years+, or at least had a look and stress-tested your position, and decided to ride the lightning. The strangler is new business – new starts, adding to the portfolio. The obstacles are significant, if you want to use leverage. The numbers don’t work like they used to. That’s all fine – but if you think about the way that the market works organically – if everything else remains equal – older, probably unencumbered landlords pass away or sell up, with only a fraction handing their portfolios down through the generations. New, younger landlords – much more likely to be using leverage – work out where and how to deploy their money. Returns on government bonds – or, for those less likely to invest in bonds generally, in 1-5 year savings accounts, look more attractive. Investing at under the rate of inflation is not to be recommended – and inflation remains the biggest danger to wealth, once you have some – but inflation shouldn’t run at the 5% or so that’s on offer for some investments right now (although remember the tax – if you are a 40%+ payer, you are taking a 3% return which may well be below inflation’s average for the next 5 years!). 

Regardless, 5% compared to 0.5% in early 2021 (or even less than that!) is where we’ve got to. Investment gets deferred elsewhere, rather than property. Supply and demand – already under gigantic pressure since the Osborne Onslaught started a tidal wave back in 2015 – was already in a very precarious position, and I’ve just laid out how it is even less attractive today just thanks to the price of credit and stacking deals than it has been for years. 


In 2019 it was great – flat market, cheap money, easy enough to get deals. In late 2020, and until mid-2022, it was difficult – market flooded with lots of extra money, even cheaper interest rates, and a lack of supply combined with huge demand – but if you bought well during that period and fixed rates, then happy days. Mid-2022 onwards – trappier. Mortgage rates moving upwards and then surging intra-Truss (blink, and you missed it). Q1 2023 looked like rates coming right back down, but it was too early and instead yields went to the points they were in 2022, or beyond that depending on the duration. Another tough year for bonds. 


So – it feels like something is still off. I’m left asking myself – what am I missing? There’s all the ingredients for ongoing rent rises until tenants are crying – and until more and more are forced into social, or supported living. Affordability ceilings are a way away, but at nearly 25% rent increases on new lets in the past 2 years, and forecasts around 7% for the next 12 months – it won’t take long, in property terms, to get there (depending on wage increases, of course). Supply and demand is SO bad that it has very limited effect any more – affordability seems to be the chief defining factor by some way.


What else could be wrong? I think, on balance, it is this tapestry of “stable rates” being predicted that I’m struggling to swallow. I do think rates have to remain high until inflation is conquered – and that’s why I was on the side of an increase last week. The wobble in the gilt markets mid-week was all based around the market believing that a little more than they did before. Stability just feels so unlikely when we are now on an interest rate tightrope, higher than anyone would have dared predict 2 years ago.


If we went into recession, in any significant way – rates would surely, at the start, still have to stay high. It would be the lesser of the evils. Then, after demand had truly collapsed – inflation would wane, and rates could be cut. Go back in history, though, and look at recessions where inflation has been high on the way in. The cuts aren’t as swift as one might like – and for good reason. And in proportional terms – this is the most swift hiking cycle, in percentage terms, by a million miles.


That’s what’s making me feel uneasy, and also unsatisfied because I don’t feel I have an awesome handle on it all. I want to know the answers, and then share them in the Supplement, of course! There is another side to this coin – keeping rates low for SO many years in the 2010s showed a serious lack of ambition, or willingness to experiment, or even political influence. I was a big Mark Carney fan but there’s definitely questions to be answered as to why we hadn’t even tried to get rates up in 2015 when the forward guidance had said we would once unemployment went under 6%, for example. (and yes, they still would have come right back down in 2016 anyway). Brexit provided the perfect excuse for further inaction – the Fed tried in the US to get rates up, but they had limited resolve and gave up too early on (in 2018).


The markets at that point thought they could pretty much control the Fed – but in this cycle, they underestimated inflation and what inflation would do. The central banks have at least tried to do their job with a degree of competency, and it is easy to criticise when you already know the answer. Looking back, my calls have not always been perfect, although a couple of the big ones have been right over the past few years. Not getting it wrong is critical on the big calls!


Either way, I will continue the quest for the truth – or at least a coherent set of arguments – as we continue into the last quarter of the year – and that brings us to a close for this week – I’d love to get some comments and feedback as always. Be sure to tune into the 9am live on YouTube if you can (or watch on repeat) – if you don’t already know about it, just search up “Propenomix” – please subscribe to the channel, and like and comment on the videos if you enjoy the weekly content (or even if you don’t, but if you don’t, how have you got this far!) – and Keep Calm and Carry On, of course.