Supplement 10 Sep 23 – The Thin Red Line

Sep 9, 2023

“The central bank needs to be able to make policy without short term political concerns” – Ben Bernanke, former Chair of the US Federal Reserve.


Welcome to the Supplement everyone. A heavier quote this week to go with a heavier supplement – this week I was at the Bank of England quarterly regional briefing, which has moved back to only being quarterly as things feel a shade calmer all around, and volatility has (temporarily) retreated again.


Before we crack on with that, however, I wanted to do the macro roundup. There were a few unmissable bits this week – retail sales far better than forecasted (but still below inflation), PMI indices revised upwards but still below 50 so things are still seen to be moving in the wrong direction, and the most notable of them all – the Halifax House Price Index giving everyone in negotiation for a deal at the moment an absolute gift, reporting a 1.9% drop for August (which is usually a down month, of course). The forecasters expected -0.3% so this really was a significant surprise, and it put their year on year figure which had been much more “contained” than Nationwide’s figure, down to -4.6% year on year. 

One more figure of interest was released this week. The average rate that mortgage dropoffs go on to, from the big lenders. The SVR average across the big banks, if you will. That was reported at a chunky 7.85% – if you consider that buy-to-let is likely to have a premium over and above that, then just think quite how serious that is! There’s blood on the streets – if you want to make decisions based on the quietest summer for years. Personally, I’d say that’s a little knee-jerk – but it could be a gift for negotiation.


Anyway – what I missed in the silly season was an opportunity to post-mortem the August Bank of England monetary policy report – and it really is well worth doing, for a number of reasons. As so often, it is not just what it says – and what the West Midlands rep has expounded to the group that meets with regularity to pick his brains and let him make sense of all the noise – but what it doesn’t say, and what that might mean. Also, I gained a unique insight afterwards into exactly what the Bank does and doesn’t understand about the current state of the buy-to-let market – the big question will be “how much do they care”, but Mark Carney certainly seemed to, and I would like to think the monetary policy committee will be interested in the feedback that I gave.


The spoiler alert is that the Bank is now at a place where I was heading with absolute certainty somewhere between two and a half years ago, and nine months ago – AND some of the facts since then have changed. As the saying goes – when the facts change, I change my mind, Sir – what do you do?


The report was written for August and we must remember that at the time, the market forecast for base rate was to reach just over 6% and MAINTAIN AN AVERAGE OF 5.5% OVER THE THREE-YEAR FORECAST PERIOD. I thought it was worth shouting about that, because I did not shout about it at the time (mostly because I was taking it easy on holiday somewhere, not monitoring the forward curve every day. Of all the metrics I do look at, I don’t worry too much about the forward curve which is the market prediction of the future interest rates, because it has not been overly accurate – although it has done a better job of prediction than the Bank of England has done in recent times). 


In the May report, the average over that period was just over 4%. That’s some difference – 1.5% or 150 basis points. Call the lifeboats!


Actually, don’t. Things have calmed significantly since then. When you look at today’s numbers compared to those used in the report, peak base is down to more like 5.75%, and the average looks more like 5% (or so) – but still, 5%. So, if you are toughing it out on base rate tracker mortgages – base + 2, let’s say – you are looking at 7% interest on average for the next 3 years, or so the market thinks.


Now, the temptation is to believe that just because the market has finally caught up with reality, that they will continue to be wrong and things will come down a little more than that. I’m inclined to believe it, depending on future shocks and how Russia/Ukraine continues to play out. With oil creeping back over $90 this week, then unless the dollar weakens further against sterling, those prices at the pumps are going to stay back over 1.50/litre and that filters back through into continued expense, just as it appeared that things were easing.


The general prognosis, however, would be “stronger for longer” – the drum I have been banging ever since the window of opportunity that was afforded to us last year to fix our debt was closed, or at least narrowed significantly. “These rates are normal”, people are saying – not so sure about that, in recent history even if you ignore the past 15 years, they still look at the high end of the range – and the market has now got itself obsessed with the soft landing. This is still an unlikely outcome, and significant economic slowdown could change things.


Those who have read or listened before, when I’ve visited the briefings, will know I’m always likely to have a question or two. My “above the line”, in front of the room question this month was around why everyone, including the MPC it seems, seems to be forgetting that central bank decisions take 6-24+ months to filter through into the real world and the economy. Here’s the case that I made:


The past two unemployment prints have been from 3.8% to 4% to 4.2%. The manufacturing PMI is through the floor at low 40s, and the services PMI has now gone negative, the big driver of our economy. Isn’t it time to pause and see what effects continue here and measure the trend? (Not because of my own skin in the game on the base rate – to be honest, brutal though it sounds I’d probably rather 6% plus and take my chances in the sell-off that would have to follow – but because I really, truly believe that’s the right thing to do right now).


The Bank rep is an excellent economist. He didn’t answer in the way that I would have done – which definitely doesn’t make him wrong. What I would have said is that that’s all well and good, but services inflation is running near 8% and wage inflation was 8.2% – and we need to see some evidence that that is calming down before we pause. I would have re-countered with the fact that vacancies are still falling back and that trend is really established now – and we will only have to wait a couple more days for the August figures to come out, which I expect will see vacancies fall back below 1 million for the first time in several years. This is a leading indicator, whereas wage inflation is just the lag effect of where CPI was 6-12 months ago, rather than where it is today.


What he did say, actually, was worrying to me and caused me to challenge it. He said that it seems that these days the decisions are being made “in the now” more than they used to be. Remember, don’t shoot the messenger – he is only the mouthpiece – but if that is his impression of the MPC, that’s the “best” example so far of the weak leadership that Bailey has espoused as the Governor, and also a sad indictment of his lack of understanding of what good central banking should look like.

It’s no accident that I chose a Bernanke quote today, because Bernanke is leading a review into why the Bank of England has been so poor at forecasting. Onto the next concern – the Bank (in spite of this high interest rate forecasted by the markets in August) now thinks that unemployment will stay under 5% in the coming years. For the first time in some time, I think they are now undercooking it, because on my numbers the forecasts look there for a more significant swathe of cost-cutting and job replacement. The recipe doesn’t add up, right now.


There’s still one massive factor that has been hard to measure, but factors in here. The cost of living “crisis”. The quote marks have to come out, because everything is a crisis these days. What’s evident in the figures is that there has been a soft landing, of sorts, for consumers in these inflationary times. They had a lot of savings during the pandemic, often built up without that being voluntary. However, these excess savings are pretty much all gone in the US, although the UK still seems to be doing well with more savings than since the referendum period right up until Covid, where savings did spike massively. There’s no doubt this was a big cushion, but the cushion has at least deflated somewhat. 


I’ve talked before about the massive wealth transfer during Covid – all that stimulus. In spite of some of the more ideological spew around all of this, the transfer really massively favoured the middle class, rather than “just the 0.1%”. There was a near-trillion put on the household balance sheets, while we all focused on government debt. Nearly 150 billion found its way into ISAs – I can’t imagine too many of the 0.1% bother with their ISA allowances, being honest. 


The cost was, and is, inflation – and these savings are still providing that cushion mentioned above. Remember the US is a fair way ahead of us in the UK – the FCA have some solid data, and in fact the best proxy might be the “big 9 balances” – deposits held by the 9 largest institutions in the UK. That only moved from £1.24 trillion to £1.233 trillion between January 2022 and May 2023 – a mere snip of a £7bn difference. Nothing, some might say. 


Well, perhaps. RPI (remember that) over the same time period, the retail price index, tells us that that’s a 16% fall in real terms. Take a breath – but for those who are feeling the pinch on certain prices and items (holidays might be a good, topical example right now!), just imagine the amount of real wealth that has destroyed. Equivalent not to the £7bn nominal dissaving in that time, but instead £205bn in real terms. Two hundred and five billion!


This is the price of the transfer from Government to Household in 2020 and early 2021. Hope you made the most of those bounceback loans…….


Still – back to the Bank. Their recent proclamations will interest you I’m sure. Q2 2025 is now the time at which the Bank thinks we will return to the 2% inflation target. This is in line with what I was saying way back when – these cycles do tend to be around the 36-48 month mark when you look historically, and as soon as the genie was out of the bottle, we KNEW wages and prices would be sticky – because they always are. I was stunned to see the Bank suggest that they had “learned” this in this recent cycle – history could easily have taught them this would be the case. That’s all I had at my disposal, after all (and the hunger to do the work, of course).


They also now see CPI at between 4 and 5 per cent at the end of this year. That looks much more likely, although let’s just reserve judgment based on the oil price, and it is time to bang the drum for the warm winter again – just remember how lucky we were last year. The Climate Forecast System (let’s not hang our hat on it, but I’d suggest it is likely better than the Daily Express model) doesn’t see a single day below freezing into late February 2024, which would be a godsend for everyone’s gas bill, of course – and ease the pressure on UK commodity prices anyway, although we will remain price-takers on oil for the rest of time (or at least until we can stop our reliance on it). 


If we can get lucky with the winter weather (and warm often means storm, when it comes to rainfall, remember – so check those roofs and gutters!) – then their 4-5% number by the end of this year looks about fair, without a significant event occurring (a real one, not just the next media crisis). Gas prices should stay more manageable, and less heating oil will also be needed in Europe in general. Then again, you’d hope from here that with 4 months to go, they could predict the end of the year’s number – it is infinitely easier than 12 months out, when they were suggesting we could be back under 3% by new year’s eve.


Their language is much more definite – inflation IS going down rapidly. That fall has started, and of course these big rises are getting more than 12 months old now – so it doesn’t mean things are getting cheaper, just that they’ve at least stopped going up – for now.


The Bank admit services price inflation has caught them by surprise – my surprise is that they are surprised. Why did they think it wouldn’t happen – there has never been a better time to put prices up, and companies are chasing wage increases as well of course. The long term forecast after 2025 now sees inflation at around 1.5%, rather than below zero which is where they have been saying it will be in recent quarters.


One point where we strongly agree, however, is investment. This is not traditional investment – this is the investment number for companies in the UK, being invested into hardware, software, plant and machinery. A small limp upwards this year (a massive fall in real terms) – then a nominal fall in 2024, and we will be cracking on with even more creaking buildings (RAAC, anyone?) and systems into the next government. The private sector has had almost everything thrown about it to try and get it to invest – but of course, with cost pressures where they are, companies have to sweat assets very hard in order to survive.


The prevailing forecast is growth at 0.25% per year until 2026 or beyond, roughly – before going back to 1.5%+. This sounds limp, but at the moment, in real time, might be a bit hopeful for 2024. Let’s see the next month or two’s PMI figures before we make a real call, though. The key – for the committee – is how persistent these wage and “second order” effects are, as they call them. Expectations do seem to be coming down, rightly so – and that will help.


At the buzzer, though, there’s one more nugget from this week to throw into the mixer. My “offline” question. I always talk to the rep not in front of the room – one because he may share something he wouldn’t say out loud (although he is very straightforward), and two because it might not be particularly relevant to the rest of the room.

Firstly, I spoke with him about a portfolio deal that I can’t make stack at the current rates. The conclusion is – if I was sitting on significant cash reserves, I could do it – but have to accept a nice discount but potentially a fair few years before I got any meaningful cashflow. I stack my deals at 100% finance – as I’ve always said – and that’s protected me in general from getting into any bad ones.


Secondly, I told him of all the portfolios I’ve seen of late floating around. Low rents – not asset managed – and floating rate mortgages. Banks wanting money back. The biggest time bomb of all for the big personal name landlords is section 24 – being assessed at 45% tax but only getting the 20% credit. Cashflow is hard or impossible for many of those who are still relatively highly geared at this time – in spite of massive rent increases across the board – I doubt many are monitoring their real time tax positions, but they will be absolutely horrible given the amount of cashflow problems that are being caused by mortgage rates. 25% of cost for the big guns of a mortgage bill that has moved from 2.1% (Base + 2 assumed here) to 7.25% in the past 2 years, means on £1m debt, you would have paid £21k, and offset £9.3k of tax (if being assessed at the 45% level), so £11.66k would not have been offset and instead taxed as profit that is not there (costing you £5,250)…..all the way to £72,500 of payments, and only £32,222 of those deductible, with £40,277 not deductible costing you £18,125 instead. So – not only £51,500 worse off in cashflow, but also £12,875 worse off on the tax bill – total incidence 6.44% of the debt quantum. Ouch, I think is the most appropriate word.


That’s not the only fruit, either. In times like these, people tend to have the cashflow fight and worry about HMRC later. That’s the classic route to receivership and bankruptcy. £64,375 worse off per million of debt than you were between April 2020 and November 2021 – not a small consideration. This only bites when the 23-24 return is filed on January 31st 2025 and triggers a big, fat bill – the largest single incidence of section 24 in one day, mark my words.


Having said that, the “stronger for longer” philosophy would mean that the 24-25 tax year will be even worse. The ones with competent accountants will either already be aware of this, or will be told when they file their 22-23 returns. Significant disposals could be on the way.


This always takes me down the same old rabbit hole – you know me well enough by now to know I want, crave and need the data. I don’t want to speculate. The dearth of buy-to-let data is a bit criminal, and leads to bad decisions at the top level within the sector – that much I know. The best data – and that isn’t hard – is really with the FCA. A few nuggets that I uncovered in my search that finish this point, and this week’s efforts:


In Q1 2023, the share of mortgage advances that was for buy-to-let purposes was 9.8%. That’s the lowest observed since 2011 Q4, and speaks as to why there is just so little rental stock out there at the moment, of course. Balances at the end of Q1 2023 were down (this is all residential mortgage loans of any kind) for the first time, quarter-on-quarter, since Q2 2017. People used savings to pay down balances, overall, or did NOT remortgage as they otherwise would have done because of higher rates. Remember, the vast majority of this activity would have been at rates agreed in Q4 2022, which was a horrible time to agree a mortgage! To put that 9.8% figure into historical context, the data since 2007 Q1 (the first date at which they started to collect it – how convenient……) shows an average of 11.83% of mortgage advances being used for buy-to-let purposes, and the 10-year average (which leaves out the financial crash, of course) is actually 13.54%. 9.8% is a long way (over 35%) below that 10-year average.


There are a whole swathe of numbers of where mortgages are at in the buy-to-let sector, but the prevailing number in the most recent figures is around 2 million encumbered buy-to-lets of around 4.6 million BTLs that exist. That’s limited company and personal name. So it is around 44% encumbered, 56% unencumbered. This may surprise many, but it is quoted in a number of sources including government-backed ones, and seems to be the best number we have got.


Hamptons international has a whole number of other stats, of which they do not quote the source, which makes me worry about their veracity. Nonetheless, they are a large organisation, and produce their own indices. They claim 59% of buy-to-lets this year have been purchased without a mortgage as investors try to make sums add up – which is interesting to say the least. 


So – it seems that in at least 50% of cases, those ideologically opposed to landlords do actually have a point – they are sitting on cash, and the interest rate does not really affect them. So be it. There is no real decent analysis knocking around over just how much maintenance costs have crushed margins though, before we start on insurance on flats (we just had one renewal which was up over 300%, and this was a flat where the council is the freeholder. 300%!). 


A stats overload today – but an enjoyable journey as I continue to hunt for the best sources in the game. Some more fruits to draw from in the future! That once again draws us to a close – and you know what that means. 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” – and Keep Calm and Carry On!