Supplement 230723 – Inflation Situation

Jul 22, 2023

“Rest is not idleness, and to lie sometimes on the grass under trees on a summer’s day, listening to the murmur of the water, or watching the clouds float across the sky, is by no means a waste of time.” – John Lubbock, The Use Of Life


Welcome to the Supplement everyone. For the first time in a little over a month there was some positive news that really snapped off the recent direction of the bond and swap markets which is fantastic news for mortgages. A few weeks ago I suggested “going to ground” and not reading or listening to any of the noise – I was starting to worry that might turn into a couple of months, but perhaps I should have taken my own advice! Luckily, that “downtime” period I filled with a little over 12,500 words of primary research and analysis and if you missed anything over the past 2 weeks I’d suggest going and catching up on them. The “real house prices” story particularly was a very illuminating piece of research.


As per the new format I’m going ahead with the bullets up front, sticking to the new number format for the purpose of the NEW ai-generated audio version which I’ve managed to get online with the help of a colleague. 


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  1. Inflation print at 7.9% was below expectations by 0.3%, a really considerable miss to the downside, and that’s great news for mortgage rates
  2. Core inflation down, services inflation down, job vacancies still coming down and unemployment up. This is the cocktail needed to try and “land the plane” without a crash. A near-impossible task!
  3. Will the Bank of England then be able to pause their relentless base rate hiking schedule? Spoiler alert – no.
  4. Politics and the upcoming election, Labour drop every pledge going – what’s going on there? Smart politicking in my view
  5. Buying well is much easier at the moment than it has been for years – however, financing well is much harder. Some medicine from Uncle Warren.
  6. Some longer insights into Vendor Financing this week which is helping with deals we are creating, offering and closing at the moment
  7. Remember the capital stack – where should the slider be on the debt/equity scale at the moment? A different answer for everyone
  8. Equity does not expect to be paid tomorrow, if being used correctly and explained correctly
  9. Don’t like the idea of sharing equity? Do better deals!
  10. Tough love for the end – how to do more deals and finance them well


So – what did happen – just in case you’ve been under a macro rock – or just too busy this week and rely on the Supplement for your market information these days! Well, Wednesday morning saw some fantastic news around inflation. CPI dropped – which we knew was going to happen – but recent failures to drop significantly had led to higher inflation expectations. June’s numbers were released and instead against that consensus figure of 8.2% that the forecasters were predicting, we printed a 7.9%. 


Oh the celebrations! That tells you where we are at in the cycle, a number under 8% is seen as a gigantic victory! However, as I’ve previously advised, missing the expectations to the downside, and the downward trend, is viewed as much more important than “the number”. This looks like perfect timing from the government having acted in their typical manner around pay negotiations, because inflation expectations will now be going downwards. This impacts future pay negotiations to the downside, in general, although the transition from “catchup” to “looking forward” won’t happen overnight.


Some might think that the bond markets have overreacted to the downside. There’s definitely still plenty of bond bears out there who would push gilt and swap prices back up – that’s for sure. There’s a current feeling that inflation is “over” – which is too strong a conclusion, too quickly – but there’s definitely reasons to be cheerful. I still think a sticky path downwards is the likely result – although remember, July is a near-guaranteed drop in CPI at least because of the drop in the energy price cap which now happens quarterly, 17% came off pricing in July on the 1st for households on variable rate tariffs (using the cap as a guide).


The 5 year swap hit a low of around 4.6 this week, although rebounded after that. This is from a high around 5.25, so 65 basis points is not to be sniffed at. That takes an awful lot of property into a zone of affordability or viability that wasn’t there at 5.25%. Remember my rough rule of thumb in these times is still to add 2% lender product margin to these numbers to come up with rough pricing for a 5 year fix, bearing in mind that this would include amortised arrangement fees. So, at 5.25% I’d be expecting to see 6.25% with a 5% fee (cough) – whereas if we can get back to the 4.5% sort of level it is more like 5.5% with a 5% fee or something around there.


There’s also the argument that margins can be cut, but lenders are still doing considerable volumes of business at this time and a blip of a few weeks in light of recent upward pressure on yields has only given time for them to increase their poor service levels somewhat. 


Anyway – we all know that CPI is the headline figure, and Rishi’s pledge figure – so the target is loosely understood to be getting under 5.25% by the end of the year. Wednesday’s figure made that a lot more likely, after it was looking nearly out of reach. But the real driver of the markets here is core inflation.


My own expectation was another print over 7%, on base effect reasons – a relatively benign month was dropping out of the data, so I was surprised (in a positive way) when I saw 6.9%. The graph now looks temptingly though we have seen a top (albeit above where almost everyone thought it would go) at 7.1% for May’s numbers but it is too early to prepare the victory lap just yet. At just 0.2% month on month, given a warm month with summer-induced spending (but, conversely, less incentive to be productive and more incentive to take holidays), it brings the quarterly annualised core figure to 9.6% still, although this is welcome respite from the double digit numbers quoted in last months’ figures. Still the right direction of travel, still been too hot of late for comfort even stripping out the volatile bits.


Services inflation, 47% component of the CPI, also dropped from 7.4% to 7.2%. Still far too high, but in the right direction. This one doesn’t attract anywhere near enough attention given just what a huge component of CPI that it is, and doesn’t get forecasted – so we can only read into the direction of travel. In July ‘22 it was 5.7%, from 5.2% in June ‘22, so a pretty hefty base month dropped off the annualised calculation – August ‘22 was 5.9% so a steadier rise, but a rise dropping off the figures nonetheless. A print under 7% for July would be most welcomed!

When we look to CPI month on month, a 0.1% rise in a summer month looks most promising – last quarter annualised we are still looking at 8.3%, but April is always an “up” month because of timings of pay rises and utility bills (which were still rising back then), when that drops off the figures will be much more promising. Another print like that down in the weeds near zero would really buoy confidence next month.

Job vacancies are at their longest downward trend in number terms since 2008-09, although they still remain historically high – this keeps pressure off wage increases though, of course, and the uptick in unemployment this month is again the potential start of a trend to the upside. Both of these do help temper wage expectations and speak to the balance of power between the employers and the employees. The retail price index (remember that?) is still in double digits at 10.7%, the lowest number since March 2022 (but still – double digits!) 


So – over to the Bank of England – not next week but the week after. Does this finally mean the hiking cycle can pause, or skip, or hold rates? (it is important to understand the nuances there – a pause might be months long, to see what bites in the economy, a skip implies a rise at the next meeting, and a hold implies that the Bank feel we’ve reached the top of this current hiking cycle) – sadly, no, I don’t think so. Another 0.25% is a message that says “we know that nearly 8% is not acceptable for CPI and are continuing to be tough on inflation”. Another miss to the downside for July’s figures (and the expectations are in the low 7s, although expect revisions as that’s been happening all week) and that would really be a solid path downwards.


The Bank’s financial stability report which was analysed in significant detail last week has basically given a pass to the Bank to continue with the hikes, slowly and surely. The probability of 6% base in this cycle though I’ve adjusted from 90% to 70%, still odds on but less of a penalty kick. The doomsayers of 7%+ are back in their boxes for the time being, but this was merely a battle being won, not an entire war. 


One more stat that might have slipped through this week is consumer confidence – Friday’s -30 number is the lowest for 6 months. This suggests suppressed summer spending (SSS!) is a possibility, and there’s no better way to temper inflation than suppressing consumption. Public sector net borrowing is also £10bn lower than expected, which starts to put money in the coffers for the pre-election giveaways (too cynical? I think not).


I thought a couple of paragraphs of political commentary might be of interest, since we will soon be talking about a general election – soon enough. Labour’s tactics are leaving many traditional labour supporters scratching their heads, but my take is that they are actually being very clever. The election is won in the centre/with the floating voter. Diehards on any side can moan and groan but they are ultimately voting the way they always vote. Those in the centre will inevitably be worried by the trope (and it is a demonstrable falsehood) that Labour spend and are not fiscally conservative. They are ahead of this one by summarily dropping pretty much every pledge they’ve made so far. 

They are copying the 1997 election strategy where the Labour party pledged to stick to the Conservative spending plan. Remember the result of that one……exactly. Starmer has nowhere near the charisma of Blair but looks loosely competent, a bit like Cameron did (and look what happened there! But never mind) – and that’s enough to stand up and win. Those in the middle will be able to vote Labour as a “best of a bad bunch” sort of play, the way I see it at the moment, and that will be enough for a majority. Sweeping changes therefore look unlikely, although the temperature and tone will be different, of course – and not panicking the financial markets will be a positive. My “fear for Kier” remains him getting deposed by the hard left which some of his senior players (Rayner for example) most definitely feel comfortable in. Rayner also looks like she could easily have a tilt at the leadership as soon as there’s a reason to – and that I find much more disturbing to the force!


So – up to speed, we can move on to today’s main course. The recent times have been a reminder that resilience is one of the number one priorities in this game, and sitting on your hands when necessary is a close second for a long and fruitful career as an investor in anything. Sometimes, things go wrong (much more often in trading businesses than investment businesses, but when they go wrong on a macro level in a reasonable way in an investment business, it can hurt a lot more). I wanted to talk about how to sit on your hands with grace – and what you do with that “downtime”, since there is so little of that in today’s world.


I was stunned this week when I saw a post on business socials around a property mentor admitting that they had had their head in the sand about the rising interest rate. I stopped myself from commenting, because it wouldn’t have gone well. But I also reflected – the head in the sand approach should never be the best one. Why did that person do that? Especially when positioning themself as someone who is going to help others, for personal monetary gain? It has to be one of two things in the mixer – lack of education, or lack of resilience.


Investment sometimes feels like a war – more of a hundred years’ war or one of the long conflicts of history – with a whole number of battles. Preserving your troops is key. Training your mind is harder, but absolutely essential. This is why I love Uncle Warren so much – he is so full of great quotes in these situations. 


One of my favourites:  “Successful investing takes time, discipline, and patience. No matter how great the talent or effort, some things just take time: You can’t” produce a baby in one month by getting nine women pregnant.”


Resilience comes from facing adversity again, and again, and again. Yes, I hear a Chumbawumba song somewhere in the background. It doesn’t come from a life of fluffy pillows and no hardship, and no bad news. Quite the opposite. “Tough love” has reasoning to it when you are trying to raise children – but first of all, turn it on yourself. The same is needed if you are trying to genuinely help people move forward in their investment careers as a mentor, consultant or otherwise.


Speaking to people daily, as I do, at either Partners in Property events or connections made at other networking meetings, I see and hear a lot of the same things, identify the trends, and think about solutions. At the moment, people are struggling for cashflow. This should really not be a surprise – refinancing takes longer and longer and whether you use your own funds, investor money, bridging, development finance, or a blend – all of those have significant costs (opportunity cost of your own cash is something you absolutely must understand if you want a worthwhile career as an investor). Not only that but the price of credit is up, significantly (thanks, Sherlock). This is simply the current iteration of a number of Covid-fallout scenarios that we have faced, and is likely not the last one before there is any kind of softer-landing that will make everyone feel better.


However – that’s investment for you. Uncle Warren quote 2 of the day: “Our favourite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint.”


The flavour of today’s, or this week’s, or this month’s challenges are just that. Changing with the wind. You’ve still got to do the same as always – and something that likens a lot more closely to Warren’s philosophy himself than he likes to admit. The way forward in property is to buy at value, finance well, deliver well and manage well. That’s the business in a nutshell. Buying at value and financing well is always difficult to execute at the same time – for some years, financing well was relatively easy with low rates; however, in 2021 for example, buying well was really not easy – it was really quite hard. It ebbs and it flows.


There’s one major piece of the jigsaw that many people seem to be missing, at the moment, and I wanted to use the rest of today’s column to dive into it a little. Equity versus debt is the topic of the day.


After all – where are the problems? Finding the right opportunities – if, for the moment, we ignore the cost of debt, is not one of them. Plenty are keen to sell. If dealing with unmotivated vendors – note down the opportunity, add it to the pipeline to monitor and chase, and move on. If the deal is then on the table, then depending on the size of the deal, position of the vendor, and your own skillset, knowledge and experience, the first port of call for reasonably priced capital is going to be the vendor.


Vendor finance is commonplace in commercial-sized deals, even if the primary asset class of the underlying purchase is residential property. Security will often need to be offered, of course – but vendors are often very realistic about the interest rate – if any – they are going to receive on monies left in their deals. Run-offs, earnouts, part now part later, deferred consideration – many different ways of describing what is essentially the same concept. 


If the vendor’s ear isn’t open to that sort of chatter, then I’d expect the price to reflect that. Nonetheless, now onto your version of the capital stack. If you look at every deal as if it can be funded with your own cash (even if you don’t have any at the time), someone else’s cash (private individual), or an institution’s cash (for part or all of it) – that’s pretty much covered the universe of opportunity once you’ve moved past the vendor finance questions.


Then let’s take a different tack. We could fund this deal with 100% debt (even if it is a loan from ourselves, or another business of ours) – or we could fund the deal with 100% equity. The investor might just be looking for that person who is trustworthy and can deliver solid deals – and do all the operational legwork. For that they may put 100% of the money in and agree to a 50/50 equity split, or something that looks reasonably nearby. If the deal is amazing, they may well agree to less than 50% of the equity!


The reality often ends up being somewhere between the two poles, but not necessarily in the middle. You might have 70% from a senior debt lender as a bridge or a development loan, if works are significant or speed is the key element of the deal; 25% might come from an equity partner and 5% might come from your own pocket. That wouldn’t be particularly uncommon.


The point is, though, that as a “raw” equity partner, this is not loading or saddling the company with a gigantic amount of debt. The debt servicing problem goes away. 


This isn’t the only answer, either – you might well be able to come up with some kind of hybrid solution. Some debt, some equity. A coupon on the shares, but payable only after a trigger event? That way the investor might be able to justify a lack of return in the first 12 or 24 months of a deal, but look forward to regular “back-seat” income in the future.


Sounds complex? Well, it isn’t easy. You can’t go out and do this tomorrow if the above sounds like Greek to you – but that’s not the point. The point is to push your thinking and take you outside of the box that will otherwise limit you, and your path to being a successful long-term investor.


Or – completely swerve all of that by finding fantastic, discounted, cash-flowing deals which are returning north of 10% on the total costs of doing the deal. Then, you can just afford the current debt pricing.


The final point though is that I know – from talking to people and consulting at a deeper level with others – that there are lots of deals out there at the moment that people know in their heart of hearts are good deals. Deals that in 5 years time you would be really happy that you owned, but you just can’t find the way to do it today. This line of attack should give you the edge that you are missing.


Bad medicine time though:


Can’t find deals? Work harder AND smarter

Can’t find money? Broadcast what you do. Play to your strengths. Work towards particular targets on the raising investment side.


Those two pieces of tough love are effectively evergreen – but it does feel like at the moment some reminders are needed.


Enjoyable as always folks…….see you next week, until then – just make sure to Keep Calm and Carry On!


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