Supplement 280523 – Buckle up!

May 27, 2023

“Five Ups of life: Buckle up, Start up, Keep it up, Don’t give up, Cheer up.” – Vikrmn, Author

Welcome to the Supplement folks. Was that the week that was? Anyone else left wondering what on earth has been going on? Well, of course, we will get into that today – with some “in the now” keep calm and carry on tips, as usual.


The debt ceiling issues in the US as discussed last week are looming on, and the extended deadline (4 extra days) is somewhat helpful, but also serves to unnerve markets even more. Next week is D-week – and the strong, overwhelming likelihood is that everything will be fine, but there could be curve balls the Republicans have in their pockets. It will either be something never seen before – which could be nuts; or a re-hash of something already seen before, which is more likely – something like a spending cap (which will then be broken, dissolved and run roughshod over at some point in the future).


What this gives us sight of is what would truly happen if the US was to lose its world’s reserve currency status. I’m often asked my view on this, and my view is one of TINA – not a tribute to the great lady who sadly passed recently, but There Is No Alternative. It isn’t much of a value proposition, because one day there IS an alternative – but with China’s attitude towards capital controls (and no choice on that front, because lifting them sees capital flight like no other, ever), Russia’s attitude towards hegemony, Brazil’s attitudes towards electing nutcases, India’s attitude towards foreign policy (and it being a long way behind in the global economic superpower stakes, in spite of significant growth), and South Africa in turmoil – a collaboration to unseat the dollar looks a long, long way off. Something major will have to change. The euro remains a bigger competitor in terms of volumes traded, but there’s enough sceptics, and Brexit would hardly have helped – also, the relationship between the EU and the US would be irreparably damaged if the EU took steps for the Euro to become the world’s reserve currency. There’s legs in the petrodollar yet, folks. It’s filed away as “one day” without a real plan as to how it would happen. 


None of these overarching issues, which affect global bond markets, are helpful; however, we had our own chickens home to roost this week. Inflation – as outlined a couple of weeks ago – had a couple of stories to tell. Firstly, CPI was down, and the wider media which uses Economics as it uses sport, told a story of “dropping from double digits, inflation down” etc. etc. This is of course the narrative that the government would prefer to push.


We didn’t hit the 8% that the market had predicted, nor did we hit the 8.2% that was the market consensus. Another miss to the upside, which just keeps on worrying people. We also, happily, didn’t hit the 9% that I feared – 8.7% was the number, so a massive upside miss in terms of forecasting – after my revision, I was closer (but happily wrong!). This wasn’t the real story though.


If you dug deeper – not overly deep, but the FT or financial press generally, the narrative was different. The focus, as per my article a couple of weeks back, is all on the core. And core was indeed really bad news, right at the top end of my range – for reasons unbeknownst to me, the consensus was 6.2% which was the same as the month before, despite all the petrol poured on the fire by massive minimum wage increases – I said it simply wouldn’t happen, and it simply didn’t. The number was 6.8% – an even BIGGER miss to the upside, and one that was above my 6.5% best guess.


Let’s hover there for a moment. This week has been an absolutely CLASSIC reaction to all of this. Markets are emotional. I’ll elaborate. 


I said a number of times the heat pumped into the economy by April being – the month of the biggest collective pay rise in decades, including many benefits, plus the month that the heating goes off (typically, although this year it was chilly) – made the rise in core inflation an absolute penalty kick. Think about it in a really simple context – people are poorer, relatively, than they were. Almost everyone is. You’d need to have had a massive promotion, or a windfall, to keep up with inflation for the past 2 years. Almost no-one measures their relative wealth in real terms, and many companies (for example) would be happy to be worth 7% more than they were at this time last year (which is the average pay rise in that time, as it stands right now), but they would still be worth less once adjusted for inflation.


Despite this being inherently obvious, it largely seemed to get ignored. The models perhaps don’t account for this very well, but this was a historical one-off going back a few decades as I said. I saw zero discussion of it from the central bank or other economic commentators on UK inflation. This does (whilst it doesn’t sound like it) contain some potential good news.


Let’s stay on this logical train of thought for a moment. What happens now? Well, the typical overreaction is in the midst of happening. The news has only just dawned on the whole of the market that the drum that some of us have been banging for nearly 2.5 years now is annoyingly correct. Those that saw it coming are already used to it. Those that have really only seen it in piecemeal chunks are not.


Zoom out. Our bond yields are currently one third of a percent higher than Greece’s, and a full percentage point higher than Portugal’s. If you remember the EU debt crisis of the 2010, and chat around PIGS (Portugal, Ireland, Greece, Spain), you should also remember that that really wasn’t resolved to an acceptable degree and both have considerably higher debt-to-gdp ratios than the UK – 117% and 171% respectively. Both are much more reliant on Government spending to drive their respective economies. This makes no particular sense to me; both also have a lower credit rating. Neither are as attractive an international destination for investment in the broader sense (although Portugal attracts plenty of brits thanks to the lack of a double taxation treaty, of course). Portugal’s CPI is a shade lower, but its core has been into the 7s in recent months and has come back to 6.5, a bridge we have only just crossed. Greece’s CPI has collapsed right back near target, but its core inflation is similarly in the 6s and doesn’t yet necessarily look conquered.


This sounds like an overreaction on the UK – the one major defining factor is the long term view of the Euro and its strength versus Sterling of course, on which one struggles to be anything but bearish – but this backdrop simply looks incorrect. There’s one more thing I’ve omitted here though, which markets worry about a LOT more than I do, very deliberately.

That’s the trend. Our trend is now downwards for CPI – we can see that. That’s positive. Our core trend though is not necessarily downwards, whereas for Portugal and Greece it looks though it most likely is (especially Portugal). The upside could be much higher.

And yes, it could. However if you follow my “April effect” logic detailed above, it really shouldn’t be. Wages will try to catch up with prices; of course they will, but it is inevitable that the companies win that one in the end. They are smarter and stronger together than the average individual worker – it is just as simple as that in a capitalist society. I have little more than a gut feeling for this, but I feel that core inflation will drop right back next month and April will prove to be a relative anomaly. 


Month on month, UK inflation was at 1.2%. If you annualised it, that would see CPI at 15.4%. The last 3 months have been 1.1%, 0.8% and 1.2% – if you annualised that, it would see CPI at 13.1%. Portugal’s would be 10.8% and Greece’s would be 8.7%. However, that leaves out months that are typically deflationary (like January) – and doesn’t paint the best picture for the UK, but something that allows a 1.25% gap in the bond yields, from the stronger economy to the weaker? I don’t think so.


The market feels a bit like a baby in these situations. Crying, desperate to be cradled in a parent’s arms – I can visualize a cartoon image of tears everywhere. What it needs is the good old Bank of England to pat it on the back, wind it, and soothe it.


That’s the likely play here. As we sit today, we are not far off the carnage of late September/Early October 2022. But we don’t have a complete idiot in charge any more. For those who haven’t seen, the market forward curves are now once again predicting 5.5% base rates by the end of the year. 


The Bank only really has two choices when it meets next month (Thursday 22nd June, shame it isn’t sooner but an emergency meeting is not warranted and would spook markets even more, on balance). 0.25% up or 0.5% up. If the meeting was today, 0.5% is the right choice for sure. 


The market will likely calm before then. Next week, perhaps not so much until the debt ceiling is resolved in the US – although you could argue that a US default would make UK bonds MUCH more attractive, and the bond market so often does what you don’t think it will do – so yields being dragged up by that don’t really make much sense, to me, but as we get into June. The point has been made for many months now in one form or another, but this is why we need a recession. Arguably.


There is a slightly alternative viewpoint – less of a disagreement than a reframing. We are already in a de-facto recession – because everyone (pretty much) is worse off in real terms. Employment is still very high so it isn’t painful – but 3% off the whole country is a lot more (3% is the gap between current inflation and current wage increases) than 10% off 10% of the country, for example. That’s typically economically brutal, because if you are in that 10% it hurts a lot more. Very utilitarian, and very typical of a recession. 


Erosion of purchasing power puts undue pressure on people, who have a tendency to want to “keep up with the Joneses” – although the idea of not going forward of course crushes morale and spirit, which leads to ongoing sickness problems (and the UK has had a massive increase in this since 2019, 26% to be precise) – this is often written off as “Covid”, although it clearly has to also ascribe some of this to the failings in NHS waiting lists since Covid, which will obviously damage long-term health. This is a vicious circle – poorer healthcare, poorer productivity and economic output, less tax to fund a functioning health service – and needs to be reversed quite urgently. The self-reporting statistics that the ONS keep are not great reading at this time and revert back to not long after the financial crisis (these weren’t being kept in the 2000s unfortunately and most start at 2011). Parliament is of course aware, but since the trend is (recently) downwards I won’t be holding my breath for the promised government report on economic inactivity.

So, have we seen the worst of the volatility this week? Lenders pulling fixed rate products left, right and centre as I’m sure you will know? Now probably isn’t the time to throw back to the number of times I’ve mentioned this year to take the current pricing rather than risk the upside, and next week is the first week to really “hold hard” for some time. Next week “could” be worse depending on the news coming out of the US. In terms of metrics, we get mostly lending and credit data, Nationwide’s efforts on what happened in May, and none of that will likely reflect the events of the past week.


What’s likely here is credit tightening. If you can’t see a fixed rate you can’t take it, of course. The first to go are the specialist loans, although I’m sure the lenders of last resort will still be at the table – this is Christmas-time for them. Tougher to get SA mortgages or the loans on flats above shops, that sort of thing. Credit pricing going upwards automatically tightens credit anyway, of course, just because of the simple rules of supply and demand. 


Let’s also get down to business. Sitting writing this today, the news that inflation is stronger for longer finally really getting through to the broader marketplace is likely to keep dragging prices and wages upwards. This helps affordability and helps to deflate nominal debt. But. Instead of a steady outcome to this year, which is where I thought we might be, the bigger probability is a further price drop, perhaps in the order of 4-5% from here. Some will argue 10% has already come off the top, although the number looks like more like 5% to me – 10% drop in the nominal prices total, which is the bearish end of my range, in times of such inflation, would be not far off the late 80s/early 90s market.


That’s not to say we have 5-7 years of property doldrums on top of us. The economy looks very different. Far fewer people on floating rate mortgages, at lower loans to value. Some are inevitably going to have to sell their properties, and will still have a lot of equity there – those who overpaid in 2021 on a 2-year fixed rate at 1% have a really horrible shock coming if they are not on top of the figures, but this is a tiny proportion of the whole market of course. Those dropping off a 2018 2.5% resi 5-year fix have likely had about 15% net capital growth, even if we do go down to 10% off the top, and have paid 5 years’ worth of capital (although capital repayments are minimal at the start of the term) – so they are not in trouble in equity terms, even if they are in cashflow terms. 


There will be some tough decisions for some to make. This isn’t 2008-9, but this is likely to put even more pressure on the rental market. Potential homeowners who now can’t buy because of rates. Those who have to sell to go into rental. Lots of reasoning behind even more rental demand. Affordability will be a significant issue too of course. Younger people likely to stay behind with parents while they can. 


These are “in the now” decisions. If I’m right, and this is a blip in core, then these messages will subside – but we saw this pretty much kill the market in 2022 when Truss was in charge. It took months to get started properly again – and, today, some of those deals will be falling apart. In terms of what’s in the pipeline right now, your first priority should be to renegotiate if you have concerns over pricing in general. This is one of the very worst times I’ve ever seen to overpay for a property.


Property is slow, remember. If next week sends yields even higher, and creates lots more headlines in the mortgage market, the market won’t likely get restarted until September. The flip side is, there will be a huge amount of demand at that point as it all gets bottled up, IF inflation is truly on a reliable downward trajectory by then. Also remember that interest rate rises take at least 6 months to filter through in central banking terms. We are currently an economy with a base rate at 2.75%, even if we are about to go to 5% at the next MPC meeting (most likely). 


It’s also timely to remind you of my 5.5% stress test logic. All these loans that were originated before 2022 that are dropping onto variable rates, in the owner occupier market, were stress tested at 5.5%. They will be at or around this price, on a re-fix, even next week. This is not carnage territory yet. But my goodness, it is dangerously close.

What will lenders be worried about? The interest rate in 2028, and the likely path of the market until then. They will be quelled by the 5-year likely path, which most commentators see at around the 10% level for capital growth – a period of “healthy” overinflation at around 3-5% could easily put that upwards, if core inflation remains particularly stubborn even when it is on its way down, which it has a habit of doing. 


Unless a really brutal recession is induced, of course, in which all bets are off. That will need a catalyst that is non-governmental and that the government or the Bank of England cannot combat. By no means impossible, but politically unlikely with an election coming up, of course. What’s the betting on us hearing that phrase “whatever it takes” before next week is out? And certainly by the end of the year?


  1. Enough macro. On to the famous bullet points to allow us all to keep calm and carry on:


  • If you haven’t got decisions in principle in, and need some term funding – turn the news off for the next 7 days. The next thing you read or hear should be next week’s supplement. Anything else will be negative for your mental health!
  • It’s time to deleverage. Consider what you have that you can liquidate before the market does start to fall, if we see any more shocks or if my bearish forecast is correct.
  • Tap up your pledges and contacts. People want stability at this time and using term funding from private lenders at high single digits – if your projects can support that – if you can offer security – is a win/win situation
  • Review your asset management strategies. If you aren’t intending on raising rents annually going forwards, you WILL struggle over the next 5 years. You need to start acting now in order to build a war chest for when the fixed mortgages you do have, you clever people who have long fixes still in the tank, drop off, particularly if you have a lot of 2.xx, 3.xx or 4.xx debt
  • The longer term path of BTL cost of debt is still 5-6% in my view. We are currently, today, forecasting 6.5% for any deals we agree, and are close to going 6.75%, and probably will early next week. You must stress test at these levels or higher, or problems will await. 9% cash-on-cash yield is where you need to be unless you have other vehicles throwing off money, but negative cashflow doesn’t appeal now, or ever, to me anyway.
  • Stop spending money. Please share this message with 70 million UK citizens – because if it stopped, then inflation would stop very quickly. The consumers control it. This is tongue in cheek of course, but a cash warchest (whilst it feels counterintuitive in a time of inflation) is a good thing, trust me. 
  • Remain financially attractive. Don’t miss payments. Get organised around this stuff if you aren’t already!
  • Consider a personal loan. 25k is still available – today – at 5% APR. Unsecured. Could be important liquidity, even if it feels like a pebble in the pond. Liquidity is everything; cash still IS king when you need it.
  • Don’t panic! Today might leave you reeling a bit but this is the reality of today’s marketplace, not an epistle saying that the sky is falling, or that property doesn’t work any more! You must review your portfolio in the cold light of day.
  • Don’t be trapped! Speak to others about your situation, particularly fellow investors. It helps – it helps massively! Don’t take all your advice from Facebook – naturally – but do…….


Keep calm and carry on. Until next week!