“If the words don’t add up, it’s usually because the truth wasn’t included in the equation.” – anon.
Welcome to the Supplement – we’ve made it through “Blue Monday” again and the nights get lighter and the bank accounts (hopefully) get to replenish from here. I’ve had a demanding but interesting week this week, and, as usual, am grateful to the people that I’ve interacted with – some for the first time, some for the thousandth time – who have made me see things from their points of view, and also given me some clues about where there are some gaps in the tapestry that is the property market and the economic outlook at the moment. With today’s piece I’m going to try to patch some of those holes and answer some of their questions and concerns.
A quick roundup of the backdrop first of all, since we’ve had a surprising month in the backdrop of the past 12 or so – this is the second week in a row where a major inflation forecast has been bang on the money! Last week it was the US, and this week the UK. The US has inevitably seen inflation peak now in June 2022 for this cycle, and has started to become more predictable (for the moment) – the UK peak could well be in, but it might still be too early to call that just yet – the price cap coming off in April 2023 has got implications that very few people are talking about despite how near that is. If that was accompanied by another bull run upwards in energy prices, because of Russia or because of many other possible reasons, we might see a nasty adjustment – April is already when minimum wage chips up nearly 10%, and for some businesses will be a month where they adjust – although the observant will see that January has already seen some significant price increases on the shelves (we won’t see those figures until next month in the reporting).
There does, however, finally seem to be some acceptance that the UK is potentially facing even more sticky and stubborn inflation than some of the other major developed world economies. This will lead to more stubborn and sticky interest rates, of course. In fact there’s a fairly huge realisation coming and a bit of uncertainty on which side of the fence things will fall on, dependent on when this event occurs.
As part of my rather overdeveloped schedule this week I was asked (and agreed) to speak at an independent property event in London – thanks to Richard Woodstock and everyone for their hospitality at the Ealing Property Meet. If you are in the area – or even if you aren’t – I’d recommend checking it out for a warm welcome and a great room in terms of breadth and depth of experience. I am starting to realise just how much there still is to be accepted by the wider market in terms of inflation and what’s left to play out in this cycle.
Let me frame it one more time in these terms. We’ve had a debate – damn near a good old-fashioned streetfight. Is inflation transitory, or is it secular? I.e. will it pass relatively quickly and will everything return to “normal” – or is it in the system permanently with a touch of extra vigour? As usual in these situations, the correct (but unsexy) answer is a little from column A, and a little from column B. There are definitely transitory elements – the easiest way to understand these would be to remember that many production facilities were shut down in 2020 expecting a vast drop in global demand, but that stimulus from governments kept demand high and thus messed about with the price of timber, oil, copper – in fact, any commodity or natural resource you can think of.
There are, however, also secular elements. This still isn’t being appreciated in the figures as I see them. One massive issue that remains with what I’d call “legacy economics” – which you could couch as things that are demonstrably incorrect by looking at the data – is the concept of rational expectations. We still seem to write (the financial press overall, and not the ones clickbaiting for headlines) and observe as if rational expectations are an accurate picture of people’s behaviour. People simply DO NOT avail themselves of the best information available in the market – the majority don’t care about it in my opinion, or don’t possess the skills to be able to determine what the best information in the market available is. They also don’t learn from past trends as efficiently as the theory suggests.
Instead we have behavioural economics – the school that observes how people behave and comments upon it. That leads to “nudge theory” and government departments that subtly attempt to lead behaviour in a certain direction. A little bit “big brother” I’m sure you will agree – hopefully with the right intentions, although in 2020 we could definitely question whether this was used in the best long-term interests of the country.
This is all good for the textbooks but how does it all manifest itself in reality? People don’t tend to be great predictors of events, particularly when they are quite boring and play out over a long period of time. Humans are great at adapting to events once they have happened, but poor at predicting them. This means that when a recession is definitely coming, the majority won’t act as if there’s a recession coming until it’s actually here – until they really can’t afford various goods and services rather than budgeting for the hard times before they arrive (if they do arrive, of course – there are many out there who have predicted a crash or recession once every 3 months for eyeballs or YouTube clicks. One of my favourite phrases – he’s predicted 9 out of the last 2 recessions).
The figures are there on paper. From a wider economic perspective, and technical perspective, the UK may well not be in recession just yet. November caught out the analysts and actually saw a small growth in GDP, meaning December needs to be -0.4% or worse to get us into technical recession territory. That might have happened because of the cold weather spell – notoriously bad for GDP – and from observing the outside world a few times in December, it certainly seemed more quiet than I would have expected, and anecdotally friends and wider networks seemed to have had a more subdued Christmans than might have been expected, for a variety of reasons. One more guaranteed recession not landed, just yet.
The expectation though of course is that 2023 will be a tough year. Wage rises simply haven’t kept up with inflation – very, very few will be better off than they were at the end of 2021. This is where things start to unravel – or not add up at all – as far as I see a lot of the analysts’ predictions.
The labour market is particularly tight and the unemployment rate is absolutely key in terms of understanding where a large chunk of government revenue is going to come from, and also where a decent slice of the spending is going to go to. If you imagine a household with 2 children and 2 adults – the typical “average” – if the parents both have full-time jobs, the likelihood is that they are positive contributors to the economy. If those jobs are both minimum wage, they will likely still be in receipt of some benefits, but the tax they pay will make them net contributors. If one is unemployed, they may well be net negative contributors from the system – if both are, particularly if it is long term, they definitely will be and also there are longer-term implications for whether their children will be long-term positive net contributors to the economy or not.
Ergo it makes massive sense simply from an economic perspective, rather than zooming out to an entire societal perspective, to ensure that unemployment remains low. As a government you want as many people in the net positive contribution column as possible, of course.
In the face of a gigantic number of net migrants last year into the UK – 504,000 – although all of this number are not eligible for work, some being students for example – the participation rate problem still persists. Many in the working age demographic have chosen to take themselves out of the system – the covid stimulus gave them the time, and the opportunity, to step back from the workforce and inflation hasn’t yet dragged them back in!
There are still 43% more job vacancies than there were before the pandemic, comparing October to December 2022 to October to December 2019. Really very significant on the effect it has on wages. We also, as I posted about mid-week, have phrases like “a de facto general strike” being used as union bosses co-ordinate their activities to cause maximum disruption with the hope of getting the people on side in their cause to up their pay. I’ll leave the politics and morals of that one aside – just like any good economist should….
This is where the secular element of that inflation needs further analysis and discussion. The expectations for 2023 are that wages will continue to rise (partially in catching up to inflation) are in the 5% region – the 2024 expectation for minimum wage is already set out by the low pay commission, who see 6.3% as a likely rise (which puts 5% into context somewhat). Whether it is 5% or 7% for 2023, these numbers are unlikely to be far off.
Then, the economic history buffs and the econometricians should be stepping in, in my view. If you can point me to the precedent in history where wages are rising in this fashion, and unemployment is comparatively low (and yes, of course it will go up this year, but rising above the 5% mark at this point looks very unlikely to me, and even 5% is historically very low), and inflation simply tails off in an orderly fashion…….let me save you the effort. You can’t. That hasn’t happened and in the context of the above conversation you should be able to see why that’s the case.
People aren’t preparing for a nuclear war when they are getting 5% pay rises. They are grateful that the energy bills (hopefully) haven’t eaten all of that and have left something on the table. They are likely spending 100% of the pay rise because of the increased cost of living, and, as such, behaving in an inflationary fashion. This is how wage-price spirals work…..at a nominal level.
Then, there’s another issue that will cause ructions this year in general, back to expectations. Inflation expectations, in reality, for the average household, are not particularly rational. They are not looking forward in the same way that the low pay commission have done in their analysis. They look at inflation – today – and expect that to be the best predictor. In the absence of other information, they work it out in the way they work out the weather, as a whole. Same as today. The “fair” level of pay, with the question being answered by the employees, should go up by 9% this year. I dare say if you asked the employers only they would similarly come up with a number on the opposite side of the divide, and say that 2-3% would be appropriate since we are in difficult times and other costs have risen so very much.
The argument of the analysts is that these are “base effects” from one-off price rises. This is simply untrue – and when you look at the price of oil (for example) in historical context, adding inflation – the price is just nothing like it would be expected to be if you’d fast forwarded from the early 2000s to a 2020s with a hot war on the ground with Russia and Ukraine, and a dicey geopolitical situation in other parts of the world.
This idea in some of the analysis at the very top level, from last year, that inflation will just drop off like a “good boy”, in some orderly fashion, mythically down to an arbitrarily set 2% target which hasn’t been adjusted in light of the most significant economic activity for at least half a century, is frankly fairy-tale stuff.
If true demand destruction occurs because we have a recession of massive depth – twice the size of the 2008-9 financial crisis, then all bets are off of course. However, I’m going to need you to guide me to the black swan that makes that occur.
Since extolling some of this over the past few months at Partners in Property meetings, and clarifying my own view in my head, backed up by source data as always, I’ve seen a very small amount of press in the financial world that is starting to look at this view. There’s now expectation that rates won’t be cut before the end of 2023 (this is very similar to the Federal Reserve’s party line, although remember they’ve hit peak inflation in June 2022, and we are not even sure if we are there yet). The markets don’t believe the Fed but they are starting to believe the Bank of England, and the numbers predicted look more like 4.5% peak base rate for 2023 (a prediction I could get behind – although I might still be tempted to go lower than this) – where the predictions and I differ is the duration of these higher rates.
The new world SHOULD see a base rate between 2% and 5% being used, with quantitative easing unwound, in the absence of significant shocks to the system. If you’d lined up 100 economists worth their salt (and thrown me in for good measure too!) at the beginning of 2022 and said “by the end of the year, UK base will be 3.5%, and the US will be at 4.25-4.50%, and the economies will be running steady or even growing” – I would suspect 90%+ would have disagreed with that statement. Even putting into context that monetary policy takes 6-24 months to really make its impact, to get to those rates from where we started the year took multiple hikes of reasonable volume.
The next 6 months will be massive, of course, as rate hikes calm down to 25 basis points most likely in both of those economies, and then we play the Charlie Munger game – sit, wait, observe, ready to act but mostly avoiding tinkering. Stay informed. Will the world actually cope with all of this? It’s almost like these economies were ready for this – again, in absence of good historical precedent for this situation, no-one knew. The sensibility around the mortgage market particularly in the mortgage market review in the early 2010s in the UK – unlikely to be lauded as great work, but perhaps should be considered for it – protected everything by introducing those stress tests at a 5.5% interest rate. When the pay rate has hit 5.5% (and we are below that, having only been above it for a few weeks in October 2022), the existing debt – which is far lower by value than the last time there have been major wobbles in the system – has looked relatively secure. Money out of people’s pockets (or savings accounts, first of all, most likely) – sure. Disinflationary to an extent – not a terrible thing at this time.
At this time, this doesn’t sound or feel like a world where inflation tends to zero in 2024. It feels like a battle – a struggle – a further cut in the standards of living when we compare real terms/inflation adjusted to the false, security blanket position we were in in 2021 for example. The real lesson is that 2021 was the fraud, not 2023 or 2024. Expectations were set too high, as the true cost of the government shotgun was not understood or costed.
The one big thing that the central banks and the governments are getting right at this time is to treat inflation as the enemy that needs to be extinguished at all costs. The FT ran a headline this week (with the strapline “CPI calm and carry on” – that’s a bad one even by my low standards) – it’s well worth a look but the ultimate conclusion from a couple of analysts who definitely seem to be leading the charge on my soapbox is that there is a significant probability that the UK Central Banks will be the slowest to cut rates.
Of course they will. They are behind in the cycle. Inflation looks more stubborn than the US – for sure – and also in the Eurozone. The lack of energy independence causes us a specific problem, certainly compared to the US. Then there’s that other small matter of Brexit which has caused us exchange rate problems, and trade inefficiencies. The economic damage was never in doubt – the benefits we would all ascribe different weight to, I am sure.
Until the rest of the world wakes up to this reality, however, we need to plough ahead. To drill this down to “so what, what do I do?” – don’t sit and wait for interest rates to come down a lot on your mortgage refinancing. The significant risks still remain to the upside, NOT the downside. You might overpay by 25 or 50 basis points on the “nut low” rates – something you likely never tracked when you paid 3.5% or 3.0% or 4%, because it was “cheap enough”. You can’t do business like that – set a reasonable expectation, take action, fix and carry on if you are holding stock with debt.
Likewise, don’t buy new deals that are predicated on mortgage rates coming down to 5% easily enough – they will get there at some point, without gigantic fees, likely at some point this year – but you can’t plan for the best and hope for the “not worst” – that’s not how the saying goes. Opportunities are still out there – far more than there were in the past 2-3 years – but you can’t let motivation take over. Stick to the analysis, stack wisely, and press ahead.
If waiting on the sidelines for x or y to happen – I can’t help you. I saw many in 2020 predicting doom and allowing that to stall them into inaction – 3 years on they’ve made no moves forwards whatsoever in their portfolios or financial positions, whereas those who have pivoted and cut through the storm have forged ahead a great amount. Not many of us can afford to wait 3 years before we do anything – and it would be easy to wait another 1 or 2 or more if we let the environment dictate everything. Take inspiration from the fact that the best traders and investors are active in every single market, and remember this is a get rich slow game.
One last chink of light through the clouds – rents are rising, significantly. If wage growth for 2023 is likely at 5-7%, this ups affordability further. These drops in capital value are absolutely nominal compared to the rises of the past few years, and this strong pricing is, in my view, here to stay. Demand keeps going up, supply continues to stall – the basics of economics. Keep calm and carry on, folks!
