When America Sneezes- Sunday Supplement July 31st 2022

by Jul 31, 2022

 

 

By Adam Lawrence

Listen to Adam discussing this weeks supplement on the podcast My Property World with Will Mallard 

’When America sneezes the word catches a cold’’ anon

Welcome to the supplement as we close out July. Firstly a big thankyou to those who responded to my research assistance request – I did a bit of a silly thing and reached out the week before going on holiday. I’ve spoken to a couple of people – thanks – and have got more to speak to. I will get to you – just recovering from the post-holiday week where everyone “wants a piece’. Things have calmed a little and next week I will be reaching out to others who responded to my request from a few weeks back. Big thanks to everyone who took the time to do that!

This week I wanted to focus on the current situation as far as rates are concerned, try and iron out a few concerns that I think some might have, and make this as actionable as possible.

It starts with the US

We have to start with the US technical recession – and at least as importantly, the markets’ reaction to that news. Despite a very poor beginning to the year for both stock and bond investors (was 20% down on a 60/40 stock/bond “traditional” portfolio, although some gains have been made this week), it is often said that when the market doesn’t go down any further on the release of yet more bad news, it has reached its bottom. I don’t disagree with that – but I don’t see all the bad news as yet priced into the current market levels. In my view there’s more bad news to come, but that will take some months – mostly in the form of inflation being more stubborn – or more secular – than has been expected thus far.

Business as not so usual

The market has actually done very well this week on the back of the recessionary news – as if, again, it has found its bottom. Because the news at this time is relatively thin on the ground, it’s a case of business as usual and a likelihood of rates coming down sooner than expected. However, the US central Bank has raised their base rate of interest by 0.75% this week – so, something somewhere doesn’t add up. Is that the last raise? The “dot plot” (where members of the committee indicate where they think rates will be over the next few periods and years) suggests that’s not the case – but also suggests that rates will come up and then come back down in 2023/24.

Is the UK catching a cold yet?

The UK is well behind the US curve – at least 6 months – but the messaging is the same. The bond yield curve – which is effectively representative of what the market believes the right rate of interest is for debt of different lengths/durations/maturities is predicting a recession in around 6 months time in the UK – and the direction of the energy price cap would definitely agree.

However, this is most relevant to those holding floating rate debt. If your debt is linked to the base rate, then as that goes up it becomes more expensive. If it is linked to SONIA (the replacement for LIBOR), a similar story is true with a different (almost always higher) benchmark. If instead you are used to using fixed price leverage, which the vast majority of investors are, the more pertinent number is the yield on 5 year government bonds which is down, significantly, in the month of July. I feel it is too low because the market believes once the energy crisis is over that inflation will abate – my view is more complex than that with a good portion of inflation still being stubborn even if the war between Russia and Ukraine came to a sudden end – but nonetheless, the right price for mortgage debt for Limited companies on 5 year fixes to interpolate from today’s price would be between 3.75 and 4.25%.

Prices are a little higher at the moment because service levels have been crushed by a huge demand for fixed debt as rates have gone up at such a fast pace this year. This is a phenomenon that I didn’t see coming, and in fact the direction of travel is sideways at the moment, most likely, when the UK central bank meet next week to, surely, raise the base rate of interest by another 0.5% – anything else will be a major surprise, especially given that the governor floated it after the last meeting, said it was quite likely some weeks ago, and then pretty much described it as nailed on within the last fortnight.

The yield of the 5-year government bond has been at a very low level since covid, but since 2016 the level has only been around 1% as an average. The yield today is around 1.65%, but this has touched 2.3%+ in the recent months – so there’s been a significant swing backwards from there. This might give you some frame of reference as to the pricing I’ve mentioned above for 5-year fixed rate mortgages.

Longer term factors

There are other, longer-term factors to bear in mind that mean this conversation cannot be had in isolation. Many cite the 40-year trend in lowering yields and this “bull market” in bonds (as the yields come down, by definition, the price of the bonds is going up) – and indeed have been citing it for 15+ years – without necessarily examining the reasoning behind it. There is significant correlation between a lower interest rate and a higher nominal house price – without a doubt – but also, the doomsayers often forget that correlation and causation are two different things. There was a huge trend upwards in the interest rate in the 1970s – it did not stop property prices moving on significantly in that decade, for example.

As with many trends, some commentators expect a reversal. The Bank of England doesn’t agree and some very deep analysis on this was delivered by the Governor in a recent speech at the Official Monetary and Financial Institutions Forum. The global real interest rate (the interest rate modified for inflation) has been heading downwards at a fair rate for the past several decades – the phenomenon is not just limited to the UK, although the UK’s rate has gone from positive to negative, whereas in the large economic engines worldwide as a whole it is just about treading water, or has done – and the main reason cited is the change in the population pyramids and demographics. People are living longer, and are economically less active from an income tax perspective than they ever were. A good way of understanding this stat (and why pensions have caused such a mess, untended, over the years) – when the national insurance and pension benefits system was commenced and the pensionable age set at 65 for males as it was at the time, the average life expectancy of a male was 67 years – or in simple terms, the average pension would be a couple of years of pay-outs and then there you go. What a swindle eh? With that expectancy now at 81.2 years overall – and a much more gender-balanced workforce – you can see the huge difference.

What does this mean?

What has this meant? It has meant that capital sitting, taking little or no risk, instead of delivering a return after inflation, is instead penalised. The ways round this then become – take less money in terms of returns on capital or take more risk in order to get higher returns. Pension funds have been forced into this corner and the traditional 60/40 stock/bond portfolios have trended much closer to 70/30 in recent times, with investments in hedge funds, private equity and the like becoming more commonplace, certainly for a few per cent of the fund.

When you look at this underlying trend, and the reasons behind it – whilst life expectancy growth has stalled a little in the past decade, it is not a trend that you see going downwards anytime soon. When you consider the amount of attention pushed towards healthcare on the back of the pandemic, if anything you’d expect the trend to go back to making progress over the next decade and life expectancies to continue going upwards.

Government floating rate debt

We then turn to the commonly cited argument that the government holds a significant amount of floating rate debt of its own – which it does. In the UK we call these instruments index-linked gilts – bonds whose coupon depends on the inflation rate. Of late there have been many headlines around how much that bill has gone up in the past 12 months – this is more of the same media nonsense and clickbait effects I am afraid, around base year effects – it is worth remembering that just 18 months ago, the Bank of England were considering a negative interest rate for the first time in the UK – that’s just how much and how quickly interest rate expectations and actions have changed – so comparing the bill to when bond yields were crushed – one year ago to the day the 5 year bond yield was languishing under 0.25% per annum (so in relative terms, the yield on that is up over 500% since then…..)

Truss vs Sunak

Rishi Sunak Versus Liz Truss

A better comparison and a more even commentary is achieved by looking at the data over a longer period, of course – and as usual, it is not as worthy of headlines and clicks! Nonetheless, with Liz Truss now long odds-on to be our next PM, her debt issuance plans will no doubt drive the deficit into a place it has not been before in a “Trumpian” style way. The continuation of what Boris wanted to do, before Covid captured the imagination – a £600bn+ infrastructure spend is what was promised in Rishi’s March 2020 budget, which was diluted because of the pandemic of course; the big opportunity missed is that this would have been a fantastic strategy in the early part of 2021 when government debt was so incredibly cheap, and thanks to the general ideology and political misunderstanding and deliberate obfuscation of government debt, the opportunity was missed (for which both Johnson and Sunak should carry the can). Ploughing on with that plan now has one significant downside – the debt is already more expensive.

However – the astute will note as they often do – when the government is loading up with debt, the rate is unlikely to drift to a particularly high level. Oh, but the central bank is independent I hear you say – yes, yes it is. But it does not have a remit to undermine or bankrupt the country, of course, so this argument makes sense.

Conclusion

This is the market view at the moment and it makes a lot of sense. The one thing it has missed – and the one thing that makes me slightly more nervy and wanting to control the upside risk of the price of debt in the near term – is that I believe this inflation is more stubborn than the market yet realises. Even when energy is back towards a more normal and functioning market – and that could be years away, the shadow of inflation and sticky prices, and sticky wages which mean prices have to be sticky, will not see things calm down overnight. The current market expectations, and Bank of England modelling expectations for inflation control, look like fantasy in my view. This means higher rates than the market currently expects, and potentially higher yields – but the danger is very much concentrated on the base rate and SONIA risks, not the 5-year bond yield (which I still see 2.25%+ as a more accurate price today than 1.6%, but let’s bear in mind I am far from a bond trader).

Time will tell – for the moment, fixing for 5 is still very affordable and reasonable and if you aren’t cash flowing at the current rates, you don’t have investment grade stock in my view, you are solely punting on capital growth – a far riskier business model, in my mind – but one that has been used with success in some parts of the world for years (Sydney in Australia springs to mind).

Feedback

I had a request/some feedback this week which I’m grateful for – asking for further reading ideas. Investopedia is a great site for laypeople’s understanding on more advanced financial and derivative concepts – although (like Wikipedia) should not be considered gospel of course. I’ve talked about the 5-year bond this week as a proxy for the 5-year swaps market – without going into significant detail but you can read more in investopedia’s “introduction to swaps” article – worth a couple of reads for those interested in furthering their knowledge in this area.

Until next time – keep your head while all others around you are losing theirs – the word “recession” means some funny things happen, usually…….

Adam

Adam Lawrence

Adam is a partners at  Partners In Property you can find out more about their monthly events here