Entries from March 27, 2011 - April 2, 2011
UK house prices at "fair value", based on rents
The consensus view that housing remains significantly overvalued reflects the high level of the house price to average earnings ratio. A national accounts version of this metric is the value of the housing stock divided by aggregate household disposable income. This stood at 4.31 at the end of 2010, 52% above the average of 2.84 since 1965 – see first chart.
The "equilibrium" level of prices relative to earnings, however, has trended higher over time as rising demand – due to an expanding population, a fall in average household size and the tendency to spend more on accommodation as income increases – has clashed with inelastic supply. The housing stock / aggregate income ratio at the end of 2010 stood 5% below a log-linear regression line – first chart.
A superior valuation metric is the ratio of prices to rents or its inverse, the rental yield. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes.
A national accounts version of the rental yield is the sum of actual and owner-occupied imputed rents divided by the value of the housing stock. This finished 2010 at 3.56% – almost exactly in line with its average since 1965, of 3.57%.
The yield reached a low of 2.77% in September 2007, consistent with house prices being overvalued by 29% (the percentage deviation of 3.57 from 2.77). This excess, however, has been eliminated by a combination of a 5% fall in prices – according to the Department of Communities and Local Government index – and a 24% rise in rents.
The statement that housing is not expensive does not, of course, preclude a fall in prices to an undervalued level, for example if a shock to household income resulted in forced selling. Displaced owner-occupiers, however, would add to the demand for rented accommodation. Any downside for prices from current levels is likely to be temporary and limited as long as rents continue to increase solidly.
Encouraging UK economic news
A weighted average of services and industrial output rose by 1.2% in January, more than offsetting December's 0.8% weather-driven fall – see first chart. The January level of output was equal to September's recovery high and 0.7% above the fourth-quarter average.
Overall GDP, however, was depressed by a surprise further 9% fall in construction output in January following a 16% December plunge. GDP is estimated to have increased by only 0.6% after a 1.8% fall in December to stand 0.5% below its fourth-quarter average – first chart
Fortunately, construction weakness probably reflects carry-over from December's bad weather disruption and output should recover strongly over coming months. Consistent with this view, construction orders, which lead output and softened in the middle of 2010, rebounded to a new recovery high in the fourth quarter – second chart.
The EU Commission's UK business surveys for March are encouraging, showing significant rises in confidence across the services, industrial and retail sectors, in the former two cases to new recovery highs. Employment expectations, in particular, strengthened impressively, confirming an improvement in labour demand signalled by rising online job vacancies – see third chart and previous post.
UK banks absorbing bulk of gilt issuance
Gilt yields have been suppressed by strong demand from banks and building societies, which bought a further £7.7 billion in February following £10.5 billion in January, according to monetary statistics released today. Purchases totalled £29.6 billion between November and February, more than in the first 10 months of 2010 and equivalent to 84% of net gilt issuance – see chart.
Banks are buying gilts partly under regulatory pressure but also because private sector demand for bank loans remains weak. Any revival in credit demand would probably slow the rate of purchases and put upward pressure on gilt yields. For the moment, banks are effectively delivering the QE2 stimulus sought by MPC arch-dove Adam Posen.
Increased bank demand for gilts has offset a recent slowdown in overseas buying, which was boosted last year by capital flight from peripheral Eurozone economies. Foreign investors purchased £3.5 billion of gilts in February and £13.2 billion in the last four months, down from £67.6 billion between January and October 2010. The Portugese debt crisis should support overseas gilt demand near term.
Other features of today's monetary and revised GDP data include:
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The Bank of England's favoured broad money measure, M4 excluding money holdings of "intermediate other financial corporations", fell by 0.5% in February, causing three-month growth to slump to 0.5% annualised from 3.2% in January. The February decline, however, was the result of money-holders switching into foreign currency deposits (not included in M4ex), possibly in anticipation of sterling weakness. Foreign currency deposits, excluding holdings of intermediate OFCs, rose by £11.8 billion in February, equivalent to 0.8% of M4ex.
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Ignoring the foreign currency distortion, M4ex rose by 2.2% annualised in the six months to February, up from 1.6% in the prior six months. While growth remains sluggish, it is probably more than sufficient to finance trend economic expansion and 2% inflation given a rise in the velocity of circulation. Nominal domestic demand grew by 6.2% in the year to the fourth quarter despite M4ex expansion of only 1.8%. The Bank of England has recently acknowledged arguments for expecting velocity to continue to increase (see a box in the February Inflation Report and an article in the latest Quarterly Bulletin), implying that an acceptable M4ex growth rate may now be well below the minimum 5% previously suggested.
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M4ex growth of 2.2% annualised in the six months to February compares favourably with Eurozone M3 expansion of 0.6% over the same period.
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With the decline in GDP in the fourth quarter revised back to 0.5% from 0.6%, the Office for National Statistics now estimates that underlying output (i.e. excluding the impact of December's bad weather disruption) was "broadly flat" versus last month's assessment of a "slight fall". Based on labour market and survey data, further upgrades are likely. Note that GDP growth in the fourth quarter of 2009 has been revised up from an originally-reported 0.1% to 0.4%.
Markets facing monetary headwinds
Global monetary developments are signalling a prospective slowdown in economic growth and less favourable liquidity conditions for markets. The recovery in the Dow Industrials index since March 2009 continues to display a remarkable resemblance to the rally following the 1906-07 "bankers' panic" bear market, a comparison also suggesting a need for caution.
Six-month growth of G7 real narrow money has slowed progressively from a peak in July, reaching an 11-month low in February – see first chart. The money supply usually leads economic activity by between six months and a year. The last trough in six-month real money growth in January 2010 preceded a low in six-month industrial output expansion 10 months later, in November. Assuming the same lead-time from the recent peak, industrial output should begin to slow from April. Business surveys should soon start to signal this shift.
In addition to the money supply leading economic activity, the gap between real money growth and industrial output expansion is a gauge of "excess" liquidity available to flow into markets and push up prices. Global equities, on average, have underperformed cash when real narrow money has risen more slowly than industrial output. Six-month real money growth crossed beneath output expansion in December, with the gap since widening.
Previous posts have compared the recovery in the Dow Industrials index since March 2009 with an average of rises following six prior bear markets when equities fell by about 50%. The Dow stood 6% above this "six-bear average" at Friday's close while the average falls by 8% by the end of 2011 – second chart.
As discussed in a post in June last year, the recovery in the Dow since March 2009 bears the strongest resemblance to the rebound after the January 1906-November 1907 decline. Like the 2007-09 fall, the 1906-07 bear market was associated with a credit bust and financial panic. Both crises climaxed with the failure of a major institution – the Knickerbocker Trust Company in October 1907, Lehman Brothers in September 2008 – and a subsequent decisive rescue effort (co-ordinated by J P Morgan in 1907, before the institution of the Federal Reserve).
The 20% plus rise in the Dow suggested in the June 2010 post on the basis of this comparison has now occurred. US stocks entered another bear phase at the corresponding stage of the post-1907 recovery. A repeat performance would involve an imminent 14% correction in the Dow and a 20% fall by year-end – second chart.
Weakness on this scale is unlikely barring a major shock but less bullish economic news, slower growth in real money than output and the approaching end of QE2 suggest that equities and other risk assets face increasing headwinds.