Previous posts have assessed house price valuation using the national rental yield, defined as the sum of actual and imputed owner-occupier rents in the national accounts divided by the value of the housing stock. This measure has signalled house price undervaluation in recent years, contrary to the consensus view. This remained true in the first quarter: the yield stood at 4.48% versus an average since 1965 of 4.26%, suggesting that the average house price is 5% cheap relative to rents – see first chart.

The Office for National Statistics (ONS), however, revised its rents data earlier this year and plans to make further methodological changes in the 2014 and 2015 Blue Books. The 2014 revision, to be published at end-September, should lower recorded rental growth over 2010-11, resulting in a reduction in the rental yield from 2010 onward. The revised yield series should still indicate house price undervaluation over 2011-13 but on a much smaller scale. Current prices will probably be slightly above fair value on the new basis.

The ONS historically has based its estimates of rental inflation on a survey of household living costs. It plans to switch to a new methodology using data from the Valuation Office Agency (VOA), an arm of HMRC, in the 2015 Blue Book. The VOA is already used as a source for the actual and imputed rent components of the CPIH consumer prices index. Pending the 2015 revision, the ONS is aligning estimates of rental inflation since 2010 with the CPIH components. This change is being implemented in stages, with the final stage occurring in September.

The estimated impact of the September 2014 revision on the historical rental yield path is shown in the second chart. On the new basis, the yield may peak at 4.34% in the first quarter of 2012 versus a long-run average of 4.24%, implying house price undervaluation of 2% at that date – down from 9% on the previous basis.

The revised rental yield is estimated to have fallen to 4.13% by the first quarter of 2014, suggesting 3% overvaluation. This compares with peak overvaluation of 27% in the third quarter of 2007. So prices are now slightly expensive but still far from bubble territory.

The ONS changes may be questioned. The living cost survey data, showing faster rental inflation, could be combined with the VOA information, rather than discarded. Sceptics will note that ONS methodological “improvements” rarely raise inflation estimates. The changes will affect the GDP deflator and current-price GDP, so may have a small influence on the monetary policy debate.

A statistical model of voting intentions continues to suggest that the Conservatives will fail to achieve an overall majority at the 2015 election despite an improving economy.

The model is designed to predict the poll differential between the main government and opposition parties based on economic factors. It was estimated on ICM-Guardian poll data extending back to 1984. The poll differential depends positively on average earnings growth and house price inflation, and negatively on the unemployment rate, retail price inflation and interest rates (Bank rate). More details are available in a previous post.

The Conservatives were 1 percentage point (pp) behind Labour in the June ICM-Guardian poll. The model estimates a 5 pp shortfall based on current economic readings. The 4 pp difference is within the historical margin of error of the model. Other recent polls have been less favourable for the Tories: the average calculated by the UK Polling Report website shows them lagging by 3 pp.

The model estimate of the Conservative / Labour differential has risen from a low of -10 pp last year as the economy has improved. The continued shortfall is attributable to low average earnings growth. According to the model, a big rise in earnings growth would be needed to generate a Tory lead of 6 pp, which is probably the minimum required for the party to achieve a Commons majority*. This is possible but would bring forward Bank rate hikes, with an offsetting poll effect.

The chart, an update from the previous post, shows three possible scenarios. The first is based on the latest MPC economic forecast in the May Inflation Report. In this forecast, average earnings growth rises to 2.75-3% by May 2015, the unemployment rate drops to about 6%, inflation is stable and Bank rate increases by 25 bp early next year. The model predicts a tiny Conservative lead by election time, consistent with Labour obtaining most seats in a hung parliament.

The second scenario is intended to be a “best case” for the Tories. Earnings growth rises to 4% while unemployment drops to 5.5-5.75%, but lower-than-expected inflation results in the MPC keeping Bank rate on hold. The Conservative lead reaches 6 pp by May 2015 – just sufficient to deliver a seat majority.

The MPC’s guidance, however, implies that it would raise Bank rate earlier in this scenario because of a faster erosion of slack. The third scenario uses the same economic assumptions but incorporates 0.25 pp rate hikes in November, February and May (just after election day). These hikes cap the Tory lead at 3-4 pp, suggesting similar numbers of seats for the two parties. Such an outcome might force a repeat election later next year or in 2016.

Non-economic influences could be of greater importance in the coming election, with additional uncertainty injected by the Scottish and promised EU referenda. A stronger economy should continue to aid the Conservatives but is unlikely to be sufficient to deliver victory.

*Each 1 pp rise in earnings growth boosts the Conservative / Labour differential by 4 pp, according to the model. See the previous post for a discussion of the relationship between voting intentions and seat allocations.

Investors are positively inclined towards the dollar. A net 58% of global fund managers believe that the US currency is undervalued, the second highest reading in more than 10 years, according to Merrill Lynch. US futures market investors, excluding “commercials”, are moderately long the dollar against other developed market currencies, based on the weekly commitment of traders report*.

Dollar bulls expect the currency to be boosted by a continued rise in US / foreign interest rate differentials as the US economy grows strongly over the remainder of 2014. Monetary trends support optimism about US economic prospects: six-month real narrow money expansion rose to a 17-month high in May and is stronger than in most other developed economies.

The bullish argument, however, ignores recent deterioration in the capital account of the balance of payments. The current account deficit has been stable but the balance of direct and portfolio investment flows has moved from a significant surplus in 2012 to a small deficit in the latest 12 months – see chart. The “basic balance”** deficit, therefore, has risen to its highest since 2009.

The capital account has been weakened by a rise in portfolio investment outflows, partly reflecting the ebbing of the Eurozone crisis and optimism about “Abenomics” in Japan. Higher US portfolio investment overseas could be sustained as the global economy improves. The direct investment deficit, meanwhile, could widen as US corporations step up foreign take-over activity, partly for tax reasons.

A basic balance deficit requires an offsetting surplus on the short-term capital account. US economic strength and a rise in US / foreign interest rate differentials may attract a larger inflow of short-term capital but there is no guarantee that this will be sufficient to outweigh the wider basic balance deficit, resulting in upward pressure on the dollar. Bulls may continue to be disappointed.

*The net long position against six other developed market currencies was equivalent to 15% of open interest as of last Tuesday.
**Basic balance = current account plus long-term capital flows (conventionally defined as direct / portfolio flows).