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As many of us are aware, there are two most British of conversations – the weather and house prices. Maybe it is because we have just experienced the
wettest winter since records began in 1910 (according to the UK National Weather Service), or maybe it is because house prices have experienced a
remarkable renaissance. Once again, the whole nation appears to be focused on the performance of the UK housing market. Jon Cunliffe, the recently
appointed Deputy Governor for Financial Stability at the Bank of England (BoE), called housing “the brightest light” on the risk dashboard of the Financial
Policy Committee (FPC), while the vast majority of questions at the BoE’s May 2014 Inflation Report press conference centred around the prospects of a
bubble having developed in the UK housing market. With that in mind, what is the state of the UK housing market? And, more importantly, what are its
Prices are rising faster than volumesAs most readers are aware, UK house prices have been rising strongly for much of the last 12 months, with increases of 10% now common across major house
price indices (see Figure 1).
What started it? And, importantly, is it sustainable?While there is much debate about the cause of the turnaround in the UK housing market, its seems pretty clear that a combination of falling mortgage rates,
less systemic risk from Europe and the UK government’s “Help to Buy” scheme have all contributed to the improvement in the housing market (see Figure 2).
Although the “Funding for Lending Scheme” at the BoE has also been cited by some as a key stimulant, we believe this has been a less powerful factor than
the other reasons we have cited.
To date, the improvement in housing transactions in the UK has been very disappointing, with volumes still barely at levels consistent with previous cycle
lows; there is certainly ample scope for transactions to rise. To make the recovery more sustainable, we would need to see higher volumes (and lower price
rises would be most welcome). Unfortunately, until the banking system is fully recapitalised, and therefore able to provide additional financing for
(risky) new home building, it is hard to see a rapid acceleration in UK housing transactions. This should be a warning to us all. Without a fully rehealed
banking system, and absent a government programme to significantly increase social housing projects, it remains likely that prices will continue to take
the lion’s share of the improvement in UK housing sentiment.
Are valuations stretched?There are a number of ways to look at valuations, including house price/earnings ratios, the cost of owning a house compared to renting and housing
affordability indices (comparing the proportion of earnings needed to service a mortgage being amongst the most popular indices). We believe that the
simple combination of a house price/earnings ratio and an assessment of affordability provides you with enough information to make a reasonable assessment
of the current state of the UK housing market.
For starters, the average house currently costs just under five times average earnings. Figure 3 may suggest that this is not too bad; however, just pause
for a moment before drawing that conclusion. For example, current levels are commensurate with the peak ratio seen ahead of the prior UK housing boom in
the late 1980s, and we are still some 16% above the average UK house price/earnings ratio of the last 30 years.
While the activity of the FPC in the months and quarters ahead will undoubtedly prove fascinating, particularly for those interested in both the housing
market and the broader markets, it is the activity at the MPC that will prove the most interesting. It is here that we would like to take you back to
Figure 2, showing UK mortgage rates alongside the UK swap rate, which you can think of as a broad proxy for the current cost of funds to the banking
system. Prior to the global financial crisis, the cost of funds to the banking system equated to the interest rate available on a 75% loan-to-value
mortgage. In contrast, post-crisis we have seen mortgage rates come down by much less than swap rates. Given this development, and the fact that house
prices look high relative to long-term metrics, it seems sensible to believe BoE Governor Mark Carney’s repeated statements along the lines of “any hikes
in official interest rates will be gradual and will have a much lower terminal point than those seen before the crisis”.
New Neutral rates will be a part of the UK environment for years to comeAs my colleagues Bill Gross and Richard Clarida elaborated in PIMCO’s recently published May 2014 Secular Outlook, “The New Neutral”, we expect
secularly low official interest rates to support growth given continued high levels of aggregate debt. This will most certainly include the UK, where gross
levels of debt remain high, the banking system remains under regulatory pressure and the savings rate remains low. As we have seen in the last 12 months,
that does not preclude an economic recovery; but it does strongly suggest that the interest rate cycle will be modest and that low rates will be a
characteristic of the UK economy for years to come. So, to answer the initial question – do we believe there is a housing bubble? No. An overvalued asset
that will be secularly supported by low policy rates? Yes.
As for our view of the broader investment implications, while the UK bond market will go through its usual cycle, investors should get used to low rates
for the foreseeable future. Credit selection and “spread product” will remain supported by benign underlying interest rates and a gradually healing
economy, while inflation will be underpinned by modest (but respectable) domestic and global aggregate demand.
As with the global market, mid- to low-single-digit total returns for bonds look likely, which together with any PIMCO alpha should be sufficient to create
the potential for a relatively attractive real return. It may not sound like much, but for a fairly low risk asset in an economy likely to grow at 2%–2.5%
in real terms over the secular horizon, this is not such a bad deal.
contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit,
inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with
longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the
current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity
and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investors should consult their investment
professional prior to making an investment decision.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for
informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment
product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be
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States and throughout the world. ©2014, PIMCO.
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