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Sharply rising house prices, lax mortgage lending standards, strong consumer spending, a low savings rate and rising inflationary risks: Does this sound familiar?

Whilst this summarizes the recent past for the U.S., and now seemingly the U.K. economy, it also reflects well the experience of the U.K. throughout the early 1990s. As many look at the evidence from the U.S. as a guide to the likely path of the U.K. economy, we can just as easily cast our minds back 20 years to get a good sense as to how the U.K. will respond to a turn in the housing cycle. Indeed, I believe that the U.K. of the post Lawson boom will form an excellent road map for the next few years. As such, a brief recap of the past should give us a good sense of our destiny. Sadly, that does mean that the next 18 months will not be much fun. That said, just as the late 1980s/early 1990s ‘purged’ some of the excesses out of the system, so the eliminating of the current excesses should leave the U.K. economy much better balanced.

Where we are now
Much has been made of the similarities between the current (preliminary) weakness in the U.K. economy and recent performance of the U.S. economy. Slowing housing market, inflationary concerns constraining the monetary authorities, a labor market holding up well and a daily debate about whether the economy can be dragged down by weak housing. Well, we all know how that debate played out in the U.S. and many take that as the blueprint for the U.K. in 2009. I would, however, like to take a slightly different tack – after all, we have been here before. So maybe we should look to our own behavior during previous retrenchments from excess rather than the behavior of our cousins across the Atlantic.

U.K. housing – now and then
As you can see from the chart below, the level of housing activity as measured by mortgage approvals is already at cyclical lows. These levels would suggest there is more weakness in house prices to come. I think most of us would now take such a house price forecast largely for granted. The key question from here on is whether housing activity can bounce (as it did in 2003) or whether we languish (as we did around 1990).

To answer this question we need to address the affordability of housing. As a ratio to earnings, we know that house prices are at a high of six times average earnings. That said: house prices were already high in 2003 as well, so why not expect another bounce?

The key difference between now and 2003 is not the price of the house, but the cost of servicing the debt of the house purchase. Irrespective of the availability of mortgages (which is much lower), the price of the debt is both materially higher than in 2003 and barely coming down with the lower repo rate. The chart below uses the Bank of England data set for 2-year fixed rate and tracker mortgage rates. The 2-year fixed rate is then further broken down into the rate available for a mortgage with a 95% loan-to-value (LTV) ratio and 75% LTV mortgage. The tracker data is only available for a 75% LTV mortgage. As we can see in each case, rates are barely off their peaks, despite 80 basis points (bps) of cuts from the Bank of England and 100 bps reduction in the wholesale 2-year interest rate (defined as the 2-year swap rate). So we know that the availability of mortgages is falling and we know that the rate available on mortgages is not falling. With activity already languishing close to the early 1990s levels, an early bounce like that in 2003 seems therefore unlikely.

Implications for the economy and the Bank of England
Many argue that the link between the housing market and the economy is both imperfect (I would agree) and unproven (I am not so sure). Many also argue that this time the effect on the economy of a serious downturn in the housing market would be less severe than in the 1990s’ cycle since debt service costs are lower and employment is high. Sadly, I cannot agree with this. Think of it in the following way: companies employ people to produce things, people buy those things and you have a virtuous circle. When people stop buying things you risk a vicious circle where companies reduce production and employment of people. So is there any correlation between housing activity and retail sales? I am afraid so…

Alongside the simple effect of lower housing activity, there will be a wealth effect associated with lower house prices. As individuals’ ‘wealth’ falls with house prices, so individuals typically save more to compensate. To put this into context: Prior to the slowdown in the early 1990s the savings ratio fell to a low of 4% of income in the third quarter of 1988 before rising to a peak of 13.5% in the first quarter of 1992. At present the savings rate is 3.5%. In the early 1990s the rise in the savings rate resulted in a contraction of consumer spending and GDP. I find it hard to see how we can avoid repeating that experience.

Where is the good news?
I was struck the other night by a BBC report on the housing market. Having highlighted all of the impending doom, the reporter concluded by saying that “this will not be a repeat of the 1990 experience.” For what it’s worth I do not agree, but having sounded like one of the four horsemen of the apocalypse, I think it is important to be aware that there are safety valves which should ensure we do recover. Clearly, the Pound Sterling has already started to depreciate and hence our exports should improve, as should our bloated current account deficit. Similarly, as is abundantly clear from Chart 2, there is plenty of scope to lower interest rates. Yes, to some degree the Bank of England is constrained by the high level of spot inflation but inflation represents where the economy has been and not where it is going. As inflation comes down the Monetary Policy Committee (MPC) should be able to ease rates down below 4%, enough to ultimately stabilize the housing market. This should leave us with a more balanced economy and more affordable housing. The journey may not be much fun but the end point may well benefit us all.

Mike Amey, CFA
Executive Vice President