Don't pop the champagne yet

Lending Strategy Dec/Jan 2009 | By John Murray

In addressing some of the industry’s leading players at the exclusive London venue for this year’s Lending Strategy winter lunch David Smith, economics editor of the Sunday Times, launches in at the deep end.

“I’d like to start by saying a bit about the economy - the position now and the outlook - and then move on to the housing and mortgage markets while bowing to the greater knowledge around the table,” he says.

“With regard to the economic position there’s an issue with some of the survey information we have been seeing as well as the official figures that came out recently. These suggest that in Q3 2009 we were still in recession but I believe revisions will be made to these figures.

“My view is that the economy embarked on a fairly gentle recovery around the middle of this year after quite a sharp decline and the official figures will eventually be changed to show this,” he adds.

Smith says other surveys which have proved to be accurate in the past - particularly one that questions purchasing managers and measures business-to- business activity - suggest the country returned to growth as much as four months ago.

“They also suggest there’s not the difference between the UK and other countries that the official figures imply,” he says. “The official figures show that countries such as Germany, France and even Japan came out of recession earlier than us but I think the picture is pretty similar across all advanced economies.

“One of the most striking things about this recession has been how hard-hit all advanced economies have been. There’s been an average 4.5% drop in gross domestic product this year, making an average peak-to-trough decline of some 6% during the recession.

“This contrasts with the performance of some of the bigger emerging economies,” he adds. “For example, China will have grown by about 8% this year while India will have grown by some 6%. I don’t think we have ever had such a contrast in performance between advanced economies and emerging ones.”

And Smith says this could continue to be the story as we move forward, as advanced economies are weighed down with problems in the banking sector, the loss of capacity, the fact there’s still a rebuilding and a deleveraging process going on and the issue of a big public debt overhang.

“I think this will be a theme of the recovery - fairly modest recoveries in most of the advanced world and quite strong growth in the rest of the world,” he says.

“It’s been quite a deep recession but one relative positive is that employment has not fallen as much as might have been expected, and unemployment has not gone up as much as thought. This is not just in the UK - it’s also true of France and Germany although much less so of the US.

“The US has seen a shrinkage of its economy of something under 4%,” adds Smith. “Ironically, this is a milder recession than in Japan and Germany but the US has seen a much bigger fall in employment. Here, we have seen a fall in employment of only around 2%.”
Smith believes this reflects a lot of imaginative management in UK businesses. He says firms here have managed their workforces flexibly in this recession.

“We have seen shorter working weeks, pay freezes and in some cases pay cuts as an alternative to unemployment,” he says. “I think this is a much healthier approach than elsewhere. When activity rises again it’s much easier to increase the hours or days people work and give them a pay rise than to hire workers from scratch.

“In terms of the nature of the recovery it’s true that most recoveries are a lot more rapid than forecasters expect in the worst of the bad times. Certainly, the consensus view at the moment is that there will be an extremely slow recovery.

“It’s also likely to be an impaired recovery because of the problems among lenders, and figures will probably reveal that banking capacity has fallen again in 2009,” he adds. “That’s partly because of the withdrawal of some foreign players but the same has been true of most economies - lending capacity around the world has fallen.”

But set against this Smith argues that even in circumstances where one thinks economies can’t possibly grow, sometimes they surprise on the upside.

“I foresee two potential surprises,” he says. “First, this is a false dawn and we’ll slip back into recession next year, and you can attach any combination of letter shapes you like to this - L, V, U. I know that somebody has even suggested VW.

“So there’s a risk that we recover a little bit and then bump along for a while. Of course, there’s also a risk of slipping back. But second, something not many people think about is the possibility that recovery could be stronger than expected. In fact, that was the case after the recession of the early 1990s.

“For three or four years after that recession we had pretty strong growth in the economy - it grew by about 3% a year which is better than the long-term average,” he adds. “This was helped by the fact sterling had fallen, as it has this time - in fact, it has fallen further this time.”
Smith points out that it was quite a healthy economic recovery back then too - export and investment-led.

“So don’t discount the possibility that recovery could be stronger than the present gloomy assessments of most economists,” he says. “But one thing’s for sure - there will be tax increases. We know about the new 50% Income Tax rate and we know National Insurance contributions are going up but I believe we’ll see a VAT hike to 20% after the election. And there may be other tax increases too.

“Whether we’ll ever see Liberal Democrats’ famous mansion tax I don’t know. That could depend on there being a hung parliament and a coalition government but it’s something to think about.

“We are also heading into a period of a tight squeeze on public spending with big reductions by any standard,” he adds. Departmental spending in the Treasury’s existing plans will fall by 10% in real terms in the three years after 2011. That’s never happened before apart from a one-year cut in public spending after the International Monetary Fund stepped in back in 1976, so it will be unusual indeed if this happens.”
In Smith’s view, capital spending in particular will fall sharply. He says it’s likely to halve in real terms from £44bn to £22bn in three years so it’s clear some tough decisions are on the cards.

“To return to tax rises, the logical result of these is that interest rates will stay low for a long time because if you’ve got fiscal tightening you don’t need monetary tightening or, as the Bank of England would see it, easing off the accelerator in terms of monetary policy,” he says.

“I expect to see rates staying low for the next two or three years. In terms of the housing market, you know the numbers as well as I do. It’s been a strange market this year. The recovery in mortgage approvals has been pretty strong - up 68% year-on-year and more than double the low point reached in November 2008.

“So we are seeing a pretty strong increase in mortgage approvals for house purchase but we’re still operating well below the levels we were seeing before the recession,” he adds.

He says perhaps the best indicator of this is to look at overall approvals, taking in remortgages and other mortgages into account.

“These are running at around 110,000 per month, which is about a third of the average level in the first half of 2007,” says Smith. “So there’s been an increase from the lowest point in November last year but it is still well below what we are used to. “The interesting thing about this is that most of us thought we needed to see around 80,000 monthly mortgage approvals before house prices stabilised, let alone started to rise.

“In terms of house prices we seem to have reached equilibrium at a much lower level of activity,” he adds. “Of course, we know the reason for this - supply has been extremely limited as far fewer forced sales have been coming onto the market than would be the case in more normal circumstances.”

He points out that house prices are up by around about 8% from their lowest point and also up by some 4% from where they were at the end of last year.

“So against all the odds - and not many pundits expected this - house prices look like ending 2009 higher than they started it,” says Smith.

“And that’s in the context of a prediction at the start of the year of a 25% fall by Capital Economics, but more typically of 10% to 15% falls by mainstream economists.

“Why has this happened? As I say, supply has been limited but quantitative easing might also have had an effect - it has certainly pushed up other asset prices. If we really have seen the bottom in house prices it means something unusual has happened in the housing market - we did not get the normal overshoot.

“Normally, you don’t just fall to a sustainable level but well below it,” he adds. “So if you look at Nationwide’s price trend figures we just got back onto that line having been well above it. But we’ve not fallen further.” Smith adds that Halifax’s house prices-to-earnings ratio fell to something like its long-term average and then bounced up from there.

“Again, that’s unusual,” he says. “Normally there would be an overshoot so we should not discount the possibility that prices could fall again but I would be surprised if they fell sharply. I don’t expect a second wave of falls anywhere near as pronounced as the first.

“This is important because some professionals expect it. For example, Fitch Ratings expects another sharp fall in prices of the sort we have already seen but I don’t agree.

“I believe the ratings agency it has made a simplistic analysis but what it says is clearly important because it informs the way markets and investors think about mortgage-backed securities,” adds Smith. “We will see who is right over the course of next year.

Smith concludes by saying he does not expect prices to continue rising at their recent rate, stating that it would be better to have a period of stable house prices to allow the market to adjust.