Escape route
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Feeble and slowing growth is particularly toxic when combined with rising inflation - the antidote to one is a catalyst for the other. Economic growth is weakening rapidly while inflation will continue to increase. What's more, there is a high risk that these measures will deteriorate further and more quickly than expected.
Not since the early 1990s have prospects looked this gloomy. Growth slowed to a crawl in Q2 2008 with preliminary estimates showing just 0.2% growth, likely to be revised down, after an anaemic Q1 when it grew just 0.3%, revised down from 0.4%. That took the annual rate of expansion to 1.6%, below the bottom end of the government's forecast range of 1.75% to 2.25% for 2008.
Inflation has continued to accelerate. In August the consumer price index hit 4.7%, worse than consensus expectations and more than twice the government's target of 2%. The retail price index, a broader measure of inflation that reflects average living costs more accurately, rose by 4.8%. It seems likely CPI inflation will breach 5% this autumn, the worst performance since 1992.
Our industry is at the forefront of the slowdown. We have been consistently more pessimistic than the consensus on the outlook for the wider economy over the past year and a half yet we continue to reduce our expectations. Our forecast for the full year of 1.1% growth is under the consensus of 1.5% and well below the Treasury's official forecast. Most observers in our view underestimate the impact of a housing market slowdown on the wider economy.
With Q2 GDP growth so weak, the UK is likely to have slipped into recession by the second half of this year. The 2009 consensus looks far too optimistic as a result. Growth could be less than half the 1.1% consensus prediction.
The Monetary Policy Committee wants to see a slowdown to squeeze out inflation. Its August minutes suggest it is waiting to see whether the slowdown is going to be enough to achieve its target.
It wants to create just enough insecurity and unemployment to ensure consumers and companies don't anchor current rates of inflation in their long-term planning.
Entrenched higher expectations of inflation could set off a vicious circle of rising wage demands and prices that would need a sharp recession to break.
But there is enough evidence to suggest a recession is here. The slowdown has spread from the housing and mortgage markets and is now spanning manufacturing and services. Net trade should benefit from the weaker pound but our main trading partners are seeing their economies slow too.
Consumer spending cannot withstand falling real wages, rising unemployment, falling house and share prices and the squeeze on credit - it is the household sector that will cause UK GDP to shrink. This would probably be enough to pare back inflation expectations without the need for higher base rates. In a prolonged recession, rates would be cut quickly as long as the main inflationary pressures were beginning to subside.
The housing marketThe housing market has succumbed to the credit crunch and transaction numbers have plummeted along with mortgage approvals. Transactions tend to lag behind approvals by about a month. Only 57,831 homes were sold in April according to the Land Registry, 53% fewer than in August 2007 when 124,000 properties changed hands.
On the assumption that approvals don't drop significantly below June's weak figure, we would expect transactions to have hit about 40,000 in July when they are reported this month, the lowest level since the series began in 2000. It is hard to envisage them falling much lower.
Transactions should find a higher floor than approvals as a core of house purchases takes place without recourse to lenders. As approvals recover transaction levels will rise too, but with the outlook for the mortgage market gloomy, transactions will not recover their recent highs in the near term.
A lack of finance and slow turnover is also pushing prices down. The broad-based Land Registry index reported national house prices fell 1% in June, leaving house prices 3.1% below their peak in January this year. Lender indices with smaller samples show a bigger decline. In June the Royal Institution of Chartered Surveyors reported a balance of 88% of surveyors reporting falling prices.
Meanwhile, stock is building up on agents' books - Rightmove reported a record 78 properties per estate agency in August and asking price falls of 2.3% on the month.
The key to the longevity of the housing market decline depends on the duration of the mortgage drought. Demand has been stifled by the lack of mortgage finance but the question is whether the resultant weakness in the market has now knocked confidence and caused a self-sustaining decline in prices that thawing the mortgage deep freeze won't fix in the short term.
More consumers will sit on their hands, waiting to try and buy at a lower level. If this has already happened, prices could fall quickly and overshoot significantly. The less than helpful support via changes to Stamp Duty will only exacerbate delays.
We cannot see any signs of prices stabilising in the short term and would expect to see falls continuing for the rest of this year at least. But we also need to consider the supply side of the equation.
Housing supply is falling rapidly. The government's target of 240,000 new homes for 2008 will be missed by over 100,000. Any deep decline in prices is likely to be followed by a sharp upswing as newly confident buyers scramble for the limited number of homes.
Housing supplyThe housing supply outlook is much tighter than most realise. The construction industry is in freefall, with new-build volumes this year likely to be down around 40% and any recovery in 2009 set to be slow. Social housing provision is minimal too. The implications are dire.
According to research from Propertyfinder.com, over the long term the number of homes in the private and social sectors in the UK has exceeded the number of households by an average of over half a million properties in any single year. The empty homes are either in the wrong part of the UK, in need of renovation, earmarked for redevelopment or simply unsuitable for local demand. Propertyfinder.com calls this excess "frictional housing supply".
Since 1998 this excess has been in a rapid and sustained decline as supply has failed to keep up with demand from the growing number of households. It is no coincidence that house prices have grown most rapidly in this period. In fact, there is an 82% correlation between rising house prices and the reduction in the fric- tional housing supply.
Based on current trends in housebuilding and government projections of household growth, the number of households will exceed the number of properties by 2011 for the first time on record. This suggests that despite the current slowdown, unless there is a major expansion in building, prices can only go in one direction in the long term and that is up. The findings were confirmed by the Housing Federation, which predicts a 25% increase in property values over the next five years.
The incentives recently announced by the government to assist the new-build market will help this niche but do little to resolve overall market difficulties, particularly the mortgage supply issues faced by lenders.
Mortgage marketThe scale of the upheaval facing the mortgage market is unprecedented. By 2007 two-thirds of net new mortgage finance was provided by the wholesale markets. With that channel almost completely closed, lending has collapsed.
We expect net lending to total around £55bn for the whole of 2008, half the level of 2006 and 2007. But this actually overstates the strength of the market. The first half of the year will feel healthy by comparison with the second. Net lending in June was a meagre £3.1bn. Even allowing for some recovery from this exceptionally weak level, the second half of 2008 will see net lending only a little over a third of recent figures. We do not expect it to exceed £55bn in 2009, with a weak first half giving way to improved conditions in the second. Some expect things to be worse.
Gross lending is also in decline, although not as rapidly given the 1.4 million borrowers coming off fixed rates this year who will be in the market for remortgages. We expect to see £243bn of gross lending in 2008 and £230bn to £240bn in 2009 compared with £357bn in 2007.
Until the wholesale markets reopen we would not expect a significant recovery. The interim Crosby report suggests we may have to wait until the end of 2010 for the market to normalise again. We doubt that £360bn of lending will be back on the cards even by then.
The BoE is firmly against including new mortgage-backed securities in its Special Liquidity Scheme or providing long-term government mortgage guarantees, making it difficult for the Treasury to introduce the measures in the autumn for anything more than a brief interregnum. King pointed out industry business models need to be adjusted and lenders must act more prudently.
Specialist lenders have suffered the biggest hit. In June gross lending by specialist lenders was one-third of the level in June 2007. Building societies employing more cautious lending criteria lent two-thirds as much, while banks lent 80% of last June's gross volumes. With specialists most dependent on brokers and banks most able to squeeze distribution channels, this is not good news for the broking industry.
This contraction in gross lending is sharp but to put it in context takes gross lending only back to 2002 levels. The difference is the number of mortgage approvals that support this volume, given that average advances are around two-thirds higher thanks to house price increases.
With brokers dependent on transaction flow, approvals are a more important metric for our industry and they are weak. The number of approvals for house purchases in June 2008 was less than a third of the level seen in June last year. We have further reduced our expectation for purchase approvals to between 600,000 and 650,000 this year, around half 2007's figures. Next year is likely to see similar levels.
The remortgage market is holding up better. June volumes were 20% lower than the same month in 2007. We expect 1.1 million approvals this year and next, around 9% down on 2007.
Although most borrowers are well-capitalised with plenty of equity in their homes - on average around £80,000 - higher mortgage rates will naturally put some households under pressure. Arrears and repossessions will rise as a result. Abbey reports arrears are up 18% year-on-year. With first-half repossessions of 18,900, 48% up on the same period last year, the Council of Mortgage Lenders expects about 45,000 for the full year, well above last year's 27,000. Auction houses already report brisk business. The first half of 2009 will look difficult too. If the economic slowdown is sharper than we expect, repossessions next year will be higher than in 2008.
Compared with the outstanding number of mortgages, repossessions ran at 0.16% in the first half of 2008, in line with 1998 and far below the 0.4% peak in the second half of 1991. With interest rates unlikely to keep rising, that peak should not be reached again.
the Future for brokersWith gross lending around the £240bn mark, income for broking firms will be 30% to 40% below 2007 levels for this year and next. Incomes are unlikely to return to their peak for the foreseeable future. The implications for the industry are serious. At the end of June there were 7,078 directly authorised brokerages, unchanged on a year earlier, although the numbers have dropped slightly from the peak seen at the end of 2007. The number of individual brokers is around 30,000.
There has been remarkably little change in headcounts or the number of firms despite the dramatic decline in volumes compared with last year. This is because the broking industry only began to see real volumes affect them in Q2, as they were temporarily shielded by the increase in the use of brokers by consumers.
We believe there will be a shakeout and we should expect significant redundancies across the sector. Some firms will need to close and others merge as the industry adjusts to a much smaller market. Developing other income streams will be key to survival.
The industry must adapt to a world of sustained lower lending volumes and greatly increased muscle from choosier lenders no longer struggling under the weight of competition for every bit of business they can write.
Middle-ranking firms are likely to be most vulnerable. While the big networks are highly efficient with the best processes and the strongest relationships with lenders and many small sole traders maintain close relationships with customers, a large number of firms in the middle have been highly transaction-focussed, buying leads from the internet at low cost and with less focus on maintaining links with customers while volumes were plentiful.
Lender behaviour is going to change too. Marketing departments seemed to run many lenders in the fight for market share but now power will swing back to credit risk managers. Lenders will want a more balanced portfolio approach with a spread of geographical risk, property sectors and borrower types.
This presents an opportunity for brokers. With more borrowers finding their access to finance restricted, they will need the advice brokers can provide. Although we would expect the high levels of intermediary usage to drop, we expect the use of brokers to settle at a higher level than the long-term average as a result of these changes. A customer-focussed, advice-driven business model rather than a volume machine is likely to serve firms well.
We will see a smaller, leaner industry but the remaining firms will have the best staff and more diversified businesses. Last September 71% of larger firms worked outside mortgages. By March 85% did. Smaller retail firms are evenly split and only just beginningto show signs of widening their activities. Diversification will be key. n
AMI's tips for surviving the credit crunch
GDP Growth Source: Office of National StatisticsMortgage approvals Source: Bank of Englandkey notesUK Economic
Indicators Q1 2008 Q2 2008 2007 2008e* 2009e*
GDP 0.3% 0.2% 3.1% 1.5% 1.1%
CPI 2.4% 3.4% 2.3% 3.9% 2.4%
RPI 4% 4.4% 4.3% 4.3% 2.6%
Claimant
unemployment (m) 0.82 0.8 0.825 0.91 1.02
Base rates at
end of period 5.25% 5% 5.75% 4.5% 4.38%
*average of independent forecasts Source: HM Treasury July 2008
House Prices Price Y-o-Y % M-o-M %
(July 2008) change change
Halifax £177,351 -8.8% -1.7%
Rightmove £235,219 -2% -1.8%
The Land Registry (June) £180,781 0.1% -1%
Nationwide £169,316 -8.1% -1.7%
Source: AMI
