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Uncertainty leaves economy in jeopardy

The outlook for the mortgage market has deteriorated in recent months as the impact of the slower economic recovery and upheavals in Europe are taken fully into account. But this revision in expectations has been pretty modest so far compared to previous shifts in the market.

Our forecasts for mortgage lending and house prices hardly changed during 2011 and we see little reason to alter them significantly now. There are plenty of unknowns and potential threats to the central forecast and these are what I want to explore.

The key central forecast, as identified last month, is best described as a muddle through scenario.

The economy is expected to take two to three years to return to trend economic growth while inflation is forecast to ease over this year and to remain low.

Gross mortgage lending is projected to be around £132 to 134bn for the next two years and house prices are forecast to fall in the short term before stabilising in 2013/2014.

The first scenario I want to consider is a collapse in the euro (see table below). Under this several economies in Europe decide to leave the euro and in effect walk away from some of their sovereign debt.

Euro collapse is the most frightening scenario we face given its potential to destroy confidence

This would drive up risk premium, the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, across mainland Europe and in the UK.

Higher market interest rates, a poor banking sector outlook, even slower world economic growth and the prospect of higher sterling would combine to drive the economy further down in the short to medium term.

Under this scenario the UK economy would limp on as it has in 2011 and would need even more active policy intervention to return to a modest economic growth profile in the medium term.

The biggest risk with this scenario is that continuing economic uncertainty prevents a swift return to any degree of economic normality. This scenario is the most frightening we face given its potential to surprise and to destroy confidence.

The second scenario (see table top right) is a world economic double dip driven by the combination of weak economic growth in Europe and the US.

This would prove less painful than a euro collapse as a double dip is likely to be short-lived in the US and UK given the economic fundamentals.

The UK has rarely experienced a double dip and we would need to go back to 1975 to find the last significant experience of this scenario. Recovery from this situation is likely to be stronger and more sustained than in the euro collapse scenario but it must be remembered that Europe needs economic growth more than anything to help improve the fiscal deficits of several of the major economies.

The third scenario (see table below) is inflation collapse followed by a welcome rapid economic recovery. Inflationary pressures from world commodity and food prices abate quickly, so central banks can ease policy faster than expected.

Low inflation would not improve the fiscal constraints in the short term but stronger real income growth for consumers and increased surpluses in the non-bank corporate sector should allow robust consumer spending and investment growth in the medium term.

This scenario shows gross lending rising to over £200bn by 2015. Although the probability of this situation happening is low, it could be adjusted up if we see significant evidence that fiscal deficits have improved and the corporate sector shows a step change in investment intentions.

For those who like neat probabilities, I have four years. The weighted scenario is not dramatically different from the central view but the forecast spread around this view is wide by the time you get to 2015. There is little doubt that we are in for a slow and protracted recovery out of this mortgage recession. More competition, enhanced funding and less client fear should help the market recover over the next three to four years.

Domestic concerns are completely overshadowed by European and world economic worries. The UK needs to focus on delivering growth in the domestic economy to ensure a positive outcome for the market in the medium term regardless of the international context and uncertainties.

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