Seeds of stability and growth

Although the prospects for lending expansion are subdued this year could set a stable base for recovery if action is taken to curb public spending, says Gary Styles, strategy, risk and economics director at Hometrack

Last year will be remembered as the one when the economy bottomed out at a level 6% lower in GDP terms than at its peak in 2007. Yes, 2009 represented the worst year for growth since 1921. GDP performance was considerably weaker than the 1980s and 1990s.

So where does this leave us for 2010 and beyond? Well, it looks increasingly likely that this year will be seen as representing a stable base for a sustained recovery in 2011 and 2012.

Interest rates are expected to remain steady throughout the year as the economy struggles to return to a sustainable growth path. Bank of England base rate is forecast to start to rise in 2011, with mortgage spreads remaining similar to their current levels as lenders rebuild balance sheets and avoid overt growth strategies.

The diminishing level of competition in the mortgage market, as highlighted by the level of consolidation and absence of new players, will enable lenders to maintain wide mortgage spreads and lenders will only offer competitive deals to what are perceived lower risks in the market.

Of course, the fiscal deficit is casting a long shadow over medium term numbers and the government will have to grapple with making big cuts in public spending and increasing taxation by the end of 2010.

Economists are split on the precise timing of any substantial tightening in this regard but I would argue that the recovery would need to be underway for at least a couple of quarters before any substantial tightening is implemented. If this is not the case we run the risk of a deep double dip in economic output.

The size of the challenge should not be underestimated and in practice the sort of spending cuts required have not been seen since the 1930s. This will be a time for a radical and open review of all public spending which should not include any arbitrary ring-fencing of supposed core areas such as education and health.

The process will require open engagement with the public and trade unions to build implicit support for the radical decisions needed. Cuts will be difficult to sell to the public unless there is transparency, fairness and openness about priorities.

As a result of the above fiscal and monetary assumptions economic expansion is likely to take two to three years before returning to its trend level of around 2.5%.
The outlook for real household income growth is held back by low wage growth and higher unemployment, and later by an increase in the rate of consumer price inflation.

The economy will take some time to adjust to slower consumer spending and borrowing growth plus an increased emphasis on investment and exports. The savings ratio is expected to rise over most of the recovery period and average 6.5% compared with the 3.4% seen at the end of 2008 and 2.4% in 2007.
So where does all this leave the mortgage and housing markets?

The housing market showed surprising strength in price terms in 2009 but this largely reflected the mix of higher value transactions seen during the year. Many key sectors of the market remain depressed and although reported price rises have helped provide more confidence fundamentals remain weak.

I expect housing activity to pick up around 20% during the next two years as consumers become more confident that prices are close to bottom.

Mortgage margins are expected to remain at around their present levels so increasing interest rates from 2011 will act as a drag on the market.

But fiscal challenges will ensure only modest growth in real household incomes. For this reason strong house price inflation looks unlikely. Net mortgage lending is forecast to rise to around £18bn a year in the medium term, which is less than 20% of the record level seen in 2007.

Lenders will continue to rebuild balance sheets by maintaining wide mortgage spreads and avoiding higher risk sectors.

The realisation that any lending is likely to remain on-balance sheet for many years has engendered a more conservative approach to lending from several of the growth players of the past.

Remortgaging is likely to remain subdued until mortgage rates move significantly below basic SVR, and this could take some time.

House prices are forecast to move in a tight range until 2012 and 2013 as any increases are likely to be matched by additional supply. While lending expansion remains subdued the outlook for house prices is limited to low growth or stability.

So volatility in house prices will remain a feature and the market will have to learn to live with clusters of negative numbers.