Changing Economic Policy and the Property Market

In a previous post, we focused on Britain’s new prime minister and noted that since Liz Truss had only been in post for a few days, it might take some time before the property market saw any direct impacts from her new economic priorities. In the event, those impacts were felt much more quickly.

On 23 September, her new chancellor Kwasi Kwarteng announced his mini-budget and it proved to be controversial, to say the least. Its most immediate effect was to send the value of the pound plunging to historic lows against the dollar, driven down by international markets that were far from convinced about the affordability of proposed tax cuts and massive borrowing.

When it comes to macroeconomics, credibility matters, and when global markets ditch the pound, that has some profound effects. First, it adds to inflationary pressures. That’s because any goods or services (including food, gas, petrol and industrial raw materials) brought in from overseas have to be paid for with a devalued currency. Consequently, they will cost proportionately more. Those extra costs are incurred by businesses and then passed on, percolating right down to the consumer level and affecting virtually every aspect of ordinary life.

Second, those same inflationary forces typically compel the Bank of England to raise the base rate, which increases the cost of borrowing. And third, devaluation can wipe considerable value from stocks and shares and that, in turn, has very unpleasant consequences for the pensions sector.

On 27 September, Bloomberg reported that UK markets had lost $500 billion in the wake of the PM’s new policies. This loss in value threatened to kickstart a pensions crisis so, in an effort to prevent it, the Bank of England began buying up government debt. It vowed to buy £65 billion of government bonds to help "restore orderly market conditions.”

To a meaningful extent, the Bank’s intervention worked, and the value of sterling has since recovered some lost ground. More worrying, perhaps, is the more enduring sense of market uncertainty. Many economists have said that they still regard the PM’s policies as unfunded and unsupported by data and, to judge by many media reports, they are not even supported by a majority of Conservative Party MPs.

The lack of support on her back benches – indeed, even from at least one member of her own cabinet – has left the PM and her policies looking vulnerable. At the time of writing (5 October), Liz Truss is facing a possible government revolt on her plans to deliver a real-terms cuts to benefits. Similarly, at the party conference, she announced that many of the mini-budget measures would not be voted upon until next spring – thereby delaying (but not eradicating) the prospect of a series of potential rebellions.

One BBC commentator recently observed that although Liz Truss has a technical majority in the House of Commons, she is having to act as though she were in a hung parliament or part of a coalition government.

Already, the chancellor has had to U-turn on the proposed cut to the 45p rate of income tax for top earners. Similarly, despite the PM’s previous assertions to the contrary, Treasury staff at the Conservative Party conference conceded that details of the medium-term fiscal plan would indeed be brought forward. These details will reportedly be published some time before the end of October, rather than on 23 November as originally planned. They are expected to appear alongside a keenly-awaited forecast from Britain's independent financial watchdog, the Office for Budget Responsibility (OBR).

One of the main criticisms levelled against the PM and chancellor has been a lack of explanation. They sacked the long-serving Treasury Permanent Secretary Tom Scholar and, despite an offer from OBR, refused to allow it to publish any evaluation of the likely impacts of their new policies.

This muddied any possible understanding of how government intended to balance the books, and drew early criticism from numerous influential voices. Amongst others, these included the (Conservative) chair of the Treasury Committee, Mel Stride MP; the Institute for Fiscal Studies (IFS); and most strikingly, the International Monetary Fund (IMF), which issued a rare and stern warning. Recommending an early re-evaluation and offering the sort of advice more commonly aimed at developing nations, the IMF wrote:

“We understand that the sizable fiscal package announced aims at helping families and businesses deal with the energy shock and at boosting growth via tax cuts and supply measures. However, given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture, as it is important that fiscal policy does not work at cross purposes to monetary policy. Furthermore, the nature of the UK measures will likely increase inequality.”

By acquiescing to the demands of MPs, the IFS and the Treasury Committee, Kwasi Kwarteng might now be able to restore some degree of calm to jittery investors, and if the numbers look credible, they could also help to limit how high the base rate might eventually have to go.

Reuters reports Mel Stride’s reaction to the Chancellor's plan to bring forward publication of the fiscal plan. He said that it could help:

"to calm the markets … and reduce the upward pressure on interest rates. In particular getting the forecast out ahead of the MPC meeting on 3rd November might help to reassure our rate-setters (i.e. the Monetary Policy Committee) that they can go with a smaller base rate increase than would otherwise be the case."

The BBC’s economics editor, Faisal Islam agreed, but with some caveats. On 4 October, he wrote:

“Whatever the impact of these reversals in politics, they should help settle some nerves in markets. They will provide the basis for solid judgements by traders… The Office for Budget Responsibility (OBR) will cost all the policies announced by the chancellor and provide new numbers for extra borrowing, taking into account a slowing economy and higher interest rates.

“The budget watchdog will also cast judgement on the government's claims that its raft of reform policies will boost economic growth. The less convinced the OBR is on growth, the bigger the fiscal hole.”

That last point is important. The publication of the OBR report will only restore calm if its findings are positive – i.e. if they broadly support the logic of the PM’s new policies. If the report suggests considerable under-funding or irrationality, then global confidence in the UK economy could be further undercut.

Investors will therefore be hoping that the report – and any further changes to the original mini-budget plan – will look sensible, realistic and financially prudent. That will be especially important now, at a time when, as the FT reports, failing credibility is prompting analysts to downgrade the UK’s economic growth forecasts. Moody’s, for example, notes that “recent actions had made stagflation and a deep recession almost inevitable.”

The FT adds:

“… many economists see no improvement in the medium-term outlook, with predicted annual average growth fixed at +1.5 per cent, well below the chancellor’s target of +2.5 per cent. In fact, (Moody’s Analytics) said there was a risk that medium-term growth “trends lower” as questions linger “around the stability of the pound and the desirability of the UK as an investment location.

“Kallum Pickering, senior economist at Berenberg Bank, said … that while tax cuts would support demand, the “confidence shock” and “significant tightening in financial conditions” that followed the government’s announcements “will overwhelm any of their near-term effects.”

“Economists from Berenberg, UBS, Goldman Sachs and HSBC are forecasting three quarters of economic contraction from the three months to September, followed by either weak growth or the economy flatlining until the end of next year.”

Market confidence is therefore an important commodity, so investors across a wide range of industries will be awaiting the OBR report with considerable interest.

Inflation and Interest Rates

The new mini-budget measures will almost certainly have an inflationary effect, as the previous chancellor Rishi Sunak warned. The prospects of a weaker pound and higher inflation will put more pressure on the Bank of England to raise the base rate – one of the principal tools that it uses to try to keep the cost-of-living under control.

The Bank has already stated that “The MPC will not hesitate to change interest rates as necessary to return inflation to the 2% target sustainably in the medium term, in line with its remit.” That’s a message that has prompted markets to price for a considerably higher base rate – with most expectations averaging between 5.5% and 6% by August 2023.

For property investors, this is clearly unwelcome news. Most obviously, it will cause borrowing costs to surge, so it will erode the profits of any landlords who, approaching the end of fixed-term deals, are forced to re-mortgage. It could also deter new acquisitions and lead to lethargy in the first-time-buyer market – both factors that could result in less market activity overall.

More generally, the rising cost of borrowing will reduce potential buyers’ disposable incomes and perhaps also drive an increase in mortgage defaults. These are both developments that could quickly sap energy from the property market and lead to reductions in average asking prices.

In short, house price contractions are looking more likely now than they were just a month ago.

For millions of ordinary families, mortgage costs are the single biggest drain on household budgets and such a sharp rise in borrowing costs would hit the market hard. For most mortgage-funded householders, any potential savings resulting from changes to stamp duty and (in 2023) the basic rate of income tax, would be entirely wiped out by higher interest payments.

Tom Bill, head of UK residential research at Knight Frank, said:

“Cuts to energy bills, income tax and national insurance could become footnotes in Liz Truss’s economic plan, all dwarfed by higher mortgage bills.

“The recent volatility is naturally causing buyers and sellers to hesitate. The only thing that moves quickly in the UK housing market is sentiment and it’s been damaged over the last seven days. Even if the government can start to reverse the impact of the mini-budget, the reality of higher rates has dawned on people, wherever they end up peaking... It therefore feels almost inevitable that prices will fall next year.”

Since the mini-budget, Knight Frank has published a revised UK house price forecast. Whereas, in the first half of 2022, the company had predicted +5% growth, it now forecasts a -5% fall. It writes:

“We expect prices in the UK to fall by -5% next year and (again) in 2024. This represents a total decline of almost 10% and takes house prices back to the same level as last summer.

“As supply and demand continue to normalise, the dominant theme of the next two years will be tighter budgets due to higher monthly interest bills.”

Working on present assumptions about government policy and the base rate, the company predicts house price growth of +6% by year-end of 2022, but then two consecutive years of decline, followed by relatively weak growth. Its cumulative growth figure by 2026 is a rather lacklustre +1.5%.

Cost-of-Living and the Rental Market

In the same forecast, Knight Frank also revised its UK rental market predictions. Here, the outlook is much more promising, with high demand meeting very short supply. As a result – and notably, despite rising cost-of-living pressures – the company expects to see healthy continuing growth.

It predicts +5% rental growth by year-end 2022, followed by annual gains of +4% (2023), +4% (2024), +3% (2025), and +3% (2026). That would deliver a cumulative gain of +20.5% over five years. However, the agency ends with an important disclaimer: “A high degree of fluidity on financial markets and inside the Conservative Party means we will revisit these numbers before the end of 2022.”

Consequences for Investors

Since the mini-budget, market sentiment has declined quickly and, according to some commentators at least, it is dragging down the prospects of healthy capital growth next year. Rather than the growth previously predicted – ranging between +5% and +8% in 2023 – some economists expect average values to fall by between -10% and -20%.

That’s only a forecast, of course, but with mortgages costs already at a 14-year high and set to go higher, it’s easy to see why markets may be nervous. Fast-rising mortgage costs and declining sentiment also help to explain why strong capital growth may look a lot less achievable now than it did just a few weeks ago.

As they stand, the government’s new policies could also affect certain demographic groups more than others. For example, poorer tenants will be harder hit by Liz Truss’ decision to scrap Boris Johnson’s pledge to keep benefits rising in line with inflation. By offering such households an increase that follows the trend of average wages, not the cost of living, her government will be delivering a real-terms cut to their incomes. That, in turn, will increase the risks of arrears for investors who have properties aimed at lower-income markets.

Of course, that only applies to policies as they stand. As we’ve seen in recent days, the chancellor and the PM have already been forced to backtrack on the 45p income tax decision and the publication of the OBR report.  With many Conservative MP’s openly criticising the PM’s management and policies – particularly those that appear to be benefiting the rich at the expense of the poor – it’s possible that further policy changes could emerge.

Rental Demand

While short-term capital appreciation may be looking harder to achieve, there are no such concerns over rental demand. Even before the mini-budget, rental housing stock was extremely limited and demand was intense. Nothing has happened to change that, and it could easily be argued that recent policy changes could deliver even higher rental demand over the coming months.

One driver of that could be the escalating mortgage costs (and risks) to first-time-buyers. A rising base rate may prompt many potential buyers to defer any decision and to continue renting. Likewise, as living costs and mortgage costs escalate beyond many people’s original financial calculations, it’s possible that lenders will start to see more borrowers defaulting on payments. That’s an outcome that could lead to repossessions and yet more people returning to the rental market.

It's also very possible that rising mortgage costs could tip the balance for some wavering investors and compel them to sell up. The market has seen the departure of many small-portfolio landlords over the course of the last year and, as more rented properties are sold, so tenants find themselves presented with fewer and fewer choices.

Those trends, then, look set to extend an already wide gulf; to increase rental demand and to limit stocks still further. That, of course, is a formula for price growth, so those investors who hold firm and remain in the market should be able to count on steadily rising rental returns.

Grounds for Optimism

The present circumstances are decidedly unusual. The war in Ukraine has driven global commodity prices to unprecedented heights, and the world is still rebounding from the Covid pandemic. These factors alone create an economic landscape that is strange and challenging.

In the short term, it’s probably fair to say that the mini-budget hasn’t helped. It is hard to imagine or recall a set of government policies that have attracted such widespread criticism, nor prompted such obvious discontent within the government itself. It’s impossible to predict how the politics and the economics will play out over the next few weeks, but they will certainly be the subject of intense scrutiny and debate.

In the meantime, however, it’s important not to lose sight of the wider, longer-term picture.

The UK’s economic growth forecast may be lower than the PM would wish, but the country is still an important player in the global economy. It has suffered the fallouts from Brexit, Covid and the invasion of Ukraine and yet, despite all these setbacks, its economy is still growing – just. According to the latest ONS data, the UK narrowly avoided the recession that so many had expected, and beyond the next year or so, it’s expected to return to growth again.

Other important indicators also bode well. Employment rates are high, so many people will be better able to withstand the (hopefully transient) cost-of-living shocks that are currently so challenging. Moreover, house price indices still show robust annual growth and rental indices paint a similarly positive picture.

Above all, housing is an asset that people simply can’t do without. It’s an essential commodity and while demand continues to exceed supply, the longer-term prospects for price growth remain very good.

If, as some predict, prices temporarily fall, then investors will be quick to recognise the opportunity. The longer-term growth trend still looks likely to be strongly positive, just as it has been since the end of the second world war, so a brief dip in prices could ultimately deliver some attractive opportunities for those who are willing and able to buy.

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To find out more about investment opportunities in residential markets across the UK, please call our advisory team on 01244 343 355.