Update on the real house price cycle
We have updated the Nationwide house price index through June, expressed in terms of deviation from a sustainable long-term trend. Our way of measuring house prices focuses on house prices as a cycle in real terms, in common with our approach to other assets. The index from 1957 is deflated by general inflation and then a trend fitted (using a simple regression technique), firstly for the whole history up to the time of the observation (hindsight-free) and secondly for the whole period to date. The current level relative to trend is expressed as a ratio, equivalent to overvalued, undervalued or normal. Both ratios show extreme overvaluation and have been rising rapidly for the past four quarters.
The data through June was still reflecting buoyant lending conditions. Right up to the mini-liquidity squeeze that hit inter-bank markets in dollars and euros last week, sterling mortgage lenders were still aggressively competitive. This may change very quickly, now that bank balance sheets and wholesale capital markets are so globally integrated. What the real house price cycle chart shows is the extent of the potential fall in real terms, given previous cycles. We have repeatedly argued that the previous down cycles have been concealed by high general inflation. This time round, ‘real’ will mean ‘for real’.
Explanation We measure house prices at No Monkey Business much as we measure returns from investment assets. We are interested in long-term trends of achieved return because we believe that, if the data history is long enough, they reflect sustainable growth paths, given the constraints imposed by economic realities. Economics also provide the reasons for the shape and degree of cyclical deviations from the sustainable path. For property and financial assets, the limits of deviation may well reflect some form of equilibrium theory of economic behaviour.
We use the Nationwide index because it has a long history, from 1957. It measures the price history of a changing ‘average’ home, reflecting the improvement in standards over the period. Without that adjustment, an index would record the gains from higher standards but not the investment in achieving them, so overstating the sustainable capital return on investment.
The house price index omits implicit rental income and so is comparable with capital returns from an equity index but not total returns (ie returns with income reinvested).
We are only interested in real prices, as deflated by general inflation. This is the only measure of economically sustainable returns. Inflation distorts the path of an asset but does not necessarily affect the underlying economic forces that cause both the trend and cycle. These are only observable when adjusted for the actual inflation.
In the chart below we show the observed level of the real price index as a ratio of the trend. There are two trends calculated: one using the data known at the time of the observation and the other using hindsight, as if knowing at every point in the past what would happen to nominal house prices and inflation in the future. If a case is made that cycles are shaped by rational agents responding to ‘economic realities’ (whatever they are), logically it is the hindsight-free deviations from trend that matter.
Interpreting the chart now The current housing boom is unusual not just in its degree of deviation from the long-term trend (which roughly equals three previous peaks) but also in the length of time it has spent trading at a level which has previously quickly triggered a decline (which is why there are so many ‘stale bulls’).
It first peaked in the third quarter of 2005, at 50% above the hindsight-free trend, but as real prices leveled out in early 2006 the ratio fell back modestly. The nominal growth in prices over the last year has not been as strong as earlier in the boom yet the ratio against the trend has picked up again.
The length of time spent at high levels has also had the effect of lifting the whole period trend from 2.4% pa in 2005 to 2.6% today. The ‘true’ sustainable rate is probably closer to the 2% rate observable before the start of the current cycle. The underlying economic reasons for a ‘natural’ trend of around 2% pa were explored in an earlier post: ‘House prices: crash avoided or crash postponed?’.
Messages for UK mortgage finance from global credit markets We view the cycle around the sustainable trend as being a monetary phenomenon, reflecting the changing cost and availability of credit. The government has much more influence over how credit is created than how many houses are built and scrapped.
We are lucky that the discipline our central bank exercises over credit creation has not been usurped by non-bank investors to quite the same extent as has occurred in the USA. The mortgage market in America has effectively been doubled by the sale of collateralised mortgage products to portfolio investors, mainly via hedge funds. Tapping new finance sources (that do not merely replace deposits elsewhere) effectively escapes the constraints that apply to the total size of deposits on financial companies’ balance sheets.
But if this new source of housing finance dries up, and banks generally move to protect their balance sheets (emphasising their own liquidity and loan quality over short-term profits growth), British banks and the sterling wholesale market are also likely to reduce the growth of housing finance, and possibly even its real level.
It is perfectly possible that changes in credit conditions will not be the trigger for weaker prices here. However, the particular contribution of high-earning professionals to the London housing market means that their irrational exuberance will be tamed by any global shift in credit and stockmarket conditions, via the mechanism of expected future levels of investment banking profits, employment and bonuses.
The UK also has its own Trojan horse in the shape of buy-to-let investors. The proportion of let properties has not increased significantly above its long-term average of about 10%. What has changed has been a shift from relatively professional landlords to gullible and inexperienced amateurs – see my post last year on this. All the anecdotal evidence supports the view that the ‘smart money’, hardened investors with previous cyclical experience, has been pulling out for some time already.
So the notion that we are better off than the US, which faces a horrendous house price crash, may be somewhat illusory.