An Englishman’s Home Is His (Expensive) Castle
(Bloomberg Opinion) --
The U.K.’s attempt to extricate itself from the European Union is turning into a slapstick national embarrassment. Those efforts add an extra layer of complexity to an economic problem that is otherwise startlingly similar to that of the U.S. The unemployment rate has improved to a point where it looks historically good.
If the Phillips curve is to be believed, then start to get worried about faster inflation. The U.K. showed early in this decade that it is more prone to inflationary pressure than other leading developed economies, as the pass-through from the sharp depreciation in sterling that accompanied the financial crisis drove up consumer prices. But at this point, the money is not going around as fast as probably should. Much as in the U.S., inflation appears to be under control:
This means that the U.K. has much the same monetary policy dilemma as its friends on the other side of the Atlantic. But to this must be added two other distinctly British factors. One is, of course, Brexit. Mark Carney, the governor of the Bank of England, has made clear that the bank must “prepare for the worst,” which would be a “no-deal” Brexit in which the U.K. suddenly exited the EU in March with no clear arrangement to follow. That would suggest the BOE would not raise rates. Carney also has to contend with the peculiarly British obsession with the housing market, which drives the economy in ways seen in few other places.
The U.K. housing market, particularly when judged in local currency terms, boomed even more than the U.S.’s in the last decade. Most importantly, the bubble never truly burst before the expansion resumed again. This was particularly true of London, which benefited from the euro zone sovereign debt crisis as prime London property seemed a convenient shelter for continental Europeans worried about a break-up of the euro. That flow of foreign money into U.K. housing might reverse with Brexit. Meanwhile, both the current Conservative administration and its predecessor have taken measures to buttress house prices to the fury of conservative economists.
London house prices have stalled since the Brexit referendum. A sharp drop could be disastrous, even if it does not quite reduce London into a ghost town. This puts pressure on the BOE not to raise rates. It makes what is now known as “Super Thursday,” when Carney unveils the new inflation report and the new base rate, along with new targets for corporate bonds and asset purchases, all the more interesting. Former colleague and highly respected U.K. economist Gavyn Davies suggested in the Financial Times that the BOE will stay its hand, but also that Carney and his colleagues will be “fervently praying for a Soft Brexit.” With inflationary risks looking higher than they were in 2016, when the BOE cushioned the blow of the Brexit referendum with easier money, a “hard Brexit” will be difficult to deal with.
There is also a fascinating dispute over the housing market. Why exactly does it keep going up in the U.K. in a way that does not occur elsewhere. BOE Chief Economist Andy Haldane grabbed much attention two years ago when saying that a house was “like a pension”: “It ought to be pension but it’s almost certainly property… As long as we continue not to build anything like as many houses in this country as we need to…we will see what we’ve had for the better part of a generation, which is house prices relentlessly heading north.”
Albert Edwards, the famously bearish strategist at Societe Generale SA, described this as “grotesque,” while Harry Colvin of Longview Economics of London came up with a devastating rebuttal this week:
Growth in the supply of housing in Great Britain (i.e. the number of dwellings) has outpaced growth in the number of households over the past 20 years. That’s resulted in a rising level of surplus housing stock across the UK (i.e. during the main period of rapid house price increases). In 1996, for example, there was 770k more dwellings than there were households (i.e. 3.2% of the housing stock). On latest data, that surplus is 1.5 million properties (5.6% of the housing stock), see fig 1. In recent years, the acceleration has been marked: Net additions to dwellings have averaged 190k p.a. in the past 5 years while household formation has averaged just 110k p.a. in that time (see fig 2 below).
He suggests, I think correctly, that it has been the availability of cheap money that has kept house prices high in the U.K. And as the BOE is known to think that house prices function somewhat like a pension, taking measures to make money tighter and nip inflation would also bring with them the risk of bringing down the housing market, and thus depriving many people of their pensions.
With Nationwide House Price index data being published before the BOE’s meeting, this will be a fascinating balancing act before another dose of acute political risk: the government needs to thrash out a deal on exit from the E.U. by the end of November. For the time being, Super Thursday should at least give us some entertainment. Compared with the U.S., though, the housing market and the Brexit imbroglio mean that the risks are far more directly tilted toward inflation — or even stagflation.
And for the eagle-eyed, you will find that most of the hyper-links in this piece will take you to videos in which great British bands from the late 1970s and early 1980s bemoan the miserable economy of the time. Without wanting to sound like the Monty Python Yorkshiremen (even as revived by a group of great British actors including the late and much lamented Alan Rickman), back in those days we had it tough. Even if Brexit is down to the worst of current expectations, it need not be that bad. And we should all remember that the British have a tendency to over-exaggerate how bad things are, just for effect.
Back to Brazil
One more reason to distrust the rally in Brazilian equities: metals prices are going nowhere. This is a problem because Brazilian stocks have been priced for decades as though Brazil were one very large mine. There is much more to Brazil’s economy, but the relationship between the benchmark Bovespa stock index and the Bloomberg Industrial Metals index has remained remarkably strong. If one rises, then either the other follows or the rally soon ends.
The recent Bull-sonaro rally stocks, named for Brazil President-elect Jair Bolsonaro, has been accompanied by flat metals prices. There is simply no appetite to take metals prices significantly higher at present. In recent years, China has been the marginal buyer of industrial metals, and few people at present seem prepared to bet on a renewed spurt of Chinese growth.
And Back to Mexico
According to a report by Brazilian brokerage XP Investments, Mexico “has been all but downgraded to Banana Republic status by the international financial community following AMLO’s airport decision”. These are strong words. The decision by the AMLO in question, President-elect Andres Manuel Lopez Obrador, to cancel the airport project, already 30 percent complete, has led to warnings of a default by lawyers for the underwriters of the bonds sold to finance the project. Investors are fleeing the country, firms such as JPMorgan Chase & Co. are reducing their economic forecasts, and Mexico’s debt has been downgraded by various credit ratings firms. To protect the peso, the central bank is now thought likely to raise interest rates, the exact opposite of what the economy needs.
XP Investments’ take on this, which can be read here, is worth reading in full, as it is apocalyptic:
Some people, locals especially, re-encountered a long-lost scream that a “good” AMLO was likely always a distant dream. Other investors also likely decided to unwinding positions on the back of the Technology rout affecting US markets. Finally, some investors also likely got caught in the wave of asset reallocation (reducing Mexico’s weighting and increasing Brazil’s). The airport story is unequivocally bad as a first signal effect.
We do think that Mexican asset prices will find a new equilibrium at some point, and interesting opportunities will arise. But we think that markets will need to live through some catharsis before we get there. The reality is that President-elect Lopez Obrador and his team have now unequivocally shown that they are uncapable [sic] of understanding the ramifications that their decisions have on investor confidence and the hard-fought perception of Mexico being a serious country.
This is damning, and largely deserved, but I suspect that it may be overstated. In particular, it seems likely that we are already in the “catharsis” stage outlined by XP Investments. Markets have a tendency to overreact to political events in Latin America, as I wrote about earlier this week, and financial assets in both Mexico and Brazil tend to be subject to a “tug-of-war.” Good news for one means money being removed from the other. With big political events in both countries happening at the same time, the last week has seen a historic swing. Mexican stocks have consistently led since current President Enrique Pena Nieto was elected in June 2012. That has reversed, with the MSCI Brazil index outperforming its Mexican counterpart by 57 percent in six weeks.
It seems almost like overdue revenge for the Olympic soccer final of 2012. It also seems overdone.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of “The Fearful Rise of Markets” and other books.
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