UK economic growth rises above trend
The economy continues to provide a positive backdrop to the housing market. Provisional third quarter data indicated that UK economic growth rose to 2.8 per cent per annum in real terms (i.e. after allowing for the effects of inflation). This level is marginally above the long-term trend growth rate of 2.5 per cent.
One positive aspect of the data was that both the service and manufacturing sectors recorded significant increases in output. The key driving force remains the domestic economy. The net overseas trade balance in goods and services is relatively static at minus £4 billion per month. While the global economy is close to record growth levels of 5 per cent per annum, the slowdown in the USA and the very gradual pace of recovery of continental Europe is limiting export potential. These two economic zones account for a very high percentage of British exports. UK economic expansion is domestically driven. Retail sales volumes are growing at an annual rate in excess of 4 per cent. A breakdown of retail sales data shows that the fastest growing sectors include housing items, notably household goods. The impact of the Bank of England’s gradual tightening of monetary policy will be felt in the first half of 2007, when UK economic growth is expected to fall back to the trend rate of 2.5 per cent per annum.
High probability of Base Rate increase
While the annual rate of consumer price inflation (CPI) fell to 2.4 per cent in September, the breakdown showed that the fall was entirely due to a substantial one-off reduction in fuel prices. It now appears that UK inflation will remain in the top half of the government’s 1-3 per cent target range for most of 2007.
There is a very high probability (90 per cent) that UK Base Rate will rise to 5 per cent following the November Monetary Policy Committee (MPC) meeting. At present, markets fully discount a further move to 5.25 per cent in February or March. We do not believe that a move above 5 per cent is necessary given that the Bank of England projections show UK growth and inflation gradually returning to trend on a one to two-year horizon. The one proviso is that if a move to 5 per cent fails to slow the rate of house price inflation, the MPC will probably increase Base Rate to 5.25 per cent. During October, two to five-year rates rose by 0.20 per cent. This reflected both domestic and international factors, including the strength of the US equity market that has led to a movement out of fixed interest rate bonds. Our view is that longer-term rates have reached their peak, and may ease fractionally towards the end of the year – unless house price inflation remains in the region of 8 per cent.
Changing the breakdown
The latest mortgage lending statistics show that mortgage approvals in September totalled £30 billion gross (seasonally adjusted), indicating that the August increase in Base Rate has not yet made a significant impact on the mortgage market. The expected increase in Base Rate to 5 per cent should have a more discernable effect. Nevertheless, on the basis that the economy expands by 2.5 per cent next year and Base Rate averages 5 per cent during the first three quarters of 2007, we forecast that mortgage advances next year will remain resilient.
The breakdown of mortgage business next year is likely to change. We expect to see a significant increase in buy-to-let activity with gross advances in this sector averaging £5 billion per month. Equity release activity is likely to gather momentum. The rise in interest rates will also focus borrowers’ attention on consolidation of debt. The impact of the Base Rate increase will be most pronounced in the first-time buyer market. Transactions are therefore likely to grow at a slower rate next year. We do not see the distinct possibility of a 5.25 per cent Base Rate next year as a threat to our mortgage lending forecast. In absence of any new energy price shocks, we believe that a Base Rate above 5 per cent is justified only if the housing market overheats.
Unsustainable inflation
The latest house price data from the Nationwide Building Society shows that average house prices are increasing at a rate of 8 per cent per annum. We regard this level as unsustainable. If house prices were to remain in the region of 8 per cent in the Winter months, then the MPC would probably raise Base Rate to 5.25 per cent, and even higher if necessary, to cool the housing market.
The current rate of house price inflation is not in the long-term interests of the majority of housing market participants. Our central forecast is that the rate of house price inflation will slow to 4-5 per cent per annum after the expected increase in Base Rate. Average house price inflation is, however, likely to remain above retail price inflation in the foreseeable future (i.e. until at least 2010).
House price inflation reflects the surplus of demand over supply. The number of new homes built in the UK this year is likely to total just over 200,000. This is barely sufficient to keep pace with new household formation at a time when there is still a shortage in housing supply. Demand has been boosted by a range of factors including the moderately high growth rate of average earnings including bonus payments, the high percentage of people in employment, increased net migration, large scale cash transactions, and longevity. These factors are boosting demand for both owner occupied and rented accommodation, hence the relative strength of the buy-to-let market.
Laurence Sanders
