• UK growth remains above trend but predicted to ease to 2.5% in 2008
• Base rate outlook has changed – 5.75% will probably be the peak
• Mortgage market still resilient, although activity expected to be lower in 4Q 2007
• House price inflation stabilising around 0.4% per month.
Despite monetary tightening and international financial market turbulence, the UK economy remains resilient. The latest data shows that UK gross domestic product rose by 3.0 per cent in the year to Q2 2007.
More significantly, the recent Chartered Institute of Purchasing and Supply (CIPS) surveys suggest that momentum is being maintained. The CIPS manufacturing survey has risen from 56.7 to 57.3. The principal increase was in the output and export orders components. The CIPS service sector index rose from 57.0 to 57.6.
The most significant element of this survey was the high level of business expectations at a reading of 74. The strongest CIPS survey this month was the construction survey, where the overall index rose from 61.8 to 64.8. The new orders component at 67.6 represented the strongest reading since 1997.
While construction represents a mere 6 per cent of the UK economy, it is an important barometer of the economy. The CIPS surveys were conducted in August when the effects of the international credit ‘crisis’ were apparent. We predict that UK annual growth will remain close to 3 per cent until Q4, before easing back to 2.5 per cent in first half 2008, as the full impact of past monetary tightening is felt. In 2009, we predict that growth will return to 3 per cent per annum.
Base Rate outlook has changed
In recent weeks, deposit rates up to one year have been exceptionally high. Even the benchmark one-month LIBOR fixing has averaged circa 0.90 per cent above Base Rate during the month to date. There is in effect an international credit ‘crisis’, which stems from the non-prime mortgage market in the US. The effective globalisation of the US non-conforming market problems, via securitisation, has impacted on financial institutions in western Europe.
The US authorities have responded to the problem with an easing in credit conditions and it is highly probable that the Federal Reserve Board will reduce the benchmark federal funds rate to 5 per cent on 18 September.
The Bank of England has been less proactive. This may reflect the content of the Bank’s recent Quarterly Inflation Report, which stated that inflation risks have increased on the Bank’s two-year forecasting horizon. The rise in short-term deposit rates represents an indirect monetary tightening. Consequently, there is no need for a further Base Rate increase.
This view is reflected in the decline in longer term rates. This decrease has yet to be passed through to fixed term borrowers given the sharp rise in short-term rates. Period rates will decline marginally in the coming weeks, but fixed term mortgage rates will, on average, increase marginally as a number of lenders who are more dependent on wholesale funding withdraw their more finely priced mortgage offers.
Mortgage market resilient
This year’s mortgage market has shown a very strong level of lending, whether judged by net or gross advances, whether actual or seasonally adjusted data. Part of the demand reflected house purchase sales brought forward ahead of the introduction of Home Information Packs to three-bedroom properties on 10 September.
We now expect to see a temporary downturn in mortgage activity related to house purchase, although the refinance aspect of the mortgage market is likely to remain strong. Buy-to-let activity is also expected to remain around current levels, given the strength of rented housing demand from higher education students and migrants.
We expect the underlying level of gross advances to ease back to £28 billion per month, before returning to the £30 billion plus level in the Spring of next year as borrowers anticipate Base Rate reductions. The financial climate is more favourable from a personal sector customer perspective, given that there is unlikely to be a further Base Rate increase.
While short-term deposit period rates have risen substantially, the average customer is unfamiliar with wholesale funding costs. If, and when, the US authorities reduce their benchmark interest rate, we expect this to have a positive knock-on effect to UK housing market sentiment.
While the annual rate of house price inflation remains close to 10 per cent, the monthly rate of increase has slowed to around 0.4 per cent per month. We expect average house price inflation to remain around this level during the remainder of Q4 2007 and 2008. The above inflation increase reflects the continuing excess of supply over demand in many parts of the country.
House price inflation is not apparent in all regions of the UK. In parts of the Midlands and Northern England there are signs of a minor reduction in house prices in the less prosperous areas. In and around the major cities and in most parts of Southern England, housing demand continues to outstrip supply. The problem is more marked in Scotland and especially in Northern Ireland. Next year, we expect overall UK house price inflation be to be 6 per cent per annum.
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