What to do about the housing crash?
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Many still consider it premature to suggest that the UK residential housing market is about to crash, or is indeed already crashing. They therefore also think it premature to consider the impact that a housing crash might have on the economy. However, the fact is that many of the housing market statistics that we watch have greatly deteriorated in recent months - house price to income ratios make houses look even more expensive than they did before the 1989 crash, for example. For us, that implies that thinking about the economy in terms of a house price crash is a more pertinent thing to do than it has been for more than a decade.
For others, however, the fact that the house price to income ratio has soared so high seems to have bred complacency instead of fear. The fact that there hasn’t been a crash yet, goes the argument, means there probably won’t be one, and also proves that the ratio is the wrong measure to be using. Because so many of us buy houses with debt, the house price to income ratio is clearly less important than the annual cost of house price purchase to after-tax income ratio. This measure will naturally adjust for both the very low interest rates that we have been enjoying over the last few years and the very much higher than normal house prices, and should therefore be seen as a more accurate measure of the affordability of housing. This makes some sense as an argument. Ever since the 1990-1995 housing crash, households have chosen to keep the percentage of their after-tax income that they spent servicing mortgages constant at around 9% (the bottom line of the three). This wholly rational behaviour, in an environment of falling rates, has naturally translated directly into rising house prices (the less interest you have to pay, the more expensive a house you can buy for the same monthly amount).
However, there is a problem here: what you pay to service a mortgage isn’t just the interest rate, there’s a repayment portion too. And if you include the whole mortgage payment, it looks like rising house prices started to eat more and more into the household budget from about 2003 onwards. Combine this with the fact that rates started rising from their nadir of 3.5% in late 2003 and it appears that households have found the percentage of their disposable incomes required to service their mortgage debt has started rising nastily (and uncontrollably) and is already well above 12% (a 12-year high).
I say uncontrollably, because it is much easier to decide to take on a new debt than it is to decide to repay it when it starts to get expensive (especially if that debt is a mortgage). Also, house prices didn’t respond in the early 1990s to low rates and to people’s willingness to keep their absolute payments constant until after a lag. Likewise, there is always a lag before the culture of rising house prices is overcome. Note that according to data from Rightmove, in this cycle it certainly hasn’t been overcome yet: nationally, asking prices have just topped the highs of last summer. Unfortunately for these rosy-glassed sellers, buyers are no longer interested in making offers at record high prices. They’re looking for houses that are priced “realistically”, as the estate agents say (that’s “cheaper” to you and me).
If you add up all the average household debt repayments and interest charges, they now come to a whopping 22% of post-tax income - that’s the same proportion as the peak burden of 1990. Households are as stretched now as they were in 1990, a level that at that time triggered a dramatic change in attitudes and spending behaviour. People got scared, and suddenly savings rose - even though more after-tax income was being sucked in by debt-servicing costs. Consequently, consumption suffered and the economy dived into recession. In each of the last three housing downturns, house prices, adjusted for inflation, turned down year-on-year before the economy does.
What appears to happen each cycle is that the economy is strong initially, then quite late on in the boom housing picks up and house prices surge for a few years before overshooting, reversing, and diving into the red. In these circumstances, real house prices crash, and never by less than 10%-15% a year. And they keep falling by this sort of amount for at least four consecutive years (six years in 1990-1995).
When house prices turned negative year-on-year in each case, it is several months before the economy follows housing down. Thus from a simple cause-and-effect perspective, it seems clear that housing crashes beget recessions (as opposed to the optimistic but unfounded opinion of some estate agents that no housing crash is possible while the economy looks strong). Although house prices are still up about 10% year-on-year, already they are actually negative compared with six months ago. Unless house prices spurt again (which is unlikely), they will be negative year-on-year by September. Given that it usually takes a few months before negative real house prices feed into a negative economy, the best estimate for when we might go into a recession is between one year and eighteen months from now. Sometime in the summer of 2006, history suggests, we’ll enter several years of negative house prices and recession.
However, just because this scenario gives a gloomy outlook for house prices and the economy, there’s no need to rush to the conclusion that it is also automatically bad news for equities. Just the opposite, in fact: a poor economy, while it may be bad for sales, can be good for overall profitability, thanks to the fact that it often comes with interest-rate cuts. Once a house-price collapse starts, it’s generally too late to turn it around by cutting interest rates, but that never stops the authorities from trying.
History also shows that while housing and equities rise at about the same rate over the longer term, they don’t tend to have big up and down shocks at the same time, nor in the same direction. Equities dived during the 1974 oil shock, but nominal house prices rose (they fell in real terms because inflation was rampant). Likewise, neither the 1987 crash, nor the 2000-2003 dotcom crashes affected house prices. The good news for equities is that, as the 1980-1982 and 1990-1995 housing slumps proved, equities, though volatile at first, rose during both periods. Not only that, but house prices have clearly spiked above equities, which suggests they are relatively overvalued - just as they were in 1990. All this presages a period of much better returns from stocks than for bricks and mortar. For more tips on the UK housing market,see www.propertysurvival.co.uk.
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