A series of mortgage rate cuts early in the year and a further decline in unemployment coupled with the healthy state of the household sector’s finances, stimulated renewed buoyancy in the housing market this year. As a result, annual house price inflation accelerated to double figures over the summer.
House price movements over the past few months, however, indicate another clear shift in the underlying trend, with prices increasing at a somewhat slower pace compared to those seen earlier in the year. This tallies with reports from estate agents and house builders, with the latest market figures on the number of mortgage approvals showing signs of a slowdown in housing market activity.
The weakening in the housing market has largely been in response to the general easing in the pace of economic activity this year, with the softening in consumer confidence since the summer and the recent fall in employment being particularly important factors. A knock to consumers’ confidence in the immediate aftermath of September’s terrorist attacks in the US also appears to have contributed to the slowdown.
The marked slowdown in the global economy, the sharp falls in the stock market of the past year or so, and the effects of the foot-and-mouth outbreak are likely to ensure UK economic growth remains sluggish over the next 12 months.
There are, however, good reasons not to be too gloomy about the UK’s economic prospects. To date, the economy has weathered these adverse factors well, and we expect recent fiscal and monetary policy decisions to support activity and prevent a protracted and deep slowdown.
Tax cuts and pension rises are boosting household disposable incomes, and significant increases in Government consumption and investment are beginning to be implemented. Likewise, the quick response by the Bank of England to lower interest rates in response to the deteriorating global environment, should also help to underpin demand.
Indeed, the UK remains the one bright spot among the world’s major industrialised economies. Recent figures show that overall economic activity ‘ measured by gross domestic product (GDP) ‘ picked up between the second and third quarters, with GDP increasing by 0.6% in the third quarter ‘ a figure that is broadly in line with the UK’s long-term average quarterly growth rate.
There are, however, clear signs of some softening in the current quarter, with several signs that consumer demand, which has been the main driving force behind the UK economy, is losing momentum.
The recent downward trend in consumer confidence continued in October, and retail sales volumes fell in October for the first time in 18 months. There have also been signs that mortgage lending may have passed its peak, although lending remains strong.
The extent of this slowdown in UK consumer spending, however, should not be exaggerated ‘ the indications remain tentative and consumer demand is still robust. Overall, the UK looks far less likely to go into recession than the US or continental Europe.
Nevertheless, the recent deterioration in the global economy has prompted us to revise down our forecasts for UK economic growth. GDP is predicted to rise by a modest 1.5% next year, before returning to above trend growth (2.7%) in 2003.
The deteriorating global economic picture and the difficulties experienced by the UK’s trading sector could cause the Bank of England to cut interest rates further over the coming months. However, the underlying strength of credit growth and household spending is likely to mean interest rates will need to rise during the second half of next year. We predict bank base rates to head back to 4.5% during the second half of next year and on to 5% in early 2003.
An economic cushion
So, what does all this mean for the housing market? Essentially, the market is likely to continue weakening over the next 12 months in response to the slowdown in the wider economy. Nonetheless, continuing economic growth, low interest rates and housing affordability levels that are not stretched should support the housing market, preventing a collapse in prices.
This comment about affordability may seem surprising. The 30% increase in prices over the past three years has comfortably outstripped earnings growth ‘ again causing the house price to earnings ratio to rise.
However, it has risen from a low level and currently stands at 3.8. This is broadly in line with the long-term historical average of 3.6 and shows no indication that housing has become ‘unaffordable’.
Yet while this holds true for the UK as a whole, there are marked regional differences. The recent surge in house prices has been largely confined to southern England, with price rises being much more modest elsewhere in the country. As a result, the house price to earnings ratio exceeds its long-term average in Greater London, the South East, the South West and East Anglia. The gap between the current ratio and the historical average is most pronounced in London, where the multiple currently stands at 5.4 compared with its long-term average of 4.2.
The high level of prices in relation to earnings in the South has led some commentators to conclude the current level of prices is unsustainable and prices must inevitably fall in this part of the country to restore the price to earnings ratio to its ‘equilibrium’. Such analysis completely ignores the role mortgage rates play in the ability to buy a home and service the mortgage payments on that property.
A question of affordability
With mortgage rates at their lowest level for over 40 years, mortgage payments as a proportion of income are currently lower than they were three years ago, despite the rapid rise in house prices over that time.
At the moment, mortgage payments account for 17% of average gross earnings. This is below the long-term average of 22% and is considerably below the 37% peak reached in the early 1990s when mortgage payments rose substantially, following a doubling in base rates from 7.5% to 15% between 1988 and 1989.
This sharp rise in payments contributed greatly to the problems of arrears and possessions in the first half of the 1990s, as many homeowners were unable to keep up with their payments. Moreover, the current situation is remarkably consistent across regions. The proportion of earnings devoted to mortgage payments is below the historical average in all regions on the British mainland, including London.
In brief, the various measures of affordability do not suggest the market is poised for an imminent slump. The combination of high house prices relative to earnings and a huge proportion of income being taken up by mortgage payments ‘ which was a key factor behind housing market recession in the early 1990s ‘ is absent. Moreover, it is difficult to envisage such a combination developing in the foreseeable future.
The broadly favourable affordability background should help keep house prices rising over the coming year although at a slower pace than over much of the last two to three years. Prices in the UK are predicted to rise by 4% in 2002 following a 9% increase this year.
Regionally, the high ratio of prices to earnings is above its historical average in southern England which will constrain housing demand. Moreover, the prospect of significantly lower City bonuses early next year compared with the previous two years, and the adverse effects of the recent slump in equity prices, are also likely to contribute to a continuing slowdown in house price inflation in Greater London.
Against this cautiously optimistic assessment of the housing market’s prospects, the mortgage market will remain fiercely competitive over the coming years and we expect to see more customers opting for flexibility.
With the likelihood of rising interest rates later next year, many customers may opt for fixed rate products to ensure certainty of payment. However, rates will remain at relatively low levels and as such, discounts and trackers will still be a popular choice. As the market will remain competitive a lot of emphasis will remain on the ‘headline’ rate of mortgage products, although customers should ensure the APR, which is the true cost of borrowing, is used to make comparisons.
The UK is far less likely to go into recession than the US and continental Europe.
Bank base rates are likely to go back to 4.5% in the second half of next year.
House price growth will slow to 4% in 2002 following a 9% increase this year.