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Bouncing back

  • 15/01/2003
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With the housing market seemingly propping up the UK economy, just how susceptible is it to macro-economic shocks, and is a crash likely to happen?

Due to the pessimistic nature of the work involved, economics has become known as the dismal science. Perhaps because economic commentators always point out possible difficulties ahead, they could be said to have what might be termed a ‘half-empty glass’ view.

However, looking at the global economy over the past few years, even this view might be seen as too rosy. Global economic growth slowed both significantly and simultaneously in the US, Europe and Japan in 2001 and this led to the sharpest slowdown in global economic growth since 1974. As a result, unemployment has risen in most of the world’s major economies.

And although global economic growth was higher in 2002 than in 2001, concerns over the strength and fragility of this recovery remain. In the US some commentators consider there to be a risk of a ‘double dip’ recession, and growth in the eurozone is decidedly slow.

This discouraging overall picture has occurred despite the substantial reductions in headline interest rates by monetary policymakers over the past two years. Since the start of 2001, the US’s federal funds rate has been reduced from 6% to 1.25%; official rates in the eurozone have fallen from 4.75% to 2.75%, and in the UK the base rate has fallen from 6% to 4%. But a dynamic and rapid economic recovery is still not yet in sight.

Doom and gloom?

This may all sound rather glum, but the forecast for the US and the UK is not that gloomy. Economic activity has started to recover, with growth in the US in 2002 expected to turn out around 2.4%, up on the 0.3% recorded in 2001. In addition, the UK economy has grown at an annualised rate of over 2% in the past two quarters.

Perhaps the real issue is the recovery is turning out to be rather slower than many commentators had expected at the start of 2002. As it is so slow, there are still many downside risks, such as being derailed by some negative shock. This means many commentators still see recovery as vulnerable to a setback.

There are several other reasons why the major economies are not rebounding smartly. One important fact is that companies have not yet started increasing their spending on capital investment ‘ new factories and machinery. This might be due to the boom in spending on high-tech equipment in the late 1990s, and companies may not yet feel the need to expand or upgrade equipment.

Another possible explanation might be that companies are not yet convinced new investment spending will prove sufficiently profitable. They may want to see a sustained pick up in product demand before committing to investment spending.

The major driving force behind the recovery we are seeing has been the continued strength of consumer-spending growth. In the US cheap finance deals have been important in boosting purchases of cars, and consumer-confidence measures have, until recently, been surprisingly positive for continued strong spending growth. In the UK consumer-spending growth has remained strong and over the past year increased Government spending has supported this.

The key question for overall prospects over the next year in the UK concerns how robust consumer spending will be. In the period leading up to 2001, it was argued that the steady growth of consumer spending in the UK owed much to the gradual decline in the number of people unemployed and the increase in the number in work.

With the decline in the unemployment rate effectively having halted and with the number of people in work no longer rising as sharply, the recent strength of consumer spending has owed much to the housing market. In particular, over the past two years the number of house moves has increased and there has been rapid growth in equity withdrawal.

On the move

Since home moves typically also involve a considerable amount of spending on new appliances and decorating, the impetus to consumer spending is quite straightforward. In addition, many households have increased their borrowing as a reaction to the increase in their equity in their property from the rise in house prices.

Surveys show much of this borrowing is used for spending on home improvements, buying ‘big ticket’ consumer goods or for holidays. From almost a standing start equity withdrawal reached £24bn in 2001. In 2002 it probably reached around £40bn, equivalent to around 5% of income.

A key issue is to what extent this increase in equity withdrawal will continue into 2003. Most households will have seen the value of their property rise substantially over the past five years and will not have withdrawn equity. So the potential exists for the high level to continue. If it does not, then one area of support for consumer-spending growth will diminish. It would also mean household mortgage borrowing growth, which has now reached record levels in absolute terms, would slow from the present rapid rate.

The price you pay

The prospect for house prices is a vital element for attitudes to the housing market in general. Over the past year, the rate of house price growth has been both extremely rapid and unexpectedly high. In the wake of a sharp slowing in the pace of economic growth and worries about the possibility of recession, considerable increases in house prices seemed unlikely. But in effect, the housing market has bucked the overall economic trend.

A large part of the explanation for the surge in house prices is the extremely low level of interest rates. Base rates falling to a 40-year low and remaining there for more than a year has boosted affordability and encouraged confidence in increased borrowing.

At the start of 2002, few thought base rates would end the year exactly where they started. Almost all economic forecasters, and financial markets, anticipated rising base rates as economic recovery took hold.

We have seen a modest upturn in economic activity, but it has been subject to uncertainties and has not threatened the continued achievement of low inflation. So base rates have remained steady.

At the same time as demand increased in the housing market, there was little by way of an increase in new supply. In 2001, fewer new houses were built than in any year in the last 50 years. 2002 saw a 5% increase in housing completions, but this is not sufficient to correct a growing supply shortage, particularly in the South East. This imbalance has also contributed to the rapid rise in prices and does not look like disappearing in the near term, thereby maintaining some upward pressure on prices.

However, as the level of house prices rises rapidly, it sets in train a natural mechanism that should reduce the future growth of prices. This effect is now being seen in some parts of the southern regions, especially London, and in some of the higher-priced houses where some early signs of slowing house price growth may already be present.

It is likely slower house pr- ice growth will be seen as 2003 unfolds. By the end of the year, house prices nat- ionally might be about 4% higher than they curr- ently are. This compares with house prices now being around 25% higher than a year ago. This slowing in growth is already evident in London, where house price growth has been fastest over the past two years.

Even in a year when house prices have been rising rapidly, some areas have seen house prices fall. Local factors are important and cold spots can counter hot spots, so price falls in some areas can never be ruled out.

The prospect for turnover in the housing market is also for a slowing of activity. One interesting feature of the market in 2002 was transaction volumes, which although up by around 12% on a year earlier, were below the peak level seen in the boom of the late 1980s. At almost 25% below the 1988 peak, it can hardly be said we have seen a boom in housing market demand over the past year.

If the housing market slows down, other parts of the economy may well show clearer signs of recovery. Faster global trade growth should boost exports and companies may start to spend more on capital investment once they see clearer signs of a global recovery.

With inflation likely to be above the 2.5% central target in the early part of the year as past house price increases feed through, the Monetary Policy Committee (MPC) may be tempted to change its voting pattern from one where some members favour base rate cuts to one where some members favour rises.

As the MPC plans two years ahead with its view of inflation, it seems likely that as we move through the year base rates may edge up during 2003. If this process starts, base rates may reach 4.5% by the end of next year. This would indicate a firmer hand on the tiller to direct a steadily sailing ship than an abrupt change of course.

Bright and breezy

The overall prospects for the economy in 2003 look brighter than they were in 2002, but not dramatically so. Growth may reach closer to trend pace but, by its nature, trend is only average. Inflation looks set to remain within the Government’s target range, but we might see it rise above the 2.5% central target for some months.

For the housing market, a return to more sustainable rates of house price growth looks on the cards. But in all economic forecasts there is the X factor. The risks to economic activity remain predominantly on the downside ‘ the global economy not picking up as strongly, or war in the Middle East, perhaps with rising oil prices, may add to global insecurities. The risks are often as interesting and important as the central expectation. This looks to be the case for the outlook for 2003.

Barry Naisbitt is chief economist for the Abbey National Group


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