Wednesday, September 29, 2004

An almighty crash or a soft landing?

RICS Business
Never has opinion been so divided. Anna Minton presents an overview of the key factors causing the clash of consensus.

When "Dr Doom" predicted stock market meltdown in 2001 he was proved right. The question now is whether his latest intervention prophesying a housing crash will be similarly accurate, or not.

"Dr Doom" is otherwise known as Tony Dye, the economist who correctly predicted the collapse of the stock market in 2001, hence the moniker. This April his widely reported comments that house prices were set to fall by 30 per cent fuelled the fire of an already overheated debate on the future of the housing market, dominated by bears and bulls and the softer landing theorists in between.

That the booming housing market is a key problem for government was reflected by the Treasury-commissioned Barker Review into housing supply, which concluded that the main problem is affordability. The paradox for government is that while exponential house price growth prevents the less affluent from gaining a foot on the housing ladder, it is also the motor for the UK’s healthy economic growth.

Defying the predictions of the bears, so far house prices have continued to rise, despite increases in interest rates, but the bears have, if anything, increased in number. In early 2003 Andrew Oswald, professor of economics at Warwick University, argued in The Times that a housing crash should be expected between 2003 and late 2005. Then came Tony Dye’s remarks. Roger Bootle, the former Monetary Policy Committee (MPC) member and director of Capital Economics, is another bear who estimates falls of around 20 per cent. Oxford University academics John Muelbauer and Gavin Cameron, who run a website called Housing Outlook, also believe the UK is witnessing a classic economic bubble and compare the present boom with that of the late 1980s.

However, if the consensus among academics is that sharp falls at the very least are on the way, prominent bulls argue that it is they who have called the market more accurately so far. John Wrigglesworth, housing economist at Hometrack, the online property specialist, has consistently predicted gains and opposed the notion of either a crash or a soft landing. He now believes the market will level out.

However, these bullish views are in the minority. Lenders ranging from The Halifax to Nationwide are warning that the market is beginning to slow, a view shared by RICS.

"The market is overstretched to such a degree that when it does eventually level out, prices will be vulnerable to a sharp reversal because buyers, sellers and lenders are all aware of the over-valuation," says RICS economist Ryan Emmet.

With experts commenting on the same indicators and market conditions, why are there such differences in opinion?

Professor Oswald believes that as most of the statistical information about the UK’s housing market is still produced by building societies they, of course, have a direct interest in high prices. "It is not good for the public that we are short on independent commentators about the market for homes," he says. Certainly the housing boom has been accompanied by a marked growth in house price indices, ranging from Hometrack’s own index to the FT’s new house price index, not to mention the new index from the Office of the Deputy Prime Minister.

Even so, despite his cynicism, even Oswald would no doubt agree that there is a genuine difference of opinion based on differing inter-pretations of market fundamentals.

For the bears, their argument rests on the critical importance of the ratio of house prices to average incomes, which has always served as a warning indicator of previous housing busts. The cost of an average house is now between five and six times average income, a ratio that is as high as, or even higher, than before the last crash. Overall household debt is also currently at an all-time high.

During the late 1980s, similar ratios of house prices to average incomes combined with a surge in interest rates to produce the consequent crash. For those with a more bullish attitude to the market, the low inflationary climate and relatively positive economic outlook mean that those sky-high interest rates are unlikely today. While they acknowledge that debt levels are growing, they feel that so long as the cost of servicing that debt is manageable then households can stay on an even keel.

As ever, the key question with regard to property prices remains what will happen to interest rates? Giving some indication of their future direction, Bank of England chief economist Charlie Bean has said interest rates policy is designed to cool the economy without "clobbering" the consumer. The general consensus appears to be that interest rates will continue to rise, peaking at around 5.25 per cent at the end of the year, after which they will level off.

This would indicate that an all-out crash is unlikely. Even so, for those with mortgages of five or six times income, it would not take a crash to push overstretched households over the brink. Sabina Kalyan, property economist at Capital Economics, does not believe the 20 per cent downturn she predicts will spark off a recession, although it is likely to cause varying levels of difficulty for indebted consumers. "We call it a correction, not a crash," she says.

"I don’t think it will be as widespread as the early 1990s or affect the wider economy in the same way in terms of negative equity. We won’t see a slowdown spread to a widespread recession."

But both Kalyan and Emmet at RICS point out that there are new factors at play in today’s boom that were not present last time round. Chief among these is the upsurge in the buy-to-let market, sparking particular worries that unprecedented rises at the bottom end of the market are unsustainable. The dramatic price increases in previously low-value terraced housing in towns across the north of England have led to surprising figures from the Halifax showing that towns like Hartlepool, Darlington, Bolton and Crewe are topping the list of UK property hot spots with rises of between 50 and 60 per cent.

"The clincher for crash theorists is buy-to-let," says Emmet. "It could come from the bottom end of the market, which is being driven by amateur investors acting specul-atively. Serious signs of a slowdown could trigger the selling of buy-to-let properties."

"It’s hot money, not a personal home," warns Kalyan. "Investors can liquidate it just like that. As fast as the money flows in it can flow out." But, keen not to set her stall out on this particular aspect of the debate, she adds: "There is evidence that yields are falling and investors are not making so much money, but it’s not clear that there’s anything else for them to switch to. They may not be too worried by a small running loss."

The other great unknown is the possibility of an external shock that could trigger a crash, ranging from a terrorist attack to oil price rises. The most speculated outcome is that US interest rates will rise, ensuring increases in the UK will be higher than predicted.

Given the overstretched borrowing levels of UK consumers, in the context of an over-valued market, that would almost certainly lead to a sharp fall in prices. But, as Kalyan says: "I wouldn’t stake my pension on whether it’s going to be 15 per cent rather than 20 per cent or 25 per cent."


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