Will 2017 be another year for the history books?

A stormy year for Britain

19^th January 2015

A little late but this is my prediction for the year. It is difficult to be precise but 2017 will probably be the year the housing bubble burst and when that happens the UK economy will fall into a deep recession. But before we explore the fortunes of the coming year a quick look back at my prediction for 2016.

As in previous years I got the general mood of the economy right; a continuation of the indifferent growth driven by the housing sector. This is despite the biggest political event to impact on the UK economy for a number of years which of course is Brexit. It wasn't really on my radar, as a long with many other I did not think it was going to happen. If this view prevailed it would have been no more than a footnote in history. That we have voted to leave, changes that but to the surprise of many it has not manifested itself in the economy yet, although my own view was a little more sanguine on the short term consequences. In retrospect it is not surprising that an economy driven mainly by confidence in the housing market should react immediately. With the vote split down the middle, the optimism of those who won will cancel out the pessimism of those who voted to stay, such that confidence in general has remained pretty much the same. This in turn provides the assurance house buyers and more importantly lenders that the housing juggernaut remains on track to produce the interest payments that have been fuelling growth over the last few years. The fall of sterling suggests that international opinion differs to that domestically but even this has not dented the public's confidence if anything it may have created the impression of a golden period with surge in some exports and retailers currency hedging holding prices down.

Returning to 2017. As in recent years the UK economic fortunes in 2017 will be determined by the health of the housing market. In earlier years the steady rise of house prices has fed into the real economy driving a 2% growth but following a surge of buying in the spring, to avoid change in stamp duty, these rises have tapper off. In fact one of the three housing indexes, the Nationwide, shows prices peaking in August. At the same time of this house price stagnation the number of property transactions has reduced by 10%. Interestingly mortgage lending has over this same period has remained constant suggesting that some cash buyers or those using equality in other properties have withdrawn from the market. That a relatively small drop in demand can cause prices to change direction suggests that speculation has been behind much of the recent rises and that the market is quite weak. This in turn suggests that the property bubble is close to bursting. Looking back at 2008 and 1989, prices also peaked with gradual falls for a few months before tumbling. Using these events as precedence we could expect prices to tumble in February or March. Whether they do is another matter, by the standards of the last bubble prices still are relatively low and many commentators including the Bank of England expect moderate increases. What will decide it is whether the cash buyers return before lenders view the gradual fall in prices as more than a temporary blip. Anecdotal evidence from the estate agents windows would suggest the later with the number of red triangles indicating reduced or new instructions. Yet more anecdotal evidence of the slowdown has been the extended period of To-Let signs around some blocks of flats and other properties following that price hike in the spring, suggesting that achievable rents may not justify that paid for recently sold properties. Finally the London market that proved so resilient even after 2008 is falling. In 2016 prime London property values fell by 6.3% and in the same way as price rise rippled out to the rest of the UK so too will the decline. The likelihood of the London market returning to profit are even less likely to happen as it requires the return of the international cash buyer who will not only be deter by the falling property values but also a falling currency. On top of this but London has seen whole groups of cash buyers disappear. Gone are the Russians through sanctions, Asian banks are refusing London mortgages for the overseas Chinese and anti-corruption rules are being put in place to prevent criminal gangs using property for money laundering.

So what happens to the economy in 2017. If this fall in property value is only a temporary blip and they start to rise again or even just stagnate then we will see what we have become use to unspectacular growth in the order of 2% for next year, not taking into account inflation. If on the other hand the bubble does burst then for a few months it will seem to have no impact on the real economy and we will still see GDP growth at 2% per annum (or 0.5% quarter) for the first quarter. This is because of the four month lag between the increase in the money supply through lending and it effect on growth which is explained elsewhere on this blog and in my book An Interesting Theory. If the lenders did start to react to a fall in prices by reducing their new lending in February or March then we would only expect to see the GDP growth fall in the third quarter, although there would be plenty of warning sign earlier on with businesses associated with property closing or downsizing. As house prices fall so the banks will further reduce their lending but they don't stop altogether, even at the depths of the 2008 aftermath UK lenders approved 47,715 new mortgages in one month, they will just significantly reduce the amounts. Each reduction in lending has a knock on effect on growth and in turn confidence in the property market that leads to a circle of decline. A point will be reached when new lending is less than the banks are taking back in loan repayments and then money supply is contracting as will the economy. Eventually an equilibrium point will be reached where house prices, employment and wages all stabilise and banks are prepared to start lending again. If 2008 is anything to go by we could expect three quarters of contraction before we reach the bottom and on this basis the economy could be 3% smaller in March 2018 than it is now and the average house price at value much as it was then; about £180,000.

However there are differences between now and 2008 all of which make the UK economy a lot weaker. The most significant of these is the currency exchange rate. At rate of £1.22 to the dollar imported goods will add about 2.5% to the inflation rate but without a source of new money that comes with new lending this inflation will manifest itself as a 2.5% cut in GDP. The fall in the exchange rate will have a second impact on GDP and that is through the trade deficit. Currently the UK imports are running at £35 billion a year more than it exports or put another way this represents 1.95% of GDP and this has been going on for years. The reason the UK has been allowed to get away with this before is that the booming London house market has provided a profitable place to hold sterling even during the turbulence that followed the great depression, but as house prices turn in the other direction this incentive falls away. In all probability exporters to the UK will start demand dollars and Euros up front rather than on hock that has become the practise of the recent past. In total the UK economy could be 6.5% smaller by next March and this is ignoring further losses resulting from business closures or the effects of Brexit. On the positive side we will see a pickup in exports and tourism through the lower exchange rate of the pound but this in no way will make up the difference. Government will feel the need to step in but again it is unlikely to be enough especially for one that still sees austerity as solution to our current low growth. The Bank of England will cut interest rates even further which will have no effect unless they go into negative territory. With all this happening we can expect house prices to continue to fall leading to further contraction etc. in a affect a vicious circle. It is worth noting that house prices continued to fall 36 months following the 1989 crash. Can we expect a similar recession to then?

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