House prices sink further – batten down the hatches

Housing market: House prices sink further batten down the hatches - at - the best of the week's international financial media.

No sooner has everyone agreed that the housing market has probably topped out than the talk turns to how that must mean the interest-rate cycle has peaked too. According to The Daily Telegraph, the bond futures markets are showing that the consensus expectation is for base rates to remain unchanged for the next 18 months at 4.75%. Indeed, most journalists and many economists are now concerned not with rising rates, but with when we can expect lower interest rates.

Markets just doesn't work like that

But it won't be that simple. Things just don't work like that, or certainly they have never worked like that before. As Newton's Third Law of Motion suggests, for every action there is a reaction. You can't give an economy the sort of unnatural boost that the UK has received under Gordon Brown (massive monetary and fiscal stimuli to an already strong economy) without developing some major imbalances - imbalances that now have to readjust.

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In the space of not much more than a decade, interest rates have fallen from a near post-war high of 15% to just 3.5% a year ago - a post-war low. This huge swing first gave us extended economic growth and then, in turn, a bond market bubble, followed in 2000 by an equity market bubble and, finally, up until three months ago at any rate, a housing bubble. It has also led to an enormous surge in debt: in what we owe to the banks, what the Government owes to the bond market and what our country owes to its trading partners. With rates on the rise, what if all that borrowing was even partially redirected to savings? That would have enormous consequences for spending and growth.

It's going to get worse

The First Law of Thermodynamics, the law of the conservation of energy, states that energy cannot be created or destroyed, it can only be moved around a bit. The same goes for another type of energy: economic activity. You can suppress saving if that's what you want, and even cause debt-financed spending by lowering the cost of borrowing - but (crucially) only once, and only with the undesirable side effects of asset-price inflation and ballooning debt. If you squeeze one end of a balloon, the other end expands, but when you let go, the air rushes back. The system eventually reverts to equilibrium.

To me, that means that rates will stay higher for longer than people predict, because to get the system back in to equilibrium they always do. It works like this. Housing sell-offs always hit household spending, which makes up two-thirds of the economy. When that falls, unemployment rises. That hits the economy again, and all this economic weakness ends up being reflected in weakness in the currency. Finally, this in turn gives us our classic late-cycle inflation surge (all those imports we got a taste for during the previous up-swing now cost more in sterling terms. And with inflation on the rampage, interest rates can't fall that much.

This unpleasant series of events has already started. The most recent data from the National Association of Estate Agents (NAEA) suggests that house prices are down 4.5% over the last three months. That's about 17% annualised, or nearly the same amount in nominal termsthat the market dropped during the six years of the housing crash in the 1990s already. Some advisers are recommending that people don't try to get mortgages for now, thanks to teething troubles with new regulation, and for the same reason there is also the distinct possibility that lenders have set rates unattractively high to put people off until the new year. Given this state of affairs, price falls and activity levels should continue to plummet for at least the rest of this year.

Some people feel that "the rises and falls we have seen in prices in recent months are part of the ebb and flow of the market", as Halifax chief economist Martin Ellis puts it. He now sees the market levelling out "as it finds a new base". But Ellis is wrong. The Second Law of Thermodynamics tells us that all systems degrade towards disorder - they change constantly. That's true for economies as well. The one outcome we can be fairly sure that we won't see is things staying the same. After such a big run up, house prices won't level off. They'll either start going up again or they will fall further over the coming years. All the evidence suggests that they'll fall.

then there'll be a recession

And then we'll get the recession bit. The fact that each of the major housing downturns since 1960 saw sharp falls in real spending leading to full-blown recession is, warns Jonathan Loynes, chief UK economist at Capital Economics, "clearly ominous". He's right, but it is the next bit where, in my view, he goes wrong. Loynes expects the recessionary environment to cause interest rates to fall. Like many others, he thinks interest rates have peaked and that, thanks to falling house prices, they will soon have to come down to encourage the spending necessary to bail-out the economy. (Loynes expects at least a 20% fall in the UK housing market.)

But Loynes hasn't taken into account the inflation I mentioned earlier. In the past, consumer price inflation has always peaked about two years after house prices, and there's no reason to expect it will do otherwise this time, even if it will be from a lower level. So although the Monetary Policy Committee might want to lower rates next year to bail-out the domestic economy and the housing market, it is likely to be constrained from doing so as rapidly as it might like because the currency will be weakening, exports will be recovering, and inflation will most likely be rising. Those who aren't convinced should let history be their guide. After all previous housing downturns, none of which were initially forecast to be that bad, the economy collapsed and unemployment soared by at least 40%. You'd have thought policymakers would have leapt to cut rates, wouldn't you?

But they didn't. So unless there's a theory explaining why policymakers were much more stupid then than they are now, we'll have to find another way of explaining their actions. The clear evidence is that, as the economy falls, the currency falls, exacerbating the delayed nature of latent inflationary pressures (anyone notice commodity prices or the oil price this year?). Falling house prices are only the start of a much bigger story. Suddenly, if you can imagine it, there's a larger story to deal with than house prices.

So what is to be done?

With house prices falling and set to fall further, perhaps you should consider selling up and renting. Indeed, with the pound likely to be the next victim, maybe you'd be wise to rent abroad, with a large two-year downpayment up-front. And at today's exchange rate, wouldn't that be the best plan? I'd also recommend having a word now with your household's biggest spender before your bank manager makes forced cut-backs on her credit-card bill conditional on retaining your house. Perhaps taking out unemployment insurance makes more sense than usual too. Basically, if you have hatches, get them battened down. You can't rely on lower rates to bail you out until long after the storm has passed.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.