The United Kingdom (U.K.) has recently been a subject of increased attention in the media and investment circles. An improving economy—particularly relative to its Eurozone neighbors—has provided a reason for optimism among economists and investors alike. However, rapidly rising home prices and accommodative monetary policy have also raised potential red flags.
The U.K.’s economy was hit hard during the global financial crisis. GDP growth fell precipitously through the latter part of 2007 and all of 2008, before bottoming out in 2009. Though growth began to pick up in early 2009, it wasn’t until around the time of the London Olympics in 2012 that the growth rate appeared to show a more sustainable upward trend. During the years immediately following the crisis, the newly installed Conservative government slashed expenditures as the economy went through a painful deleveraging period. Like the U.S., high debt levels contributed to the harsh recession. Deleveraging was a necessary, albeit painful, pill to swallow.
As U.K. consumers moved to unwind liabilities and improve balance sheets, policymakers understood that stimulative monetary policy would be necessary to kick-start a sustainable economic recovery. In addition to introducing three rounds of a large quantitative easing program, the Bank of England (BoE) also started a Funding for Lending Scheme (FLS) in July 2012, which was designed to encourage banks to lend to small-to-medium sized enterprises (SMEs). Though the program was originally implemented to increase lending to SMEs, much of the increased loan activity flowed to the mortgage sector. Housing received a further boost in March 2013, with the introduction of the Help to Buy Scheme. This program encouraged banks to lend by committing the U.K. Treasury to underwrite 15% of a mortgage’s value, provided the borrower put down 5%.
The combination of these programs, coupled with an improving economy, has worked to drive home prices up significantly over the last 18 months; national prices are now up 11.8%, year-over-year. Given the torrid pace of improvement, the BoE has recently taken several steps back from its attempts to reflate the economy, especially given the U.K.’s previous experiences with the housing market. The first of these came at the end of 2013, when BoE Governor Mark Carney announced that banks would no longer be able to use the FLS program to fund mortgage debt. More recently ,the BoE followed-up by announcing that U.K. banks were being held to a cap of 15% on new mortgage loans where the home price-to-income ratio is greater than 4.5x. In addition to this new ceiling on riskier loans, the BoE also mandated banks to conduct a new consumer stress-test that assumes that interest rates rise by 3%; those loan applicants that fail are being denied a mortgage.
Though these steps will most likely act with a lag, they could help to curb excessive price moves and add some degree of discipline into buyers’ decisions to purchase homes. However, government policy is not the only force driving up home prices in the U.K. The country is viewed as a safe place for foreign investors to own assets—particularly real estate—and is very friendly toward international investment and capital. There are other structural reasons for the strong appreciation of British property in recent times. Earlier this year, Carney commented that Canada, a country with a population half of the U.K.’s, builds twice as many homes annually. Thus, supply and demand issues also act to drive home prices higher.
Given the move in home prices since early 2013, it is prudent for the BoE to be wary of excesses forming in the economy. Considering that mortgage rates are typically adjustable in the U.K., increasing benchmark interest rates in an effort to cool lending could have a negative impact on still highly-indebted households. U.K. policymakers have a tough task at hand in needing to avoid a new housing bubble while providing capital to a healing economy. This is particularly true given the size of the U.K.’s financial sector relative to the overall economy and the fact that the UK still runs a large current account deficit and is reliant on foreigners to buy its sovereign debt.
In our view, these factors make it more likely that the U.K. will continue to apply macro-prudential measures to select areas where they see excesses, while promoting credit availability to other areas still in need of investment. While BoE Governor Carney has moved to remove the housing stimulus, he has also recently stated that the economy is likely to see a much lower neutral interest rate in the coming years. This means that the BoE, while vigilant of new asset-bubble risks, still has a bias towards avoiding potential deflation in the near-to-medium-term.
While the U.K. is moving further along in the business cycle, we continue to see investment opportunities in the equity market—especially in multi-national companies levered to global growth. International companies domiciled in the U.K. are exposed to earlier-cycle recoveries as well as secular growth trends in other parts of the world, and they tend to be very well-managed and competitive globally.
The U.K. housing market does bear monitoring in the months ahead. We would likely become less constructive on the country and equities exposed solely to domestic dynamics should housing prices continue to rise unabated, forcing the BoE to take a more hawkish stance. This may be a risk for the U.K. investment case tomorrow, but current policy is still accommodative. There are numerous reasons to believe that the BoE and other domestic policymakers will try to rein in the pockets of excess, while keeping money flowing to parts of the economy that have a genuine need for it.
