UK Property Market – January 2010 Update

I am yet to buy myself a flat or house even though the ownership of one is important to my retirement investing strategy in the longer term. The reason for this is that in my opinion UK house prices are still overvalued by a huge margin. Yesterday the Nationwide reported that average house prices had risen from £162,103 to £163,481, a rise of 0.8%, in a single month pushing house prices to yet more highs of un-affordability.

Chart 1 shows the Nationwide Historical House Prices in Real (ie inflation adjusted) terms. The Real increase is much less than that reported by the Nationwide with prices rising from only £163,140 to £163,481 as the UK Retail Prices Index (RPI) also increased by a high of 0.6% in a single month.

This chart also demonstrates that compared to average earnings property is very expensive when a ratio is created of the Nationwide Historical House Prices to the Average Earnings Index (LNMM) and it is for this reason I have yet to buy. In 1996 this ratio was as low as 607 and today the ratio stands at 1,172. If we were to return to that number the average house using the Nationwide Index would be £84,670. Will we ever get that low again?

Last month I questioned whether we may have been at the point of the ‘Return to “normal”’ phase kicking in. Chart 2 today highlights why I may have been early in my call. The red line shows the monthly average of UK resident banks interest rate of new loans secured on dwellings to households. I have taken the average of five data sets which are the floating rate, fixation <=1year, fixation >1year<=5years, fixation >5year<=10years and the fixation >10years. This interest rate had been as high as 6.3% in September 2008 (before the Bank of England panicked and lowered the Official Bank Rate to a record low of 0.5%) and then had reduced to a low of 4.2% by June 2009.

This has meant for new loans the average interest payable has reduced by a 1/3. So when a typical person walks in to a bank and asks for the maximum they can borrow the low interest rate is going to mean they can borrow more principle which will then push up house prices. The good news however is that even though the Bank of England has not moved, the Official Bank Rate the interest paid on loans is starting to increase from the low of 4.2% to 4.5% in November 2009. This will reduce affordability which unless peoples earnings start to increase should start to push house prices back down again and there is little the Bank of England can do unless they completely ignore inflation and drop interest rates even further or perform more Quantitative Easing. They clearly won’t be able to do this without risking a bond strike or hyperinflation however personally I do think they won’t raise interest rates even though inflation is rising quickly when they meet in a few days.

Chart 3 shows the annual change in Nationwide property prices and compares this with the change in the average earnings index extrapolated a couple of months to match the Nationwide time period as LNMM is still only released to November 2009. It shows that the annual change in earnings is now around 1.4% which is significantly less than the Retail Prices Index (RPI) and the increases being seen in house prices.

So in summary house prices are increasing in nominal and to a lesser extent in Real inflation adjusted terms. However in my opinion I suggest that these increases will be short lived. Salaries are increasing at a rate which is less than both inflation and house prices. Bank mortgage rates are starting to increase from their lows which will reduce the level of principle that can be borrowed. The Bank of England and government are powerless to do anything about it without risking the country as a whole. The only fear I have now is that the Bank of England holds interest rates allowing inflation to rise quickly (I think they will) resulting in nominal house price increases but stagnation in Real inflation adjusted house prices. This will be dependent on whether salaries start to increase in line with inflation. The private sector doesn’t seem in a position to do this however while government borrowing is at record highs I fear the government will listen to the Unions requests for big increases as they have an election win to try and buy.

For now I’m staying out of the housing market.

As always DYOR

Assumptions:
LNMM data is extrapolated for December ’09 and January ’10.

How can banks be back to big profits and big bonuses so quickly?

One method the banks are clearly using is to widen the margin between what they borrow at compared to what they lend at as can be clearly seen in my chart today. This means that any interest earning cash that I am holding as part of my retirement investing strategy is losing out over the potential interest rate that I could have once expected with the extra hair cut being used for banks earnings and bonuses.

The blue line shows the monthly average of UK resident banks interest rates of new time deposits with a fixed original maturity from households. I have taken the average of three data sets which are the maturity <=1year, maturity >1year<=2years and the maturity >2years.

The red line shows the monthly average of UK resident banks interest rate of new loans secured on dwellings to households. I have taken the average of five data sets which are the floating rate, fixation <=1year, fixation >1year<=5years, fixation >5year<=10years and the fixation >10years.

The average interest rate paid to households between 2004 and 2007 was 4.81% with the average borrowing rate being 5.47%. That gave the banks a margin of 0.67%. In the last year the average rate paid has been 3.13% with the average borrowing rate being 4.53%. The banks have widened their margin to 1.41%. Finally, in the last month of the data set (November 2009) the banks have been able to further widen their margin to 1.69% with the average rate paid to households being a low 2.84%.

Bank of England datasets used:
Time deposits – CFMBI84, CFMBI85, CFMBI86
Loans – CFMBJ39, CFMBJ42, CFMBJ43, CFMBJ44, CFMBJ45

How to Make a Million UK Pounds

According to the Camelot Group around 70% of the adult population regularly play The National Lottery. Personally, I find that number worryingly high. So while I suspect 70% of the population think that this is one method to make a million I personally don’t like the odds with around a 1 in 14,000,000 chance of hitting the big one.

I’m going to propose an alternate method for UK residents. Unfortunately my method is not as instantaneous and involves a lot of dedication. However I think my method has much better odds.

So how does it work?

The first thing I need is a stocks and shares ISA. These are a great product as once your money is invested in one all returns are tax free. I have to be careful though and ensure my stocks and shares ISA does not charge me an annual fee. As of the 6th April 2010 every UK saver will be able to invest up to £10,200. For my method I’m going to suggest I stay very focused and invest the full £10,200.

The next thing to do is to decide what stocks and shares to buy within my ISA. Tim Hale in his book “Smarter Investing : Simpler Decisions for Better Results” suggests that the arithmetic average for UK real (after inflation) equity returns could be 7.0%. He also suggests UK real (after inflation) bond average returns could be 2.3%. So I’ll take these two building blocks and build a basic portfolio that consists of 60% UK equities and 40% UK bonds. I then decide to rebalance this asset allocation regularly. This could give me an average real return of around 5.1%.

Now I need to buy those equities and bonds. With a bit of shopping around I should be able to find exchange traded funds (ETF’s) for both UK equities and UK bonds to buy within my ISA with fees of less than 0.5% per annum. I’ll be conservative and assume I spend the whole 0.5% meaning my average expected return is now 5.1% - 0.5% = 4.9%.
Now of course the UK government always wants a bit of inflation. Since 1988 the average of the Retail Prices Index (RPI) has been around 3.5%. So I’ll add the inflation on 4.9% + 3.5% = 8.1% to give an average expected annual return.

Now I’m going to let the magic of compound interest go to work.

After 5 years I’ve invested £51,000 of my own money and assuming straight line average returns I might have around £65,000.

After 15 years I’ve invested £153,000 of my own money and compound interest has started working for me as I might have around £302,000.

After 25 years I’ve invested £255,000 of my own money and I might have around £821,000.
Finally, after 28 years I’ve invested £285,600 of my own money and I might have around $1,073,000. I’m a millionaire.

Of course in 28 years my one million pounds won’t have the buying power of today. Assuming the 3.5% inflation I mentioned above means my £1,000,000 would be worth around £587,000 today. That however is still a lot of money.

As always DYOR.

Stagflation and the UK Q4 GDP Numbers

Firstly, some quotes to think about:
1. "Now in Britain, we are saying, as you know, that inflation is low, interest rates are low and we expect there to be growth.” – Gordon Brown, 2008
2. "We have a strong economy, its momentum will carry us through." – Alistair Darling, 2007
3. "I think the choice is becoming pretty clear. Between a government that is determined at all times to maintain the stability and growth of the British economy. “ – Gordon Brown,2007
4. “...a weak currency arises from a weak economy which in turn is the result of a weak Government.” – Gordon Brown, 1992

So the UK today emerged from recession. What an excellent [sic] job the current government and the Bank of England has done managing the UK economy over the business cycle. Today we find that the UK economy (GDP) has grown by 0.1% in the final three months of 2009. To get these outstanding [sic] results they’ve only had to lower VAT to 15%, lower the Official Bank Rate to 0.5% (the lowest rate in the history of the Bank of England), quantitative ease to the tune of £200 billion and introduce a car scrappage scheme to name but four.

This has all resulted in:
- house prices that are within 13% of record peaks. Of course that’s great news if you’re a “hard working family”, sorry, hard working politician with multiple houses partly paid for by the tax payer.
- a heavily devalued (weak) pound.
- low returns from bank deposits / bonds for those people trying to live on savings or save for retirement.

To go with this we have the Consumer Price Index (CPI) increasing at a rate of 2.9% including the largest month on month in history and a Retail Prices Index (RPI) increasing at a rate of 2.4%.

Now I’m going to get my crystal ball out and predict how the Bank of England is going to respond. I’m betting that they will leave the Official Bank Rate on hold at 0.5%. This in turn will lead to the next big issue for UK PLC. Firstly inflation will take off, then salary inflation will start as the public sector unions negotiate first just before the election and then others join the band wagon. This will then lead to built in inflation which the Bank of England will struggle to get back in hand.

I have one word for where I think the UK economy is headed – stagflation.

To conclude I’m going to modify the four quotes above a little. “Inflation is not low”, “we do not have a strong economy”, “we do not have stability and growth” however we do have “a weak currency”.

Gold Within My Retirement Investing Strategy – January 2009 Update

Within my Retirement Investing Strategy I currently hold 3.1% (up from 2.6% at the last gold update due to a buy decision made this month) of my portfolio in gold with a targeted holding of 5%. Gold is the only portion of my portfolio that does not provide a yield (dividends, interest etc).

The first chart shows the real price of gold since 1968, with the wild ride that comes with gold obvious. This month the real (after inflation) price of gold has fallen by about 3.2% to $1,096.00 per ounce. The trend line however suggests a price today of $631.00 up from $630.00 at the last update. The historical average real gold price from 1968 to today is $600.52. So by both of these measures gold appears overpriced.

The correlation between the real S&P 500 (also displayed on the first chart) and real gold lowers slightly from the last update which was -0.34 to -0.33. The second chart provides the ratio of the S&P 500 to gold demonstrating just how far apart the two can vary. Today this ratio is 1.00. The trend line however suggests a ratio today of 2.6 and the historical average ratio from 1968 to today is 1.63. So this measure would suggest that if you were looking to choose to buy the S&P 500 or gold then the S&P 500 might be the better option.

The final point to make however is that while both the first and second charts suggest gold is overpriced on historic measures I cannot forget that in 1980 gold reached an average real monthly price of $1,728 which is a long way above where we are today.

I made the decision to buy gold. Largely this is because I have set myself mechanical requirements that bring little to no thought process or emotion into the decision. Only time will tell if the decision was correct.

As always DYOR.

Assumptions include:
- Gold and S&P 500 January prices are that at time of writing 25 January 2010.
- All other prices are month averages.
- Inflation data from the Bureau of Labor Statistics. December ‘09 & January ‘10 inflation is extrapolated.