The most notably consistent refrain of bankers and politicians over the last few months has been “I didn’t see it coming”. A perhaps rather obvious statement if you think about it, as clearly if you did and didn’t act, the charge would be incompetence rather than perhaps just oversight. The important question is of course “why didn’t you see it coming?”.  There are obviously a number of complex factors at play here, but I’d like to add just one of my own: infectious unquestioning optimism.

 

 

Running with the herd or “I didn’t see it coming”

 

There is an obvious but perhaps over-looked aspect of human thought, that of rational or perhaps irrational extremes. People on the whole either tend to be optimistic about given situations or pessimistic and are heavily influenced by personal events, the people they work and socialise with and by news events. If a personal position is good and the general view or consensus is optimistic, there is tendency in thought and behaviour to assume that what has happened in the past will be the position in the future as this is what our experience has shown us. Equally, if the recent experience is negative there is strong tendency to project this negativity far into the future even if the facts do not support this view.

 

I mention all this as I noticed that many of the same people who were on the ‘unbridled optimism side’ two years ago now seem to have jumped camps to the ‘unbridled pessimism’ school. If you look at events over recent months it is not hard to see why this view has changed. Literally everyone in banking and financial services either knows someone who has, or may indeed themselves have, lost their job and those in employment may be facing the threat of redundancy or at the very least is likely to have received a much smaller bonus. In addition there is also a ‘poacher turned gamekeeper’ aspect in that many investment bankers who created some of the ‘toxic assets’ are now on the ‘buy’ side and pessimism may suit as a negotiation positioning

 

 

It’s not linear

 

All of the above adds up to some very pessimistic views of the market that I have heard first hand in the last few weeks, often about the UK housing market.  As we have detailed in several blogs, the recovery of the housing market is central to economic stability and recovery, not just of the UK but the world economy. House prices are notoriously difficult to predict in detail (Note: Those pundits that think they ‘predicted’ the crash by forecasting it every year for several years in succession, rather like predicting someone’s death: you were going to right at some-point but wrong every point before…) but there are still some basic economic tenets that underpin the market. Everyone of course has their own views here but some views I have listened to where people are simply projecting recent house price movements inexorably forward simply defy logic.

 

In a recession events peak at different points in the cycle with for example, unemployment noticeably lagging (unemployment may well still be rising as economic growth turns positive).  We are firmly of the view that house prices will be a lead indicator of the beginning of the end of the recession, not a trailing event.

 

 

Logic not sentiment

 

In a Blog a couple of days ago, we looked at US house prices and their influence on the global economy. With the publication of the latest HBOS figures this week, we have updated our assumptions on the UK market. Below is our latest view on house prices versus affordability

 

   

  

In brief, ‘House prices’ in the graph above are the HBOS Seasonally Adjusted quarterly index, ‘Affordability’ is defined as the relative change in average wages and mortgage interest rates with both indices starting from the same relative point in 1997. To take both indices forward we have assumed that for ‘Affordability’ wages are essentially flat and that ‘actual interest rates’ (that which a consumer actually pays) do not fall below 4.0%. For house prices we have simply projected the current rate of decline forward.

 

 

What does the graph tell us?

 

Two important things to note: (1) The ‘cross over’ point where the two lines meet and where the long term affordability index lies, will be reached towards the end of Q2 this year. From this point on we believe that if house prices continue to decline the market is ‘over-correcting’. (2) The affordability indices is based on mortgage rates remaining approx where they are now.  If liquidity improves, competition will intensify and mortgage rates should fall making loans more affordable.

 

In terms of timing, we believe that the market will over-correct, but by the end of Q3 stability will begin to occur in the UK housing market. There may be a period of ‘bumping along the bottom’ but the large scale price falls we have been seeing over recent months will be over. Are we right? Well obviously time will tell, it is perhaps too early to talk about ‘green shoots’ but there are some encouraging signs emerging. The most important thing in all of this though, as we have covered before, is to base your views on facts. The eventual outcome may sometimes differ, but I’ll take reason over sentiment anytime