An update on market conditions from Stuart Law, CEO

The economic impact of COVID-19 continues to evolve alongside the sad impact upon people’s lives. Gradually more things are becoming clearer and giving us more information to make decisions upon. Whilst over time, most business sectors will recover and the economy will grow larger than ever, it will likely and necessarily be a different shape to the economy of 2019 and will also take time to evolve. It is that transition that poses the main risks as a different shaped economy means there will be winners and losers in that change, and it is our job to try to anticipate that as best we can.

The UK officially entered the deepest recession since records began in 1955 in Q2 this year with GDP down a shocking 20.4%. Fortunately, the economic bounce back has firmly started since and whilst July had a 6.6% growth in GDP it definitely doesn’t look like a rapid ‘V’ shape recovery just yet, with the rate of recovery far slower than the decline and the economy still 11.7% smaller than before COVID-19 hit. It’s also worth noting that the recession was suppressed in scale by the Government’s fast action in pouring billions of pounds into the economy through economic support packages such as Furlough and CBILS etc. 

Nonetheless, the chance of further lockdowns regionally or even nationally, as well as the yet to arrive unemployment wave deferred by furloughing, leaves us on our guard for a recovery shape that ends up resembling a ‘W’ shape or even something non-alphabetical. Few people now expect the size of the economy to have recovered fully by the end of next year, even if a miracle vaccine was discovered. Fortunately, plenty of businesses have got back to perfectly productive working, with some already doing better than before. This contrasts with many businesses who have not been that fortunate and are still suffering from the effects of the ‘new normal’ upon their businesses, or have even, sadly, already gone out of business altogether. We are not exposed heavily to those negatively affected business sectors, but some risks exist, and we are working hard on those to help control the effect on the lending book.

We think that there are several key factors influencing the economy and society as a whole that will be considerations in our future lending and we list five important ones in the remainder of this article. 

Geography and the potential migration of economic activity from city centres

London is the worst affected UK city centre with only 13% of workers back in work at present (not much more in many other large and small cities) and businesses like city centre pubs and the likes of Pret-a-Manger have been impacted terribly as a result. We will see how much the Government backs the return to the city centre office, but their resolve seems weak and many major employers have made it clear they do not wish to go back to that way of working, ever.

This could have a negative impact on city centre housing, food outlets, pubs and all forms of transport that commuters used travelling into those cities. Transport for London already had to be bailed out after running out of money. Whilst this could end up being painful for many city-centre reliant businesses, it is also a forced rebalancing of the economy geographically, which is a stated political aim with respect to London at least. Our exposure to city centres is consciously modest and particularly so with London which only received about 7% of our past funding. Our focus is typically suburbs of cities and further out and particularly regionally with 88% of housing that we fund being outside London and the South East. Our regional out of cities focus is expected to give relative strength to the loan book performance.

The money and time saved from less commuting

If it doesn’t harm, and possibly even benefits companies to have many of their workers working from home (WFH) then where will their saved commuting cost go? Where will their retained commuting time go? This could be an hour or several hours a day saved, and 5-10% of their take home pay - a huge net of tax boost. The answer may be that this money and time will be spent outside of London and other cities on bigger housing with more outdoor space, and also more time and money spent in the local communities that people live in, with a potential result of better lives with better balance.

London’s (and other city centres’) woes are likely to directly benefit the rest of the country if we believe that the nation’s GDP will recover in due course, which we do. With many people able to work from anywhere, or at least further from all the remaining offices, the flow of capital and spending into the many other parts of the country could make a large scale north/south and regional economic rebalancing more of a reality. This would take some years to happen but it does appear that the WFH genie is well and truly out of the bottle now and whilst COVID created a wholesale initial surge in WFH, even a total vaccination success is unlikely to reverse that change in full, even if someone (the Government and office property investors) wanted to.

Companies are eyeing huge cost savings and employees are eyeing huge time and money savings. We are well positioned if this happens being a regional lender (81% of all lending by value), supporting 1 in 12 new homes built by SME housebuilders, and again principally in the regions. There is undeniably a housing boom taking place at present directly related to these factors, and viewings and housing pre-sales activity is all very high. Prices were up over 2% in August, the highest monthly rate since the heady days of 2004 and at a new all-time high, and the annual growth rate is at nearly 4% as well, all according to Nationwide. We are also seeing that strength in pricing through revaluations of housing development sites and substantial activity out of town centres. We have an eye on how long this lasts and if it is sustainable in the face of the risk in first time buyer housing demand but it is welcome for the security of the loan book. Overall the move to WFH and from cities to suburbs and beyond looks positive for our type of lending.

 

Unemployment and its impact on the economic recovery

It is widely expected that in many cases furloughing is a pre-cursor to unemployment and that the main segments affected by furloughing, and therefore likely by unemployment, are the younger, lower paid and lower skilled workers. Lenders are already factoring in furloughing and unemployment risk generally into their mortgage availability and deposit requirements.  This is bound to impact lower priced housing and first-time buyer homes, not an area we focus on at present but the housing ladder of course requires activity at all levels. 

Higher unemployment seems inevitable for a while and will slow the economic recovery by slowing consumer confidence and spending. A 9% unemployment rate is a very real and forecast possibility and is very high historically so the economic impact must be measurable. The better news is that we and almost all other analysts do not expect the economy to stay squashed for too many years, meaning that those who lose jobs will hopefully be able to retrain and move into growth sectors instead. Nonetheless this is a challenging rebalancing of the economy and potential stronger and weaker businesses asking for borrowing will need to be assessed when lending decisions are being made

 

Interest rates and Government support

Interest rates and government spending to support the economy are closely linked. Low interest rates permit vast government borrowing at little cost - the last government bond issue was at negative interest rates, so better than free! This would support the idea of the government borrowing heavily to spend its way out of trouble in these challenging times and would be an inducement to keep interest rates low (even though the Bank of England (BOE) is supposed to be independent in setting interest rates).

We are also seeing leaked reports of taxes being raised substantially in the next budget to further support the funding of this this spending.  Higher taxes will likely harm the economy at a sensitive time and higher borrowings will likely mean interest rates will need to stay very low for longer. We tend to expect minimal short-term action on taxes for now but definitely expect more borrowings and much longer with interest rates kept low.

There is an alternative view put forward by proponents of Modern Monetary Theory (MMT) that suggests that government spending for a strong country like ours can come before taxes and borrowing, rather than the present assumption of the other way around. If money could really just be printed with no negative consequences for the economy, then hikes in taxes and borrowings could come later and the economy and employment would be supported today solely with huge government spending and a rapid increase in the deficit.  At present though MMT doesn’t seem likely to be adopted by the government.

So even if MMT isn’t implemented now, low interest rates give the government the chance to fund everything it needs, hold the economy and employment together and create huge borrowings at little or no interest cost to pay for it. Unfortunately getting rid of those borrowings will involve high inflation and/or high taxes at some point in the future in the present way of thinking.

We, like many others and indeed supported by comments from the BOE, think negative interest rates are still a possibility/probability in the winter. Therefore, when inflation rises again in due course it may well be without the usual corresponding rise in interest rates, as we could well see inflation tolerated for quite a while in order to help the economy on its way upwards again. If this does happen then we expect that the differential between interest rates and our target investment rates would remain healthy.

 

Brexit

Brexit is a complete unknown and there doesn’t seem to be any material advanced preparation work going in by both Government nor companies, partially as a result of COVID-19 distractions but partially because it is hard for many businesses to know what to expect. We therefore don’t have a prediction on the effect of the next stage of leaving the EU other than to assume that the unknown risks are to the downside of not having a plan but hope one is forthcoming soon and the risks eliminated or mitigated effectively. We will continue to remain cautious where businesses are exposed to EU related factors until such time as we have more factual evidence.

 

This article contains current opinions and observations and should not be taken as investment advice.

- September 16, 2020