April 2018

April 2018

Commentary

The last month has seen the level of economic uncertainty maintained and that of political uncertainty increased. In terms of the latter we have talk of trade wars, the Skripal poisoning attack, and the return of speculation about military intervention in Syria, the last one partly for (well-deserved) humanitarian reasons but also as a proxy to give Putin a bloody nose.

As the following financial markets overview reports, economic uncertainty is also looming large, either that or an increasing confidence in the return of economic normality should government intervention in interest rates (including quantitative easing) recede or be reorganised in some as-yet-unclear manner. Or just increasing confidence that the commitment of governments to market intervention will soon be tested (see comments on the return of the ‘bond vigilantes’ in last month’s update).

Uncertainty creates opportunities for those able to perceive them but also able to manage the risks, and in the particular arena of housing development that is an area where housing associations actually are very well placed. The recession drove many of the smaller developers out of business, the larger ones are not stepping up and that encourages the expectations on the social housing sector. The balance between keeping the politicians happy and not upsetting the regulator is a fine and important one but many associations are building up their skills and experience with the market and the attention as the housing market wobbles in parts of the country now is on the controls around that as well as the output.

In a good demonstration of the limitations of the large developers, Berkeley Homes, in a widely-reported trading update on 16th March, stated that:

“The fundamentals of the market in London and the South East remain compelling, but the operating environment and its impact on transaction volumes, whilst sufficient for the business plan and five year profit guidance period that ends at 30 April 2021, do not support the step-up in Berkeley’s production levels that these markets so badly need.”

The business plan and balance sheet of a Berkeley Homes is very different from that of a housing association. They are not only not interested in building homes for anything other than trading profits but also not set up with the sort of asset base and funding capability of the larger HAs.

Any association looking to generate trading income to support investment in social assets needs to maintain a strategy which can wear uncertainty and respond to it as required. Centrus works with a number of clients on stress testing their business plans. Just to draw out a couple of themes from these activities:

  • Risk mitigation needs to be grounded in the real world. It can be high level, it can involve assumptions, but the individuals running the activities involved should be asked and should be able to say “yes we could do that”.
  • A detailed exercise of thinking through exactly what would happen on every development project may not be practical, but a deep dive into larger or obviously risky ones is worthwhile. Some clients have worked quite closely with us and other advisers on thinking through the risk profile of real projects in terms of market demand and financial risks.

In terms of balance sheet management to support capacity, we believe that the sector will continue to see a more mixed funding model. Whether the current crop of REITs precisely meet the needs of mainstream housing associations or not, the basic concept of involving institutional investors to take on proper equity risks as well as provide ever-increasing amounts of debt – in the name of the RP secured on social housing assets – is in our view valid.

The stock market treatment of some of the REITs has been widely reported and we thought it would be of interest to place that in context. The charts below show (i) re-based indices and a couple of the larger non-housing REITs and (ii) a selection of housing-related REITs (the term “social housing REIT” being a bit hard to define in this context). The latter group didn’t see the volatility shown in the wider market around the end of 2017, but the risks of particular investment models also can be seen in the recent movements and it will be interesting to see how they and their investors mature in their approach to HAs.

Financial Markets and Economics Overview

After a strong global performance in 2017, the first quarter of 2018 has not been quite so rosy. Equity markets have fallen sharply, bond yields have dropped and yield curves have flattened. This coupled with geopolitical tension and money growth slowing, there are questions around whether or not 2017’s momentum will be carried through into 2018.

In recent weeks, government bond yields have dropped sharply, with UK 30y gilt yields falling c.24bps since January. This decline in bond yields, coupled with global equity performance, suggest that investors believe that economic growth and inflation outlook will no longer be as strong as previously expected.

Yield curves have also flattened significantly across developed markets. In the UK, the spread between 2y and 10y gilts has fallen by c.50% since mid-February, to around 50bps. These levels are similar to those seen following the EU referendum in 2016, when growth concerns were (arguably) much greater.

In the geopolitical space, March saw the US announcing a $60bn tariff on Chinese goods, following on from earlier tariffs on steel and aluminium products. The EU saw a hung parliament in the Italian elections and Brexit continues to grab headlines, with a draft withdrawal agreement reached on the 19th March, showing signs of progress on negotiations.

With regards to data releases:

  • UK CBI reported sales balance dropped in March from +27 to +5, partly due to poor weather.
  • UK consumer confidence picked up from -10 to -7
  • UK current account deficit dropped to 3.6% of GDP, the lowest level since 2012, suggesting evidence of UK rebalancing.
  • Euro area European Commission economic confidence index fell to 6-month low.
  • UK Q4 GDP unrevised at 0.4% QoQ.
  • Nationwide house price index saw little movement from February, with a slight reduction in YoY levels to 2.1%.

In light of the above, the UK has remained resilient. Evidence of rising wages and easing inflation pressures, consumer confidence is on the rise. In the Bank of England’s Agents’ summary of business conditions suggest that demand will remain resilient in light of Brexit. This report also showed recruitment difficulties at the highest level since 2004, which suggests increased confidence that the recent pickup in wage growth will be sustained.

Interest Rates

Inflation

Capital Markets

Bank Credit