December 2020

December 2020

Commentary

For the last monthly report of 2020 we thought we would keep it low-key, and provide an overview of the planned changes to the measurement of RPI announced alongside the Spending Review announcements on 25th November. This will have a meaningful impact for some housing associations and indeed for some individuals. Also it’s an opportunity to clear the decks before the excitement of 2021 hits us – I read that 2021 is going to be an “even better” year than 2020!

Over a number of years now, statisticians have formed a consensus that the long-established “Retail Prices Index” inflation measure isn’t up to the job. It doesn’t provide a scientifically well-rounded measure of inflation. As a measure of relative inflation it has its uses, but as a measure of inflation to apply to things like long-term pricing of financing arrangements or leases it is seen as too far removed from economic reality to be sustained. RPI has changed over the years but the published dataset goes back to 1947. The UK started issuing index-linked gilts as far back as 1981 and the present linker liability is £450bn with maturities out to 2068.

The 1992 Maastricht Treaty required EU member states to develop a harmonised measure of consumer price inflation (“HICP”). The basic concept builds on principles now applied across much of the world and the UK incarnation is the Consumer Prices Index (“CPI”) and over time that has gradually become the main inflation measure used in the UK. For example, Gordon Brown introduced inflation targeting for the Bank of England, originally using RPIX but since 2003 the inflation target has been 2% CPI.

The key metric as far as RPI reform goes is, however, not CPI but CPIH. CPIH is basically the same as CPI but it includes owner occupiers’ housing costs, including things like bills and council tax but also using “rental equivalence” to determine the raw cost of housing.

It’s immediately obvious that not everyone is a home-owner – but there are real choices in the construction of inflation indices, depending on how important it is seen as being to represent the experience of different groups in society and how one deals with the technological evolution of goods and services. The methodological differences are quite complex and include how the “basket of goods” is maintained and how prices are “chain linked” over time, but the headline mathematical difference is that RPI uses an arithmetic mean where CPI uses a geometric mean, which in combination is regarded as working a lot better to capture real-world price behaviour.

In a nutshell, the “wedge” between RPI and CPI is now around 1 percentage point, which in a low-inflation environment is not sustainable, it’s too big a difference to be helpful for policy formulation or equitable between the parties to existing contracts, and this is why the change is coming about. The graph demonstrates the impact and the fact that CPIH is, like CPI, materially lower than RPI:

The UK Statistics Authority (which ‘sits above’ the Office for National Statistics), is required by legislation to publish RPI data. Implementation will therefore be by simply changing the methodologies behind RPI to bring in methods and data sources from CPIH. The impact will be broadly to take out the “wedge” which can be seen in the above graph.

The substance of the recent announcement was really about two things: timing and compensation. The change was expected to be confirmed as happening in 2025 or 2030 or somewhere in between – and it’s now confirmed as 2030. As regards compensation, the holders of index-linked gilts will not receive any compensation. Consistent with that stance, index-linked gilts if anything rallied on the announcement at the end of November, suggesting that the change was anticipated with the main question just around timing.

The nuance around the 2030 timing is in part that there is a subset of gilts with slightly different provisions relating to changes in the RPI calculation; the last such gilt matures in 2030 shortly prior to the planned implementation of this change.

For housing associations, any RPI-linked financing will now reflect this i.e. will track CPIH from 2030. The most obvious contractual revenue stream which is affected is shared ownership rental income, which will be lower. Some associations model the business plan with a wedge over CPI for this (usually fairly modest) element of revenue; if so it would be worth revisiting the wedge assumption and potentially simply lining up with CPI.

Apart from RPs, this will affect a range of parties. Pensioners receiving pensions contractually linked to RPI are an obvious group who will lose out. Many pension fund sponsors have managed to move fund liabilities from RPI to CPI over the last few years; around a third of defined benefit scheme benefits are liked to CPI now. For the pension funds themselves and their sponsor employers, the worst affected will be those with liabilities linked to CPI (not changing) who have hedged inflation with RPI-linked assets (which will generate lower levels of income), albeit as noted this is not a dramatic recent impact as the market knew a change was coming and hopes of compensation were on the whole not high.

In markets news terms, November saw substantial £300m deals from each of Clarion and Orbit, Clarion with a 12-year deal pricing just under 1% and Orbit with a 2038 maturity pricing at 135 bps. Centrus also acted as arranger for London Borough of Sutton on a bond issue, 2055 maturity at 95 bps. The issue was noteworthy in the sense that it was issued via an innovative new platform, european private placements facility (“eppf”) which facilitates ease of access to debt capital markets and disrupts the traditional routes to market. We have continued to see a range of banking transactions also, often extensions and restructurings of existing facilities but price tension in that market remains relatively strong also.

As another aside in relation to Sutton, it is worthwhile for housing association readers to be aware of some of the context for local authority financing activity. This month also saw ongoing examination of local authorities’ investment and borrowing activities. The government noted that “… LAs bought £6.6bn of investment property between 2016-17 and 2018-19. The government is clear that this is not an appropriate use of PWLB loans.” The practical decision is essentially that PWLB will not lend to any authority which plans to buy investment assets primarily for yield, but that PWLB costs will reduce back down to gilts + 100 bps, down from the present gilts + 180.

 

Financial Markets & Economic Overview

Data releases last month showed the UK economy expanded at its fastest pace on record in the third quarter, with a GDP increase of 15.5% in the three months to September 2020. The biggest lift to growth came from the professional, scientific and technical services section and thankfully we can now see the benefit of this activity in the good prospects for a vaccine in the coming months. However, the strong increase in GDP seen in July was already beginning to wane in August and virtually flatlined in September to leave GDP almost 10% below where it was a year ago. Additionally, economists argued that growth could have been much stronger if the government had signalled in July it would keep the furlough scheme in place until March 2021. This has contributed to a surge in redundancies and a slump in hiring, which pushed UK unemployment up to 4.8% in Q3, a four-year high, whilst further big rises in unemployment are expected in the coming months.

UK CPI inflation rose in October as the price of clothing, food, furniture and  furnishings made the largest upward contributions to price rises.  The consumer price index (CPI) increased to 0.7%, from 0.5% in September, but the effect of the pandemic on the UK economy means inflation remains significantly below the 2% target the government sets for the Bank of England, with the evolution of the COVID-19 pandemic (including vaccine news) and Brexit forces which will likely guide the Bank of England’s hand at its December meeting.

Mortgage approvals surged to a 13-year high as house prices rose at the fastest annual pace since early 2015, according to Nationwide. Its monthly house price index, (a key indicator for the UK economy) saw the average price of a home increase by 0.9% to £229,721 in November. This saw the annual growth rate rise to 6.5%, the fastest since January 2015. However, the outlook remains highly uncertain and housing  market activity could slow in the coming quarters, perhaps sharply, if the labour market weakens, especially once the stamp duty holiday expires at the end of March.

The Bank of England’s Monetary Policy Committee (MPC) voted to keep the base rate steady at a historic low of 0.1%, continue with the existing programme of £100bn of UK government bond purchases, and expand its quantitative easing programme to boost the economy by another £150bn. This is helping to keep current market interest rates low, as the market continues to see negative rates as a risk at least in the short term, dependent on the future path of inflation. The Bank noted the double whammy of COVID-19 and Brexit means the UK economy is in for an ‘unusually uncertain’ time, albeit growth and inflation expectations may increase with further positive news on COVID-19 vaccines and a UK / EU trade deal.

 

Interest Rates

Inflation

Capital Markets

Bank Credit