February 2019

February 2019

Commentary

At the end of last week, we participated in a lively round table discussion, rather strangely titled “Armageddon out of here – surviving the next housing crash”. The timing was quite apt with the UK in the grip of a near zombie apocalypse, under attack from a few inches of snow.

Famous last words perhaps, but as things stand, we just don’t see the conditions being in place for a housing crash to take place. While not exactly firing on all cylinders, the UK economy has proved remarkably resilient in the face of massive uncertainty and negative sentiment since 2016, employment is at record levels and new housing supply is failing to hit the levels required to address demand in many areas. Lastly, and most significantly in our view, interest rates remain relatively near to their historic lows, and with the Federal Reserve having apparently blinked in its “normalisation” strategy in the face of market volatility.

Put simply, we believe that house prices will remain at their current historically elevated levels for about as long as interest rates stay at historic lows. A combination of low growth and modest or higher inflation might let some air out of the balloon, and there is a slightly separate dynamic in the most expensive areas of London perhaps relating to Brexit and tax changes for “non-doms” and overseas investors, but it would take a sharp increase in interest rates and a major knock to confidence (recession, increased unemployment) to create the conditions for a “housing crash”.

Nonetheless, it is important to recognise the difference between “sales price” and “sales timing” and a number of associations have reported slower sales if not significant value falls given current political uncertainty, which underlines the importance of taking these risks seriously. For any developing housing association with an exposure to the market through open market or first tranche shared ownership sales, risk management remains very important.

This raises a number of interesting questions as to how developing HAs can protect themselves from the risks associated with a dramatic event in the housing market.

1. Stress and scenario testing are a key part of this for boards and the regulator and should be fundamental to any organisation’s risk management strategy. Unfortunately, operational and governance issues and decisions (or lack of decisions!) are often more prominent in cases of HAs getting into difficulties than a lack of financial risk planning.

2. Mitigation plans are a key part of stress testing, i.e. “if X or Y happens what levers are we able to pull to resolve them, and when will we pull them”? However, while mitigation is easy on paper or in a financial model, the reality may be less straightforward. For example, if sales dry up this may bring forward debt drawdowns, but if facilities are in place, are they fully secured and capable of a faster-than-forecast drawdown? And what if MV-ST valuations are negatively impacted by house price falls? This is where the financial risk moves into the realms of the operational and governance risk.

3. Liquidity is a key factor in this type of scenario, but it needs to be real liquidity. Recently, we’ve seen rating agencies including unissued retained bonds or shelf arrangements as part of a borrower’s liquidity. This is wrong in our view. While these arrangements offer a potentially quick and easy route to market, it is an issuer option and not an investor/lender obligation and until priced and issued, it is uncommitted and should not be counted on as liquidity in the same way as cash or a facility which is charged and legally capable of being drawn. This has led us to question recently whether the type of “contingent liquidity” being utilised by most developing HAs would be better structured as short term, unsecured RCFs, as this would remove a significant impediment to flexibility around liquidity – we may explore this in more detail in a future update.

4. Many HAs have taken the sensible decision to share risk through development JVs with third parties or commercial subsidiaries within groups. This needs to come with a clearly understood discipline about levels of exposure to commercial entities and the HAs willingness or otherwise to extend loans or otherwise re-capitalise these entities in a crisis scenario e.g. failure to deliver their side of the funding or responsibilities bargain by the partner or by JV lenders. Again, we can think of at least one rating agency which takes the view that most HAs will not allow these entities to fail from a reputational perspective. We would argue that a more commercially savvy HA sector will allow commercial logic to dictate these decisions and that bail-outs may not be a given in the next downturn – but thinking needs to be joined up in the sense of being able to rationalise the consequences of that as ‘less bad’ than bailing out.

5. The final and most obvious one is to avoid overtrading! In any long bull market, complacency around downside risk sets in and memories of different market conditions fade. Every downturn claims its victims, usually those who have decided, in spite of the health warnings, that past performance is in fact an indicator of future results.

There were two issues during the month of January, Clarion first off the blocks with £250m at a spread of 148 basis points and then Notting Hill Genesis at a spread of 173 later in the month. Given the level of market uncertainty these were both helpful for the market as a whole. Interestingly, both are ten-year prints. The pricing must count as a success with the sub-3% all-in coupons for both but the spreads are wide by the standards of 2018 in that context.

Financial Markets and Economics Overview

A record breaking start to 2019, with the conservative party suffering the largest government loss in UK Parliamentary history coupled with a vote of no confidence manufactured the largest rebellion in modern times and with the 29th March edging ever closer, uncertainty is the only thing Britain can be sure of. Nissan’s recent announcement to abandon plans to build a new model of one of it’s flagship vehicles at it’s Sunderland plant underlines the lack of confidence and assurances about Brexit. Mrs. May is expected to bring a revised Brexit plan for yet another vote later this month in the hopes that the agreed upon approach can enable the UK a greater stronghold on border controls, post transition period payments to the EU, ECJ Laws and independent trade policy. Consecutive rejections however could steer a course either a second referendum, a general election or a no deal Brexit scenario.

Unsurprisingly sterling has reacted in-kind with increased volatility, however not in the expected direction with the pound strengthening against the dollar and the euro for the first time since September 2018 with increases of c.2.98% and 2.96% respectively from December 2018 to January 2019.

Gilt curve has flattened in the past month with the 10-year Gilt yield increasing by 5bps and the 30-year Gilt yield falling 10bps. Tightening of corporate bond spreads as illustrated by iBoxx indices gives a positive outlook on potential performance in 2019. this is further supported by narrowing CDS spreads.

December saw the UK Services PMI recover slightly from 50.4 in November 2018 to the 51.2 recorded in December 2018, increasing the gap on the 50 point threshold that separates expansion from contraction. Reservations around Brexit, restrictive financial markets and greater political doubt are expected to continue to stifle PMI figures in 2019. UK manufacturing PMI fell slightly dropping to 52.8 from 54.2 over the new year. However this is not supported by OECD UK business confidence indices, which saw an improvement of the same period. UK CPI inflation rate continued to fall, down 0.2% to 2.1% in December, however, still above the MPC’s target of 2%.

According to Nationwide, 2018 came to a close with the smallest annual gain in UK house prices since February 2013 with fear over uncertainty deterring buyers. According to Nationwide HPI, January 2019 saw slower growth at 0.1% year on year from the already lower growth of 0.5% year on year in December. Providing the smoke clears around Brexit and the wider economy strengthens, 2019 should see consumer confidence restored and the UK housing market responding in-turn with Nationwide predicting single-digit growth in the short term.

Interest Rates

Inflation

Capital Markets

Bank Credit