January 2017

January 2017

Commentary

So here we find ourselves in the month of January, new broom in hand, ready to sweep away the dietary cobwebs of the Christmas period and with all manner of resolutions in mind for the year ahead. As seems to be the norm now, client activity didn’t tail off in December and we appear to have picked up where we left off in the early part of 2017. 2016 saw some seismic political events which in turn had a major impact on financial markets and we expect continued geo-political instability in 2017 to generate similar volatility for clients managing the treasury and financial aspects of their businesses. While world watching is a fascinating business, life at the coal face of business goes on and for the housing sector, we also anticipate another year of rapid evolution and change. In no particular order, we cover some unfolding trends and themes to look out for over the coming 12 months:

1. Increased Commercialisation

We were struck by the recent report that L&Q is in talks to acquire strategic land business Gallagher Estates for an estimated value of £500m plus. Whether or not this proves to have substance, it does illustrate the increasingly blurred lines between the commercial property/housebuilding end of the market and the large housing association groups. The scale of development plans outlined by the likes of L&Q and Clarion Group will demand a different approach to site acquisition and pipeline. Indeed, the recent publication by Moody’s of a comparison between their approach to housebuilders and large HAs suggests that the rating agencies (and by extension lenders and investors) are also grappling with evolution of old style housing associations into much more commercial beasts with the additional risk that this entails. While on the face of it, this involves a degree of credit deterioration for the organisations concerned, from a funding perspective, we expect them to benefit from scale, strong management and their status as increasingly frequent issuers in the financing markets.

2. Third Party Balance Sheets

While capacity exists across the housing sector as a whole, the challenge remains that this may not be accessible to developing associations unless more widespread consolidation occurs. Therefore, we would expect to see a continued trend towards HAs seeking to access third party balance sheets, whether in the form of equity or more efficiently structured debt. 2016 saw the launch of initiatives such as the Civitas Social Housing Fund, a REIT which raised £350m of equity with the aim of building a diversified portfolio of social housing assets and LINQ Housing, a highly efficient debt structure established by Genesis HA and M&G with structuring and advice from Centrus. In the PRS arena, entities like Fizzy Living and Essential Living are now well established with third party debt and equity providing the majority of the capital structure. With the continued changes underway in the pensions sector, we expect to see continued demand across different forms of capital for assets with stable cashflow and regulated characteristics. Our Welsh clients may be interested in the recent announcement that eight local authorities have pooled funds of £13bn and are seeking to appoint an external manager as part of a wider initiative to create a number of British “wealth funds” to invest in infrastructure projects.

3. Debt Diversification

2016 saw three significant transactions highlighting the trend towards greater diversification of HA borrowing. A “holdco” level unsecured issue by A2Dominion, a retail bond issue by PfP Ventures (the nonregulated part of PfP Group) and an unsecured bond issued by PfP, the largest ever deal issued by a UK housing association at £400m. The nature of the structures, the lack of security and the short-medium tenors were all a significant departure from the traditional 30(+/-) year, secured, fixed rate deals and short term revolving bank facilities more typically raised by HAs. In addition, Centrus recently advised a large London based association on a Private Placement which allowed it to charge predominantly shared ownership properties, again demonstrating a greater willingness on the part of borrowers and investors to take a more bespoke approach to the needs of different businesses. With continued divergence in the sector and a need to finance significant levels of non-regulated activity, we expect to see this trend continue during 2017.

4. “Let It Go”

No, not the famous song from Disney’s Frozen, but an increased pragmatism and willingness on the part of HA borrowers to let go (in part at least) of the treasury “family silver”, namely the pre-2008 25-30 year bank loans with stunningly low margins which they have rightly held on to for dear life ever since. Time of course helps and with each year passing and with capital repayments kicking in, the value embedded in these arrangements is gradually being chipped away. We have always maintained that embedded value is slightly moot if you don’t have the flexibility to run your business as you need to, and as consolidation continues, covenants need amending and business structures change, borrowers are increasingly willing to sit down with lenders in order to try and reach a mutually acceptable commercial position. Of course, minimising the loss of value still carries great benefit and negotiations should be managed carefully but gradually, life is moving on.

5. Consolidation

In spite of some well documented false starts during 2016, we believe that the successful completion of the Affinity-Circle, East Thames-L&Q and Sovereign-Spectrum tie-ups, mean that the mega-trend of consolidation of the housing association sector remains intact. While the current government may be more pragmatic and less hostile than its predecessor in terms of its view of the sector, housing delivery is clearly high up on the agenda. In our view, while mergers per se do not deliver additionality in development terms, groups with larger balance sheets, stronger management (and therefore better ability to manage commercial risk), greater scale and access to lower funding costs should (please note the emphasis!) be better placed to deliver the numbers required to play their part in addressing the UK’s housing crisis. Indeed, we believe that should the HA sector fail to ramp up development numbers in a meaningful way, whether as a result of consolidation or not, then the risk of further negative intervention by government will remain high.

We look forward with great excitement to 2017 and working with our clients to navigate a landscape which is challenging but also laden with exciting opportunities. Happy New Year!

Inflation Soup

Readers will be aware that there are a number of measures of inflation which have one sort of impact or another on policy-making and/or financial markets. The recent announcement (10th November 2016) by the ONS makes it timely to offer a quick overview and some commentary:

The central element of the announcement in November was the statement that:

“… we will make CPIH our preferred measure of consumer price inflation … CPIH has a number of desirable properties, most notably the inclusion of an element of owner occupiers’ housing costs. It also addresses several flaws and limitations present in alternative measures. We intend to make CPIH the preferred measure from March 2017, by which time all the planned improvements will have been implemented. I recognise the importance of our preferred inflation measure being of recognised National Statistics status, and to that end we continue to work towards redesignation as early as possible.”

So tackling the existing alphabet soup of inflation measures from the top:

RPI: dates back to the 1940s and for a long time the main standard. RPI is now routinely described with words such as “discredited” since losing in 2013 its official designation as a “National Statistic”. This is despite its providing the indexation of more than £600bn of gilts.

CPI: avoids the statistical flaws of RPI and follows the requirements of EU regulations; CPI is the UK version of the “Harmonised Index of Consumer Prices” (HICP) and the basis of the Monetary Policy Committee’s 2% inflation target.

RPIJ: same in many respects as RPI but uses the “Jevons” averaging formula (see below). Sometimes mooted as a happy medium but RPIJ is now, per the 10th November announcement, to be discontinued.

CPIH: same as CPI but includes owner occupiers’ housing costs (“OOH”). OOH represents c.17% of the weighting in CPIH, so it is a material change to include it.

There is an ongoing programme to develop something called the “Household Inflation Index” aka “Index of Household Payments”. The ONS have indicated – again in the November statement – that they remain committed to this although they acknowledge a range of conceptual and practical issues not yet resolved.

The following two charts show annual growth in the above four indices over the last fifteen years (although only since 2006 for CPIH) and the cumulative movement since 2010:

As can be seen, the “outlier”, at least on a cumulative basis over the latter time period, is RPI, although both RPI and RPIJ registered the impact of the first year or so of the financial crisis in a way the other two do not as the first chart shows.

Readers may recall something of a fuss in 2012 and 2013 about whether ONS would make some quite significant changes to the calculation method for RPI to maintain its intellectual credibility, which would have (partially) removed – as the above charts illustrate – what is generally seen as some upwards bias in its measurement basis. The main issue revolved around the use of “Carli” or “Jevons” formulae based on arithmetic or geometric means for the averaging. The construction of the various reported indices does have a bit more complexity to it but there is a basic mathematical point that a geometric mean will tend to produce a lower inflation measure than an arithmetic one. But ultimately the major changes under consideration were not made.

Housing costs

The treatment of housing costs is complex. There has been work over a number of years involving ONS and Eurostat (the EU statistics authority) on bringing owner-occupied housing costs into HICP/CPI but clearly there are some significant differences in housing markets and presumably the ways in which data is collected across the EU.

ONS have described the CPIH approach to this issue as follows:

“CPIH uses an approach called rental equivalence to measure OOH. Rental equivalence uses the rent paid for an equivalent house in the private sector as a proxy for the costs faced by an owner occupier. In other words this answers the question “how much would I have to pay in rent to live in a home like mine?” for an owner occupier. … The underlying concept for a rental equivalence price index is that a dwelling is a capital good, and therefore not consumed, but instead provides a flow of services that are consumed each period. Such services encompass shelter and security of tenure. The value of the flow of services that owner occupiers receive is assumed to be the same as the rent that the dwelling might attract in the rental market.”

CPI and RPI (and CPIH and RPIJ) all include rental costs for private and social housing – that isn’t the new bit. The difference is the treatment of the costs of owner-occupied housing. RPI (and RPIJ) include representation of mortgage interest payments, which neither CPI nor CPIH do. But CPIH includes representation of OOH using “imputed” rents associated with owner occupation as described above. It is important to note therefore that CPIH remains quite different from RPI in this area. The expectation is presumably that if house prices grow significantly out of line with other costs of living they will ultimately be reflected in both, and that may be the case but perhaps over different timeframes and for different reasons.

In terms of practical consequences, without going into a great deal of detail here we would list the following:

  • A reduction in the number of measures in widespread use would be of benefit although for some time yet we will have several measures on the go. It isn’t hugely practical to swap from one to another over long tenors; this goes for leases as well as index-linked debt.
  • CPIH could come to be used in place of CPI for various government policies such as welfare payments and state pensions; that seems a reasonable possibility.
  • Uplifts to private pensions could change. This is a complex area but there is the backdrop of the ongoing debate about how best to sustain private pensions for certain employers (e.g. the DWP’s BHS inquiry), so some move towards CPIH is at least possible.
  • The Bank of England could be given a CPIH target (presumably still at 2% or a figure very close to that).
  • To date, index-linked bond issuance has stuck with RPI, but if it is true that RPI is a poor inflation hedge for government or other borrowers, we ought to see more exploration of CPI or CPIH for gilts and corporate borrowers. This is something the Debt Management Office – as far as gilts are concerned – has looked at in the past and it seems likely to be revisited at some point.

Financial Markets and Economics Overview

In a time when new current affairs related vocabulary seems to be entering the English language on a regular basis, late 2016 did not disappoint. The latest jargon creating economic event, the “Brexit Bounce”, continued with some gusto in December. The latest Purchasing Managers’ Index data is out and the UK service sector hit a 17 month high whilst manufacturing and construction’s PMIs were also above forecasts (the construction industry grew for a fourth consecutive month in December).

All this strong economic data has restarted the murmurings of a potential base rate hike in the near future. However, for the meantime the Bank of England is holding it at 0.25%, as decided in the final Monetary Policy Committee meeting of the year on 15th December. The current programme of quantitative easing will also be maintained.

Inflation rose to its highest level since October 2014 in the last reported figures in 2016 being November’s, with CPI hitting 1.2% (up from 0.9% in October). A spokesman for the Office for National Statistics noted “November’s slight rally in the value of sterling eased the inflationary pressure on businesses importing raw materials, but consumer prices continued to edge upwards, due mainly to the rising cost of clothing and fuel”.

According to new figures from Halifax, residential property prices rose by 1.7% in December compared to the previous month, with the annual growth rate approaching 6.5%. Commentators are expecting a slight easing in housing demand through 2017, as economic growth slows, but regard factors such as the ongoing undersupply and continuing low interest rates as stronger market forces which will keep prices buoyant. Halifax, Nationwide and RICS are all forecasting annual price rises of between 1% and 4% for 2017.

As the market continues to fear a “hard Brexit” the Pound appears weak against most major currencies. At the time of writing, Sterling sat at 1.22 against the Dollar (down from 1.27 a month ago) and the Euro has slightly strengthened to 1.15 (down from 1.19 a month ago). Mrs May’s comments over the weekend and on Monday are being interpreted by market participants as signals that she will indeed be pursuing that which they fear: exit from the single market, and as such are likely to only deepen the Pound’s slump.

Interest Rates

Inflation

 Capital Markets

Bank Credit