June 2020

June 2020

Commentary

 

Quarterly Business Planning and Inflation

We have discussed business planning issues in several recent monthly market updates, as well as a number of webinars and ad hoc updates. It is such a key topic, however, in the context of current levels of uncertainty that we will this month again revisit one key theme of recent business planning discussions, this being the potential future path of inflation.

We have also today issued a further ad hoc update to our quarterly business planning assumptions. This monthly market update introduction can be read alongside that but the key messages are reprised below. (Every housing client will have at least one person signed up for both but please get in touch if you would like a copy of any of the quarterly business planning documents.)

The major news story in relation to inflation is how low it has already fallen since the impact of COVID19.

The secondary story is the level of uncertainty about its future path – whether it will remain low as many expect, or blow out with a realisation that inflation will need to be increased, by hook or by crook, to mitigate the effects of much higher public indebtedness. The UK is less exposed than most countries by virtue of the relatively long average tenor of public debt in issue, well over ten years, but the political trade-offs in servicing the debt will not be neglected indefinitely.

The major practical change which we have introduced in this business planning update is that for the first time we have included a pair of ‘stress testing’ parameters, specifically in relation to inflation: projections either side of the central assumption which we are suggesting for business planning purposes. We are frequently involved in discussions with clients about their individual circumstances and indeed undertake detailed stress testing analysis for some clients, but we have tended to avoid proposing generic stress testing assumptions in this way. Given the wide range of business models across the housing sector as well as differences in client group and local economies, and differing levels of risk appetite, we do see a risk of “unwanted standardisation” if advisers put out details in this area. But the general inflation level is such a key model input and one which a number of clients have asked about, and common across the country even if local real inflation may deviate from time to time, that we have decided to take this approach.

Accordingly, we have provided a “downside” and “upside” pair of inflation projections for stress-testing purposes which show a level 1% below or 1% higher than the central figure for the first few years of the 30-year projection. The spreadsheet circulated with the business planning update paper provides the detail. Associations may of course wish to use a greater or less material deviation from their central-case assumptions but hopefully this provides a useful reference point. Feedback on whether this has indeed been helpful is very welcome of course.

The details of the market context are included in the QBP update and on the later pages of this monthly market report but in a nutshell:

  • Actual inflation was very low for the month of April, as published in mid-May by the Office for National Statistics. 12-month CPI for April was 0.8%.
  • The Bank of England (“BoE”) has published various documents in the last month or so but the most directly relevant for inflation forecasting is the regular quarterly report, now known as the “Monetary Policy Report”. Expectations of CPI inflation are much-reduced, consistent with the low figure reported for April.

This time around the BoE has chosen not to update the famous “fan chart” showing a probability distribution of forward inflation expectations and instead there is an “illustrative scenario” and a much less-detailed chart has been shared which shows inflation dipping down to zero then up again to 2%. The language used makes clear that the Bank recognises the level of present uncertainty.

Nonetheless, one feature of all BoE pronouncements on inflation – that it will revert to the policy-mandate level within a couple of years or so – remains. The following charts, from this Report and the previous one, show how the facts on the ground have changed (these being the CPI inflation projections from these two Reports only a few months apart):

 

 

The other market move to flag is in Sterling interest rates – further down towards zero with the gilt now toying with negative rates at the short end – also reflected in the updated business planning assumptions.

Please see the quarterly business planning report and spreadsheet circulated on the same date as this monthly market update (2nd June) or get in touch if you have any further queries on these issues.

The return of policy?

In terms of other recent publications by BoE there is an interesting analysis of whether constraints on mortgage lending have the desired policy effect. The BoE report that: “To the best of our knowledge, this is the first paper which studies the effects of changes in macroprudential policy on household leverage during both boom and correction periods.”

Sounds boring? Well, at the risk of reinforcing the immediate impression… the substance of it is that in 2014 a policy was introduced that any mortgage lender should have a maximum of 15% of mortgages based on a high loan-to-income (“LTI”) ratio (defined as more than 4.5x income). BoE find that this policy did work: lenders issue fewer high LTI mortgages. But there is an interesting distributional consequence that low-income householders lose out from the loss of mortgage availability both because they tend to want higher LTI mortgages and also because the reduced number which continue to be written tend to favour borrowers on higher incomes.

The reason we mention is that is illustrates well how the drift of greater intervention by monetary authorities in the economy, along with other factors such as explosion in central bank balance sheets, extent of government-sponsored investment needed to mitigate and adapt to COVID19 and the extent of government intervention in the corporate sector and the strings that will undoubtedly go along with this as a protection against the obvious moral hazard that it entails – have consequences. We could go on, but all these factors potentially lead towards a greater importance and influence on the UK economy of government policy. Does this herald a return to the “white heat” of the 1960s or the public policy explorations of Tony Blair – who knows and doubtless readers will have a range of views on the desirability of either. Brexit is also “still a thing” and whether opportunity or threat requires policy decisions, including in areas affected by COVID19 such as immigration, food policy, or regional development some of which surfaced in the 2019 election but which already have new light thrown on them. The direction of travel of policy becoming more important than politics may be one legacy of the present turmoil and something that housing associations might want to factor into their horizon scanning.

Deal activity

May has seen a significant pick-up including in previously-delayed or opportunistic funding activity in the housing sector including Bromford, Network Homes, United Welsh and Your Housing Group in terms of private placements, along with two public deals. The public bond sales were Home Group selling £100m of retained bonds from their issue last year, at a significant premium given rates movements even on that relatively recent issue, and also a tap of THFC’s bLEND bond in an amount of £125m for WDH and The Regenda Group. The bLEND sale takes the total issuance under the bLEND medium term note programme to £515m. The relative return to clarity in terms of investor appetite is underlined if one looks across the utilities sector where similarly one has seen transaction volume pick up in the course of May.

Financial Markets & Economic Overview

May saw global risk sentiment broadly positive as countries gradually reopen their economies, with some degree of optimism in the UK economic outlook.

In the UK CPI inflation fell to 0.8% in April from 1.5% in March and retail sales declined by 18.1%. Meaningful improvements are expected in manufacturing and services PMIs with similar recoveries from the April lows for the Eurozone and the US also expected this week.

The UK 30-year gilt yield ended the month a percentage basis point higher than last month. Corporate spreads kept narrowing and are at elevated levels compared to pre-crisis but stabilized compared to the peak in late March.

Government announced a three-stage plan on getting the UK back to work, with initial easing measures in May and two further phases of liberalization. However, UK banks are warning that up to half of the £18.5bn of “bounce back” coronavirus loans are unlikely to be repaid.

House price growths in the UK, as measured by the Nationwide index, slowed to 1.8% on an annual basis down from 3.7% in April after . The average price of a home dropped to 1.7% reaching the biggest monthly fall since February 2009.

The ECB is expected to announce a €500bn increase to its PEPP, although there is a risk it could be smaller or even deferred, while interest rates are forecast to be unchanged.

The Euro weakened by 3.5% compared to the pound sterling. GBP/USD back up to around 1.24 from the lows below 1.21. Virus trends improving and early June talks on Brexit are likely to further test the pound’s resolve.

US treasury drew strong demand for its newest 20-year bond that has oversubscribed at $50bn allowing the Treasury to borrow at a yield of 1.22% – 0.2% below where the 30-year bond currently trades.

In the US jobless claims have continued to rise, but the pace of increase is moderating. Nonetheless, the unemployment rate is forecast to surge to 20% in May, the highest since the Great Depression.

The impact of ongoing US-China geopolitical tensions on market sentiment, especially in relation to the latter’s new security law in Hong Kong, will continue to spar with global recovery optimism as economies reopen. In particular, China’s parliament backed security legislation for Hong Kong, which would make it a crime to undermine Beijing’s authority in the territory.

 

Interest Rates

Inflation

Capital Markets

Bank Credit