💵 The Canary In The Coal Mine

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Will the UK be the canary in the coal mine for the global credit cycle?

I mean, we already tried it once with the whole LDI pension blowout. The fallout was largely blamed on the 'mini-budget', but that was more of a catalyst than a cause.

The main problem was that pension funds were highly leveraged to a low rate world.

So, it makes sense to look at other areas of the UK economy that are also leveraged to a low rate world. Such as...

The UK Property Market

Let's get this out of the way early. I don't think this is another 2008.

Australia & Canada aside, this household debt to GDP data from 2021 shows a clear de-leveraging since 2008. There simply isn't the same sub-prime risk & leverage built up in the system.   👇

A correction though? Absolutely.

Where the UK differs from the US & Europe, is the huge proportion of homeowners with 1-5 year fixed deals (light blue).

Only a tiny proportion (grey) are on longer term fixed deals... 👇

And of these borrowers, who is the most exposed? Who will feel the most pain?

Landlords - Well, the over-leveraged ones...

59% of Buy-To-Let landlords have finance on at least some of their property portfolios.

Now this doesn't mean they're levered to the MAX. In fact, it's estimated that the average BTL landlord has only borrowed 45-55%... 👇

However, what they ARE exposed to is the change in repayments. Variable mortgage rates are through the roof...

And fixed rates are much higher than they were a year ago for anyone whose fixed rate term is expiring.

The recent surge in Bank of England pricing has been dramatic...

More Hikes and Higher For Longer got priced in, which has pushed UK rates higher across the board.

For mortgage holders, there are options to help ease the pain, but few options where the pain can be avoided altogether.

According to UK Finance around 800,000 fixed-rate deals end in the second half of 2023, and around 1.6 million fixed deals due to end in 2024.

Which means roughly 28% of the UK's 8.5 million residential mortgages are due to refinance in the next 18 months.

For context, the UK currently has around 25 million homes so we're looking at 28% of mortgages on the 34% of mortgaged homes... that's 2.4 million mortgages due for refinance in the next 18 months. About 10% of households are not going to be happy campers if rates stay high.

So, why focus on the landlords?

I have a theory that a significant group of landlords are cash poor and asset rich. Just kept rolling any returns into more assets... These are the vulnerable. The weak among the herd...

Like this guy... 👇

See, households with a rainy day fund can stick that cash in a savings account or fund and get some decent returns over the next couple of years, potentially offsetting the higher mortgage rate.

By way of example, taking estimates from a Think Tank (I know, don't @ me etc), mortgage repayments could rise on average by £2,900 per year.

If you have 50k sitting doing nothing, locking it into a fixed 1 year term deposit (such as this one from HSBC) can pay 5.05%, or £2,525, essentially offsetting most of that pain.

How many will actually opt to do this is an open question, but as long as you have a bit of common sense and some of those 'excess' savings economists love to talk about, rising mortgage rates don't need to be a total disaster.

However, if you don't have a big pile of cash to lock in some interest income, (or choose not to because this stuff seems too complicated to be arsed with - we've all met those people) then this is probably gonna hurt a bit.

Now, a LOT can change in 18 months, but if rates stay at these sorts of levels, the squeeze is definitely on.

Unfortunately, it's not just 'cash-poor' landlords that will suffer. Anyone who's been dutifully paying off their mortgage (but not saving) is going to feel the pain too.

So, back to this and a quote...

So far, all we've done is look at how people with mortgages can attempt to bridge the gap. But think about the knock on effects while this is happening. As house prices presumably stagnate or continue to fall...

... housing investment slows. That means less construction. Fewer sales means less transactions for estate agents, mortgage brokers, surveyors, lawyers etc. to earn from.

It may mean less reform work if house prices fall, because people are less comfortable spending on a 'depreciating' asset...

And when people move, they tend to buy new 'stuff' for the new house: Furniture, appliances, change windows/doors, carpets etc.

All of that economic activity is at risk as nervousness sets in.

On that note, the UK construction industry has seen the fastest decline in residential work for just over three years according to the latest PMI 👇

While we're absolutely convinced that UK inflation is going to fall rapidly over the next few months (because maths) 👇

How far/fast it falls once the energy price cap is out of the way is still an open question. However, it will mean rates are extremely restrictive after the summer.

That 2% target is a LONG way off, and if anyone is going to bet on the Bank of England pro-actively getting ahead of a trend, I'd like to pitch them my magic bean startup first.

So, could the UK end up being the canary in the coal mine?

The first major player where losses begin to matter, shattering the illusion that modern, highly indebted economies can sustain suddenly much higher interest rates?

We'll find out soon enough...