House Price Outlook (1st January - 13th January 2008)

This website is about the coming house price crash. But in order to understand the drivers for house prices going forward we first need to understand current economic conditions and anticipated future trends. Which Way Home provides a quick summary of these factors twice a month in the “Latest Market Outlook” section of the website. I hope you find it useful…

So far it has been an interesting start to the year. The stories hitting the headlines match my expectations and will act as a barometer of financial wellbeing in the months ahead.

In the first week of the year we learned that U.S. consumers fell behind on loans by the biggest margin since the ’01 mini-recession. Late payments on auto loans via dealers hit a 16 year high and the release of November ‘07 mortgage data revealed that defaults on privately insured mortgages shot up 34.7% versus the prior year.

Bringing an end to a mortgage lending debacle, Bank of America announced it would buy ailing mortgage giant Countrywide for $4bil in stock. Despite that news Countrywide still fell 25% for the week. The deal stands to make BofA the largest mortgage lender in the country – so watch out for signs of them getting into increasing difficulty over the medium term as the credit bubble continues to deflate. The end of Countrywide’s independence makes it the highest-profile casualty of the deepening credit crisis so far.

There was also confirmation that credit woes are spreading beyond mortgages. Credit card lenders gave warning: Capital One cut its targets for the third time in 9 months, setting aside $650m for unpaid credit card bills; and Amex took a $440m hit on slower spending and rising delinquencies.

Federal Reserve Chairman Ben Bernanke said downside risks to growth are “more pronounced” and indicated “substantive” and “decisive” action, i.e. a cut in interest rates. Futures traders are currently pricing in a 0.5% cut before the end of January. The Fed now considers that the risk of recession outweighs the risk of inflation.

At this point let’s stop and think about what is going on here. Central banks have continued to print paper money and to pump that money into their economies. Consequently, as the supply of money has increased, the per unit value of that money has decreased – huge increase in supply, little change in demand equals reduction in value. As the value of each dollar or pound in our pockets falls, the price of goods and services therefore increases. Unwittingly, we are becoming increasingly poor, no longer getting as much bang for our buck. Fuel, bread, milk, etc. are all much more expensive than we remember them being in the recent past. Therefore, in order to maintain our quality of life we have sought to borrow money.

Lucky for us, the flood of paper money entering the banking system has meant that banks are able to re-lend it easily, creating an equally dramatic rise the availability of credit. We want to borrow money and more money is made available for us to borrow – great! However, since the increased supply of money has eroded the value of money and we have become increasingly poor, in order to pay back the debt we borrowed, we have to take on new debt to pay for the old debt. Not ideal, but still everyone is happy.

Unfortunately, in order to maintain this upward spiral, an equal or greater amount of credit must be made available each year. If even a small portion of credit were taken off the table the system would collapse - there would not be enough money available for everyone to borrow and those whose debts become due need to pay them back. This is a big problem! In a vast number of cases people can’t. They instead start to default on their debt, forcing lenders to become more conservative, which in turn leads to even more credit being taken off the table. And so begins a vicious circle of debt default and credit contraction. The credit bubble is burst.

This is what we are seeing now. The first to suffer were overstretched homeowners in the U.S., who began defaulting on their “sub-prime” mortgages. This small adjustment in the supply of credit was enough to send the global economy into a sudden tailspin. The dominoes are now starting to fall and each default triggers disproportionate chunks of credit to be removed from circulation, eventually extending the impact beyond the financial services industry and across all corporations and individuals. We will all feel the pain in one way or another.

My view is that this credit contraction will be significantly worse than most envisage, with many large financial institutions, including household names, going bankrupt as their funds dry up.

So in light of these factors, what would we expect the short-medium term outcome to be?
• Expect central banks to cut rates in an attempt to stimulate the economy.
• Cutting rates further reduces the value of a currency as the return available by holding that currency is reduced.
• A reduction in the value of currency means that real assets, like commodities (oil, gold, copper etc.) increase in price – expect the bull-run in commodities to continue!
• Gold and silver are likely to do exceptionally well. As monetary assets they act as a store of value in times of crisis and are seen as a hedge against inflation.
• Financial chaos and multiple corporate failures will keep stock markets heading south for the foreseeable future – so you might want to sell, and certainly don’t buy!

Given these expectations, what do we see happening in the market? Do the actions of the markets confirm these views?

Since the last Market Outlook the stock market correction has deepened. The Nasdaq opened the year with falls on the first 5 trading days of the year, with volume increasing as the week progressed, including a fall on much increased selling volume on Friday 4th. Any up days were accompanied by uninspiring volume. In all the Nasdaq fell 6.6% for the period and is now 13% off its high. The S&P500 lost 3.5%, helped a little by Countrywide’s buyout. It is now 10% of its peak. While markets were temporarily bolstered on 10th as Fed Chief Ben Bernanke made rate-cut comments, the medium term trend is certainly downwards in equities.

On the commodity front, gold hit $900 as safe haven buyers drove the price through multiple, multi-year records. Oil ran up to a record $100.09 during the first week, before falling back a little in the second.

And, of course, the dollar sank on the weak economic data noted above, an increasing risk of recession and on talk of interest rate cuts.

I expect a similar theme in the next Market Outlook.

Keep reading and keep updated.

Which Way Home