BLOG: When Macro and Micro Diverge
By Scott Fulton | 2nd November 2018
Listed UK house builders have rallied strongly following the Budget’s confirmation that Help to Buy will continue in its present form until 2021 and the news that it has been extended for first time buyers until 2023. Based on the closing share prices of 26th November 2018, the larger builders have experienced average gains of over 8.0%.
Yet these share prices remain in negative territory year-to-date; down 17.0% on average despite a largely unbroken series of positive trading statements. Concerns have grown during 2018 that the clear slow-down in the second-hand market will, inevitably, feed into new build. Help to Buy may persist but its support is finite. We have been here before with the house builders, right?
We think that this misses the point. Specifically, that the market is too focused on Help to Buy and not how the new build market is behaving and could behave in the future.
We highlighted that the house builders have built up significant immunity to a slower market without Help to Buy in our recent note (Crest of a Wave, 29th October 2018). This related to the strength of current balance sheets together with the ability to manage land and generate more cash as a result; a situation which had recent historic precedent and was enhanced by the cash-rich state of many of these companies. We argued that this financial situation validated the existing high levels of dividend and surplus capital distribution in the face of slower earnings growth; a point made clearly by Crest Nicholson in its recent trading update.
However, the UK equity capital market’s relationship with house builders is ambivalent. In this sector, corporate fundamentals are often over-ruled by macro data. The housing market provides many different KPIs from many sources, several of which are not conforming to historic norms at present. In an increasingly febrile equity market, it is likely that house builders’ share prices have been buffeted by economic data which have little or no direct relevance to their underlying fundamentals.
The slow-down in the second-hand market is a case in point. Data from the Nationwide (1st November 2018) disclosed that average UK house prices did not rise in October compared to September and that the annual rate of house price growth had slowed to 1.6% from 2.0% previously. As with any “stock” market, the rate of price growth is inextricably linked to volume. HMRC data shows that, in the year to September 2018, total transactions were 1.2m, in line with 2017 but still some 30.0% below the last peak (2007). Critically, Nationwide highlighted that those people moving with a mortgage (essentially the traditional second-hand market) had not increased transaction levels since 2010.
In other words, there has been no real recovery in the health of the wider UK housing market since the financial crisis despite historically low levels of interest rates and increasingly high levels of employment. This situation has only served to confuse an equity market which has heard regularly that house builders have increased volumes, prices and margins.
This confusion is at the heart of the UK equity market’s perceptions of the house builders. Faced with fundamentals which do not seemingly tally with the macro environment and under sustained media criticism of Government assistance, investors have looked elsewhere.
We believe that it is important to look beyond these headlines. Despite the very public criticism of Help to Buy, the dynamics of the UK housing market and the fortunes of the house builders are as much a function of the Mortgage Market Review (MMR) as they are Government loans supporting house purchase. A view that has received limited media coverage but which could change during 2019.
Launched in 2014, MMR altered the provision of mortgage finance fundamentally. Self-certification was abandoned completely and the assessment of affordability for interest-only loans was substantially increased. More importantly, all mortgage applicants were now subjected to stringent affordability testing. In the UK, all existing home owners must apply for a new mortgage to buy another house. Their current financial situation now determines their ability to secure mortgage finance not the fact that they already have a mortgage.
This is the issue. While real wage growth has stagnated over the last 8 years, the UK has taken to debt as a means of maintaining living standards. The OBR predicts that unsecured household debt will rise to almost 50.0% of income by 2021 from under 40.0% currently. These debts are stress tested under MMR, resulting in many current home-owners not being able to secure a new mortgage to move; a situation which is only going to get worse without another Government initiative or a substantial and sustained reduction in unsecured debt.
As any observer of stock markets will know, a shortage of liquidity for an in-demand issue inevitably produces a price rise. According to the Nationwide, average house prices have risen by 34.0% since 2008; much of which growth coincides with the introduction of MMR in 2014 and should be viewed against real UK wage growth of less than 1.0% over the same period.
This is at the heart of the debate about the UK housing “crisis”. Received wisdom suggests UK house prices have risen to unaffordable levels because builders have exploited Help to Buy. It does not consider that, by severely restricting mortgage finance for existing home owners, the Government has created a market where only the very solvent or the very “new” can buy a home. The Nationwide’s announcement yesterday may prompt yet more relevant questions which could be answered this month by the builders. The equity market’s test is how to assess this information in the context of historically unprecedented economic data.
We are about to hear from Persimmon, Redrow, Taylor Wimpey and Bovis as they report trading updates in November. There is every chance that they will highlight continued demand strength and price resilience. They may not articulate the point, but they will report this strength because the Government has engineered a housing market which is so short of liquidity that its dynamics are determined by a Help to Buy program which accounts for less than 5.0% of total transactions. As the Nationwide reports, first time buyers with a mortgage, who account for over 80.0% of the Help to Buy program, are now purchasing more homes than in 2007. To be clear, this is the only segment which can make this claim.
Thus, the available data suggests that we are experiencing a two-tier housing market. Existing home owners are often unable to move because of mortgage regulation. This could leave total housing transactions at current levels and average market-wide house prices effectively moribund. But first time and cash buyers remain; increasingly so after the Budget. This has created a near perfect market for new house builders who have increased their production to meet this demand while maintaining capital discipline and balance sheet strength.
The media is likely to continue to lambast Help to Buy and its “subsidy” nature, but, absent a change in Government, and even then, there has been no substantive comment from the Opposition, the program will continue for at least another three years.
Therefore, the house builders should continue to benefit within the forecast timeframe. They offer yields of over 7.0% on average and have built further significant scope to maintain these returns even in the face of a wider, long-term slowdown.
The “macro” may set headlines but the “micro” will determine investment returns.