Commenting on the forecast Alex Bannister, Nationwide's Group Economist, said:
"2002 was a phenomenal year for the housing market, with the highest sales and price growth since the late eighties boom. The lowest interest rates for nearly 40 years and the lowest unemployment rate for 27 years helped boost demand for property, but our research suggests that only 15% of the increase was explained by improved economic conditions. The additional 10% appears to have been driven by a change in expectations and extremely positive sentiment. Belief that low real mortgage rates are now a permanent feature has undoubtedly encouraged buyers to increase borrowing in order to trade up and also to enter the market for the first time. This expectation alongside significant growth in remortgaging (which currently accounts for c40% of all gross lending) has led to a sharp rise in mortgage equity withdrawal.
Our forecast for 2003 is based on sentiment and expectations being neutral and that the slight worsening in the economy will result in house price inflation of 10%. House sales will similarly reduce to 1.55 million. Around the regions we expect London to see the slowest growth at around half that of the UK and the North to see the quickest. Certain hotspots, and particularly parts of London, where affordability is stretched and where employment, income and confidence are deteriorating may experience price declines. However, we do not expect generalised sustained price falls.
Sentiment is hard to predict so we have analysed two alternative scenarios. In the first, house price growth persists at c25% throughout 2003 on the back of unrealistic expectations on the part of borrowers, some of whom may have been encouraged to overstretch themselves. This stores up considerable risks for 2004, as it is likely that the MPC would have to respond by raising rates to hit their inflation target at the same time as confidence and expectations nosedive. In an alternative scenario confidence reduces following higher than expected job losses and the market slows sharply in 2003 before stagnating in 2004.
There remains a responsibility on the part of lenders and borrowers to be prudent and not over-stretch themselves. If they ignore this advice in a low inflation environment, where debt is not eroded quickly, the risks of a correction in the housing market increase."
Market stronger than expected in 2002.
Most forecasts (including our own(1)) predicted a slowdown in the housing market during 2002 - however, the market once again strengthened with house price inflation (at c25%) reaching the highest levels since the late 1980s. Mortgage lending reached record levels and most notably it was remortgaging that experienced the strongest growth, up around 80% on a year earlier. In reality the rate of remortgaging is likely to be significantly (possibly as much as 50%) higher than the published data suggests because it does not include borrowers remortgaging with the same lender. Many of those remortgaging took advantage of rising housing wealth to withdraw equity from their property. Activity in the housing market was also up sharply on the previous year, with house sales up 10% to 1.6 million and mortgage lending for house purchase up 20% to £120bn. In contrast, house building was unable to respond to burgeoning demand for owner occupation, with just c135,000 new homes completed in 2002, around 3% up on 2001. Planning delays, labour shortages and the lack of available land are likely to have been the main constraints on private sector building.
This was partly due to better than expected economic conditions…
Although the economy grew less than expected (around 1.6% compared to our forecast of 2.0%), the composition of growth also differed from our forecast with the corporate sector considerably weaker and the personal sector stronger. Importantly for households the weakness in the corporate sector has not yet lead to significant increases in unemployment. Secondly, weak corporate activity, driven by the global economic downturn and the slump in business investment, helped keep inflation down. As a result base rates were kept on hold at 4% throughout 2002 in contrast to our forecast of year-end base rates of c5%. Not only did base rates stay on hold, but the cost of borrowing actually fell due to a combination of lower fixed rate prices and intense competition in the mortgage market.
…but this alone was not enough.
Our research suggests that the key economic drivers of property demand are real disposable income growth (determined by both employment and average earnings growth) and the real cost of borrowing (i.e. mortgage rates adjusted for inflation). Both of these factors boosted demand for property in 2002 with real disposable earnings up by 4% and real mortgage rates down by 1.2 percentage points to their lowest level for 21 years. However, our estimates suggest that these factors alone can not explain the strength of the housing market in 2002. In fact based on pure economic factors we believe the increase in house prices would have been between 10-15% rather than 25%.
2002 was also driven by positive sentiment and expectations.
The rest of the increase is harder to explain. One reason this may have occurred is that expectations of future house price growth may have increased. Many households may now believe that c10% price growth is a permanent feature having seen this occur in each of the last 6 years. Given this expectation first time buyers may have decided to bring forward their purchase for fear of being unable to enter the market if they delayed. In addition there is a growing belief that low interest rates are here to stay rather than a cyclical temporary phenomena. This may have prompted some households to climb further up the property ladder and to look to do so more quickly. Others may have been tempted to buy additional properties in the expectation of healthy capital gains - particularly given the poor returns to be gained from other assets. Overall 2002 saw a sharp rise in demand for property underpinned by extremely confident households - who as a result of low interest rates and the lowest unemployment in 27 years now view their financial situation as favourably as at any time in the last 20 years.
2003 economic outlook improving but personal sector conditions to deteriorate slightly…
The outlook for the economy in 2003 is largely the reverse of 2002. We expect economic growth to rise to 2.3%, but for this growth to be more balanced than in 2002 as the corporate sector recovers and the personal sector slows. As the global economy picks up business investment should recover, however, corporate sector profitability will remain under intense pressure. This is likely to translate into further job shedding and will form the backdrop to slower employment growth and relatively modest earnings growth. In addition, the increase to National Insurance payments will further limit real disposable income growth. Interest rates will also rise to c4.75% by the end of the year and this will hit affordability. Affordability for first time buyers is already stretched because of the sharp rise in prices over the last few years - particularly in London and other hotspots. So far first time buyers continue to enter the market in reasonable numbers because lenders have been willing to increase the amounts they lend and buyers have used ingenuity in terms of clubbing together and obtaining help from parents. The ability to do so will erode over the next year as interest rates rise and sentiment changes.
…but key issue is how sentiment and expectations will change.
Nevertheless, conditions are still good for housing and our research suggests that based purely on economic conditions house prices will rise by around 10% in 2003. Of course in 2002 other factors raised price growth by around 10%. So our forecast is extremely dependent on a view about sentiment and expectations. Even if the modest increase in unemployment we have pencilled in does not dampen the market directly we still expect consumer confidence to wane as further high profile job losses damage job and income security. Confidence is also likely to be eroded when interest rates start rising mid-way through 2003. In addition, we believe households will begin to lower their expectations for future house price rises. This suggests that potential first time buyers will be less eager to rush into the market during 2003. Many existing homeowners will begin to realise that the debt they have already taken on is not eroding as quickly as in the past given the current low inflation environment(2). This will mean that many existing homeowners find it more difficult to trade up without increasing their debt (and consequently debt payments) to uncomfortable levels. This should make them more prudent and translate into less trading up on the part of existing homeowners who will look to stay in their current property for longer.
Central view is that UK housing market achieves a soft landing in 2003…
Overall we believe that sentiment and expectations will be broadly neutral for house price growth. Given the modest deterioration of economic conditions our forecast is for UK house price growth to slow from around 25% in 2002 to 10% in 2003. The slowdown is likely to focus on the second half of the year, with the current strength of the market persisting for several more months. We may even see a static period of house prices around the Summer/Autumn as the market pauses for breath in light of affordability constraints and higher interest rates.
Chart 1 shows how our view of the market over the next two years translates into typical benchmarks for house prices. If our forecast for interest rates and house prices for 2003 is correct a typical homeowner would have to give up 27% of gross average earnings on a mortgage, slightly above the historical average, compared with 24% today. However, if base rates moved to 6% (with mortgage rates of 7.5%) in 2003, this proportion would climb to 32%, still well below the peak of the late 1980s.
The chart also shows that in our forecast the house price earnings ratio will eclipse the peak seen in the late eighties. However, this is not a good predictor of affordability when rates are low and is less relevant in the current period than debt payments. House sales will be influenced by similar factors and follow a similar path in 2003, with the total number of properties changing hands expected to be 1.55 million.
…but underneath headline forecast lies a diversity of experience…
Although the UK forecast is for a relatively smooth slowdown, this masks a variety of performance at the regional level. Given affordability and economic conditions will be the most testing for London we expect to see house price growth closer to half the UK level. City employment prospects have clearly worsened and pay/bonuses appear set to remain under downward pressure. It is also London that has seen the most extreme price rises over the last few years and someone borrowing 3 times average earnings now needs a deposit of around £106,000 compared with £57,000 two years ago to be able to get a foot on the property ladder. With affordability stretched, interest rates rising, confidence declining and employment and income growth sluggish it is possible that certain pockets of London and other hotspots around the UK may see house price falls at least for a period of next year. Outside of the capital we are likely to see faster growth in the North where we would expect c15% growth during 2003. The Midlands, the rest of the South and Wales are likely to be close to the UK average while Northern Ireland and Scotland will probably be a little below average - Northern Ireland because of fast growth in previous years and Scotland because it tends to be less cyclical than the rest of the UK.
…and significant level of uncertainty suggests a range of alternative outcomes.
Given the considerable uncertainties surrounding the market it makes sense to consider a number of alternative scenarios. It is commonly accepted that house prices cannot continue rising at the current rate indefinitely, but if consumer confidence does not weaken next year, the economic fundamentals remain supportive to the housing market and sentiment remains strong, it is not inconceivable that house prices could rise another 20-25%.
However, a number of MPC members have raised concerns about the rate of debt acquisition linked to the rise in house prices. It is difficult to say categorically whether significant imbalances are emerging, however, another year of 20+% house price inflation on the back of high mortgage borrowing would significantly increase the likelihood of price falls in subsequent years, negatively impacting on the MPC's ability to meet its inflation target. To prevent a large undershoot of the target further out the MPC may try to slow the market.
Whether a soft landing could be achieved in these circumstances is debatable and a sizeable rise in rates could send the market into reverse (see scenario B in chart 2).
A second scenario (scenario C in chart 2) involves the economic fundamentals worsening by more than we are expecting. For example, if the global economy experiences a further downturn and the corporate sector does not recover in 2003, a significant rise in unemployment could result. In this scenario any support to prices from sentiment evaporates and on the back of rising unemployment and lower real income growth, house price growth slows sharply in 2003 and grinds to a halt by early 2004.
Charts 3 and 4 plot our estimate of the probability of different house price inflation outcomes for end-2003 and end-2004, and provide an indication of the uncertainty surrounding this year's forecast. We see upside risk to the forecast in 2003 with the probability of the market continuing apace and then prices falling in subsequent years being greater than the weakening fundamentals scenario. For 2004 the risks are skewed in the opposite direction with both the weaker fundamentals scenario and the boom/bust scenario leading to price growth below our central view.
(1) Our house price inflation forecast for December 2002 published at the end of last year was 6% and the forecast for sales was 1.4 million.
(2) For a full exposition of how low inflation and interest rates may have affected house buying behaviour please see our November Monthly Housing Review.
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