Markets Weekly podcast – 18 July 2022

Julien Lafargue (JL): Thank you for joining a new edition of Barclays Private Bank’s Markets Weekly podcast. My name is Julien Lafargue, Chief Market Strategist here at Barclays Private Bank, and I will be your host today.

As usual, we will start this podcast by taking a look at the recent events that impacted markets before moving on to our guest segment. And this week, in light of the changes in 10 Downing Street and the recent interest rate hikes by the BoE, we will be spending some time discussing the UK real estate market with Stephen Moroukian, our Product and Proposition Head for Real Estate Financing.

But first, let’s spend some time looking at last week’s action. It was all about inflation and earnings. On the inflation front, US CPI came in hotter than expected in June. If you recall, we mentioned last week that while the official consensus was 8.8% year over year, the whisper number was closer to 9%. Now, we got 9.1%, a 40-year high.

Of course, energy costs were a key contributor, and so was food. But maybe more surprisingly when excluding these more volatile items, core inflation was still up 5.9% year over year. While that was two tenths above the consensus, we probably can find some solace in the fact that it remains on a downtrend after peaking at 6.5% earlier this year.

So, the market reaction was negative at first, but equity markets quickly recovered partly thanks to the core inflation and partly because investors understand that this data point is backward looking. And looking at the recent price action, especially in the commodity space, it could be that the worst is, in fact, behind us when it comes to inflationary pressures.

That being said, the Fed will likely go by 75 basis points next week and 100 basis points remains a possibility, but the central bank may be worried that it would be too much, at a time when the US economy is showing signs of slowing down, at least that’s what Fed officials seems to indicate.

Now, after inflation the focus turned to earnings with large US banks posting Q2 numbers on Thursday and Friday. As we mentioned also last week, numbers weren’t too bad. Of course, earnings per share were down year over year, but that is a function of a very strong Q2 last year in 2021. In fact, the consensus was expecting financial earnings to be down 20% on aggregate in the second quarter of this year.

So, the main takeaways so far are that, first, banks’ traditional businesses, think about just lending money is doing just fine. On the other hand, non-interest income, so that’s your investment banking fee, your mortgage fee, your trading activity, all that is rather weak.

If we look at the balance sheet side, which is quite important nowadays, credit quality remained very strong and that’s a clear positive, and banks are actually bumping up reserves in order to better prepare for a slowdown ahead. This is a function of a more uncertain outlook but also because they are lending more and, therefore, they need to build reserves against these loans.

Now, finally, in terms of outlook, US banks sounded generally positive about the current state of the economy and the health of the US consumer. They were a tiny bit more cautious around the future and some of them indicated that a slowdown is likely, although it should be relatively mild, which is encouraging.

So, all in all, we haven’t learned much actually from US banks. That’s not necessarily a bad thing. It simply implies that, and confirms, our view that a lot of the bad news that was expected may already be in the price.

Now, that’s it for last week’s highlights and now it’s time to welcome Stephen Moroukian, and to spend some time discussing the UK real estate market.

Stephen, thank you very much for joining us. I want to start our conversation by just asking you to give us an update. Last time we spoke about the race for space, the return from international buyers. Can you give us a quick update on the state of the UK real estate market?

Stephen Moroukian (SM): Yeah. Hi, good morning, Julien, good to be here. So, yeah, just a reminder of the backdrop. UK property prices have seen a once-in-a-generation nationwide uplift. And in the key markets for our clients in the UK, we’ve seen that in the prime rural, prime coastal and the large country house market. And, look, on a week like this who wouldn’t want to be by the sea right now?

So, last time we spoke, we were seeing between 10% to 20% uplift, depending on where and what, since the start of the pandemic. And, whilst the predictions are that the steam will come off this growth a little bit, the indicators remain cautiously positive and, of course, a great amount of wealth has already been created in a relatively short period of time.

So, the race for space as it’s been called, is resetting itself slightly in line with the reality of the office being an anchor point again and the cost and time reality of commuting really hitting home. And, again, on a hot week like this, commuting is not something many people are looking forward to.

So, London was the peculiarity, with some very consistent performances based on property types, location and quality of property. And what we’re seeing is a slow but expected return to growth for London prime and super prime, which is underpinned by the factors of demand continuing to outstrip supply. There’s just simply not enough of the right property available and a lack of luxury new build on the horizon due to various planning rules, the cost of materials, labour shortage etc.

The international demand is definitely coming back. Heathrow flight numbers have doubled since the last time we spoke, and we’re seeing demand from new markets like US residents coming to the UK, mainland Europeans really noticeably buying up London, and those domestic buyers, and we’ve talked about this before, the domestic buyers who acquired a property over the pandemic, both the town and country strategy, they’re simply not releasing those town properties back into the market. And with prices forecast to look good, why would they?

JL: So, OK, fine, but the other key question, I guess, is have we seen any change on the back of the recent interest rate increase in the UK? And also, like most regions in the world, the UK is facing a pretty hard inflationary environment, so what does this mean for UK property and mortgages?

SM: Well, really good question, and it really goes back to some of the things that you said at the start, Julien, around credit quality and access to lending. Look, one of the main stories this quarter has been the swap markets and this is the lead pricing benchmark for long term funding used by UK mortgage lenders for their fixed rates, including Barclays.

And really, just to bring this to life for the listeners, you know, the market cost of a five-year swap this time last year was just over 0% and today, it's around 2.5%. And whilst that’s a relatively small increase in terms of the numbers themselves, clearly, the percentage quantum increase is dramatic and an incredibly short window of time also. All mortgage providers in the UK have had to uplift their fixed rate pricing as a result, and it’s been unclear during that window where these rates would settle or whether that surge would continue.

So, in the wake of this, there’s been the increase to central bank rates and, of course, the market predicting those hikes well in advance and pricing them in. So, what’s the true impact on existing borrowers and mortgage borrowers in the UK?

Well, since 2014, affordability calculations have been very prescriptive by the regulator and the Bank of England and, as such, mortgages underwritten during the last eight years have considered, and accounted for, future interest rate increases. In fact, this has been stressed as high as 7% or even 8% and, therefore, the recent increases for those borrowers on tracker or variable rates should have a relatively benign impact on those borrowers’ ability to service their mortgage, which clearly is an important factor.

And, of course, what it does mean is that they will be diverting either savings or disposable income in the direction of the mortgage versus other lifestyle expenditure.

The other key point to remember here is that around 80% of mortgage borrowers in the UK today are actually on some sort of fixed rate. So, everything I’ve just said about rising interest rate impact only affects a very small proportion of borrowers which is, of course, good news.

However, the story doesn’t end there as a meaningful percentage of those borrowers are coming off their fixed rates over the next two years, and this is what is worrying the Bank of England and regulators at the moment. As those borrowers come off, we know that they’re the types of borrowers that are keen on exposing themselves to less interest rate risk, that they took a fixed rate after all, and some will see their payments go up in a one move driven by what I said at the start in terms of the swap rate movement as they refix their position.

However, at a macro level, the likely impact to households’ income looks to be fairly limited in the short term. And lastly, the Bank of England informed borrowers that some of the stress in premiums, that it’s considered historically, need not be fully considered. And this was a big move very recently and this type of change takes a while to be understood and interpreted, but ultimately should make borrowers who are looking to refinance subject to a lower affordability requirement at some point in the future.

JL: Well, I’m one of those borrowers so I’m not looking forward to the next two years when I need to remortgage. But as if there was not enough going on with the UK, I think the other key element that we need to think about when talking about UK retail estate market is what’s happening in 10 Downing Street. So, in your opinion, does the PM race that has opened have any impact?

SM: Well, what a week it’s been and I’m sure, like me, you’ve keenly watched the debates this weekend. I think that, very simply, general elections cause delays in global buyers transacting in London, but really only where there’s nothing lost in waiting and I think we’ll see a little bit of that again, but as I said due to some of the supply shortages, some of the currency plays available at the moment, I suspect that that will be less felt.

And, look, we’re talking about one Conservative Prime Minister taking over from another and I think internationally that’s certainly less volatile in terms of a situation than a total change of government, and certainly the rhetoric that I’ve been hearing from the candidates has been around how to best lift barriers to international trade. So, the rhetoric is quite positive.

I think the six months lead-in to any general election tends to be the window where there is a hold versus buyer position, so whether that happens in late 2024 or possibly now earlier I guess is anybody’s guess, but remains on my list of things to watch.

JL: Well, clearly, there is so much going on in the UK. Thank you very much, Stephen. Your insight on what all that means for the UK real estate market is extremely helpful, so thanks again for joining us.

Now, before we conclude, a few key items to put on your agenda for the week. First and foremost, the ECB meeting on Thursday when we expect the central bank to increase interest rates for the first time in more than 10 years. And then this will be followed by the flash PMI for the month of July on Friday and an early look at what economic activity has done. And that same day we should also know if the Nord Stream 1 pipeline gets turned back on as scheduled, which is likely to be a key catalyst.

Finally, there will also be a long list of companies reporting earnings on both sides of the Atlantic throughout the week. This is going to be a very hot week, which we’ll debrief in our next podcast. But until then, please stay hydrated and let me wish you the very best for the trading week ahead.