Do recent events signal the downturn for house prices and bonds, asks John Plender
A curious feature of markets is how often the bursting of a bubble is signalled by what appears in hindsight to be a strongly symbolic event. The peak of the recent equity bull market, for example, coincided almost exactly with the departure of the famously bearish Tony Dye from fund managers PDFM. Just when his views were about to be vindicated, he found himself in the ejector seat.
Now in the housing market we have something similar, courtesy of Cherie Blair. The buy-to-let market has played a similar role in this bubble to that of technology stocks in the equity bubble. It is where irrational exuberance is at its most intense.
So it is intriguing to observe that the prime minister’s wife was buying two flats in Bristol – one for her son, the other for investment. She is surely going in at the top and I suspect that this will be seen to have heralded a market turning point.
The question now is how big the fallout will be if the market is turning. By the standards of the early 1970s or late 1980s housing booms, what we now have is pretty big. It is also different.
When those earlier booms collapsed, inflation was relatively high. As a result, nominal house prices did not have to go down for the market to adjust. Today, inflation is low.
A choice of two futures
So there are two possibilities. Either the market adjustment will take place over a very long period in which house prices stagnate in nominal terms while the nation’s earnings rise. Or there will be a fall in nominal prices on a scale that will be quite different from anything seen over the past half century.
If you take the view that UK interest rates have bottomed out and that confidence is vulnerable with a war looming over Iraq, the latter scenario looks the more plausible.
But this is not the only potential market turning point that matters for property. People are also talking about a bond market bubble. Since the global bull market in bonds has been driven less by irrational euphoria than powerful disinflationary forces, it should not really qualify for bubble status. But there are powerful arguments to suggest that the market is overshooting.
The sackings of US Treasury Secretary Paul O’Neill and George W Bush’s chief economic adviser, Larry Lindsey, are significant. Neither man was happy with the president’s instinctive desire for a big pre-electoral push for tax cuts.
With businessman John Snow in charge at the USTreasury, fiscal policy looks set to loosen, having already loosened considerably since the attack on New York’s twin towers.
Similar pressures are at work all across the world. In Japan the government continues to run big deficits and rack up large public sector debts for fear of precipitating a deflationary downward spiral. In continental Europe, President Chirac’s government is ignoring the rules of the misnamed Stability and Growth Pact and expanding the budget.
The UK is likewise opening the spigot. Its big public spending plans are taking place against slower growth than the Chancellor had hoped when the plans were forged.
Can bonds withstand the pressure?
So with some of the world’s biggest economies putting pressure on the bond markets to finance public spending or tax cuts, the current level of bond yields may prove unsustainable.
In the US, where short rates are down to 1.25%, Treasury long bonds yield less than 5%, but have been creeping upwards. In the UK long gilts yield around 4.5%, which is extremely low by historical standards.
But before concluding that huge government funding requirements will cause yields to rise sharply, it is worth noting that all the portfolio pressures are working in the other direction. Here in the UK, consultants Watson Wyatt have been forecasting that pension funds will be increasing their bond holdings in order to achieve a better match for their liabilities. The ballooning of pension fund deficits in the bear market is causing a rethink on asset allocation. Life assurance companies are likewise having to think more carefully about the extent of their exposure to equities. Similar pressures are at work in the US, where pension fund deficits have risen unnervingly as a result of the equity market collapse.
The judgment on bond yields, then, is tricky. My best guess is that the sheer volume of funding that will be required in the US will mean that Treasury yields will rise next year and that this will pull European bond yields up too. So this may not be the optimal time to make a policy change on asset allocation in favour of bonds.
And to return to Cherie Blair, it is certainly not the moment to start buying to let.
John Plender is a broadcaster and leader writer for the Financial Times.
