Upturn in world economy
The recent upturn in world growth is reflected in the significant rise in oil and metal prices, although in the case of crude oil, the uncertainty surrounding crude oil supplies has also played a role in the rise in price to above $70/barrel. The upturn in world growth has implications for the housing market. The most immediate impact is that longer-term interest rates have risen. The housing market should, however, benefit from the trade off between world and UK economic growth – the UK is a major trading nation.
There is already evidence of an upturn in the UK economy. The annual growth rate in the first quarter of the year rose from 1.8 per cent to 2.2 per cent. Quarterly data suggests that the UK economy is now returning to trend level, which is in the region of 2.5 per cent per annum. The upturn in the UK economy has re-enforced our view that the housing market outlook for 2006 and 2007 is positive.
The upturn in the UK economy is reflected in the resilience of the housing marketing. The most recent Royal Institute of Surveyors April report showed an upbeat picture of activity in most parts of the country. The exception was those parts of the Midlands and Northern England where the increase in manufacturing unemployment is impacting on housing market sentiment.
In other parts of the country, the service sector is by far the largest employer, and housing market activity is expanding. In the UK as a whole, net mortgage lending in the first quarter of the year is estimated to have been in the region of £25billion, which is on target for our forecast of £100 billion for 2006 as a whole. Gross lending is also on track in respect of our forecast of £300 billion for the year as a whole.
Longer-term rates are determined primarily by international factors. The upturn in the world economy has led to a 0.30 per cent increase in three-year plus period rates to a level in excess of 5 per cent. The two-year rate has risen to a fraction over 5 per cent.
Forward markets are now clearly of the view that the next move in Base Rate will be up. While we expect growth and underlying inflation to remain close to trend over the next two years, the Bank of England’s Monetary Policy Committee (MPC) tends to be pro-active. It is unlikely to be content with a situation where Base Rate is on hold indefinitely. There is a strong possibility that the MPC will increase Base Rate by 0.25 per cent in the first quarter of 2007 as an insurance policy against the risk that higher commodity prices eventually translate into higher inflation.
There is a finite limit to the ability of UK industry to absorb increased input costs. The prospect of one Base Rate increase in 2007 is reflected in the current level of swap rates. We believe that the swap market will eventually discount a rise in Base Rate to 5 per cent in 2007, as evidence of UK and world economic recovery gathers momentum. Our own forecast is that Base Rate will peak at 4.75 per cent next year, and that Base Rate is likely to remain within a 4 per cent to 5 per cent range on a two-year horizon.
House price inflation
The most recent house price data shows that the annual rate of house price inflation remains over 5 per cent based on an average of both the Halifax and Nationwide indexes. This upbeat picture of the housing market is supported by the most recent Royal Institute of Chartered Surveyors (RICS) survey, in which RICS states that house prices have risen for the fifth consecutive month, while the number of enquiries has increased for the tenth consecutive month. RICS does state that prices are growing at a slower rate. We regard this as a healthy signal. If house price inflation eases back to a level close to underlying average earnings, this is a sustainable scenario.
There are many commentators who regard the housing market as overvalued. We currently view the housing market as fairly valued when account is taken of the significant shortfall of new housebuilding in recent years. Since new building represents a small percentage of total housing stock, it will be many years before the supply deficit factor is eliminated. We believe that an annual rate of house price inflation in the region of 4-5 per cent per annum is sustainable until at least 2010.