Market commentary

A fragile recovery

Developments over the last month have been broadly as expected. Signals from the housing and mortgage markets have generally shown a modest further improvement in sentiment and activity. But it has not all been one-way traffic and the market overall remains lacklustre.

Most of the indices point to house prices rising modestly over the summer months. The CML's July gross lending estimate of £16 billion is the highest level in nine months and consistent with the rise in house purchase approvals. 

Meanwhile, the Bank of England pointed to a few more encouraging signs in its Inflation Report, with financial markets more positive and bank funding conditions improving a little, albeit remaining fragile. While the bank reporting season inevitably saw mixed results, it has generally supported markets' belief that the worst might have passed. Equity markets have risen sharply in recent months as hopes of an economic recovery grew.

Chart 1: UK Economic growth, quarter-on-quarter, % change

Source: ONS

A snapshot of recent economic trends is nevertheless stark. The initial estimate of second quarter output, showing a 0.8% contraction, contrasts with growth resurfacing in several other economies including France, Germany and Japan. The UK now looks to be an international laggard. While the Bank believes the economy may now start to grow, the fall in output was deeper than initially thought, and the difficulty banks face in extending credit to the wider economy remains a significant risk to growth. Reflecting these factors, the Bank stepped up its quantitative easing policy by an additional £50 billion at its last MPC meeting. This caught markets rather off-guard, but is perhaps unsurprising given the unprecedented nature of the policy. 

We share the Bank's caution that the housing market recovery is likely to be fragile. It is difficult to envisage a strong improvement in the short-term. Unemployment is now at a 14-year high of 7.8% and widely expected to rise further, while the lending industry continues to be constrained following the loss of capacity since the on-set of the credit crunch. Mervyn King described banks' need to restructure balance sheets as "a necessary part of the healing process". Many commentators believe it will take some time for this process to play out. 

Low interest rates helping many borrowers

There was some moderately welcome news in the CML's second quarter arrears and possessions statistics as the number falling behind on their mortgage payments did not rise as much as might have been feared, given the sharp increase in unemployment. The exceptionally low interest rate environment has created much more breathing space for borrowers who might otherwise have struggled - the mortgage interest component in the July Retail Prices Index showed a 45% reduction in the cost of debt servicing from a year ago! And lenders have to date been able to help the vast majority of those who have fallen behind to stay in their homes.

Our forecast of 65,000 properties to be taken into possession in 2009, and 360,000 borrowers to be in arrears at the end of the year, may now prove rather pessimistic. But it is important not to be complacent, as we are certainly not yet out of the woods. The worst impact of rising unemployment and lower incomes is most likely still to work its way through.

However, the Inflation Report suggested that rates will remain at, or near, current lows for some considerable time yet as the recession has generated spare capacity in the economy. The July CPI measure - at 1.8% - was higher than markets expected, and some interpreted this as bringing forward when monetary policy might be tightened. But our view is that a rise in official rates remains some considerable time away. This will help contain mortgage arrears, but does not, in its own right, solve underlying problems faced by those out of work or suffering reduced income for extended periods.

Pick-up likely to flatten in coming months

The bounce-back in activity from the extreme weakness around the turn of the year, coinciding with a seasonal bounce, is limited in how far it can go against the current economic back-drop. We expect improved sentiment to support the current state of the market. But a further significant pick-up is unlikely with so many obstacles in place. As a result we anticipate some seasonal slowing in lending volumes and housing transactions over the latter part of the year and the general story to be one of a slow but more stable market.

CML Research

1. Name: Caroline Purdey
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2. Name: Bob Pannell
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