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HomeInvestmentSeptember 18th, 2023: A Recap of the Unusual

September 18th, 2023: A Recap of the Unusual

We start this week’s Weekly Roundup by discussing house prices, specifically in the US and Denmark. The Economist raised the question of how US house prices could continue to rise despite mortgage payments being at their highest since the 1980s. Mortgage rates have increased from 3% to 7% due to Fed rate hikes, resulting in the median home’s monthly payment doubling for the median family. However, after a brief decline, house prices have bounced back to reach record highs. While demand for homes has decreased with rising rates, the supply of properties has also fallen. The US housing market typically relies on fixed-rate mortgages for 30 years, which is uncommon in other countries but considered a right in the US. These mortgages are securitized by government-backed entities Fannie Mae and Freddie Mac. However, the downside of long-term mortgages is that homeowners are unlikely to sell when rates are half of what the market offers. Fixed-rate mortgages also slow down the impact of interest rate hikes on the economy. The decrease in transactions could potentially harm the economy by dampening housing-related activities such as remodeling, new construction, and furniture purchases. However, people have been investing in improving their existing homes, partly due to remote working. There has also been a shift towards new builds, which offer lower interest rates through an upfront payment. If rates remain high for an extended period, the housing market may cool down, but on the other hand, a robust housing market can contribute to an overheating economy. The unaffordability of housing may also drive more people towards renting, leading to increased rents and potentially inflating prices.

The Economist also examined the Danish mortgage market and the issues caused by rising rates. Unlike the US, mortgages in the UK and Sweden are usually fixed for only a few years. Denmark offers a unique middle ground, allowing homebuyers to borrow at 30-year fixed rates without the problem of being “locked in” homeowners. Sellers can end their mortgage by buying it back at market value, which decreases when rates rise, allowing them to cash out their interest-rate fix. They can also transfer their mortgage to the buyer. This arrangement has created a more dynamic market, with housing transactions down by only 6% in the first quarter of 2023 compared to a year earlier, compared to a 22% decline for existing homes in the US. This system does not require government-backed agencies like Fannie Mae and Freddie Mac in the US.

In the Financial Times, Emma Agyemang discussed the likelihood of increased taxes regardless of who wins the next UK election. While Labour has ruled out a wealth tax and tax increases on capital gains and property, some Conservatives are pressuring the Prime Minister to cut taxes before the election, with the abolition of inheritance tax as a prominent proposal. The Institute for Fiscal Studies (IFS) recently concluded that there is no room for tax cuts without corresponding cuts to services. It seems evident that any mention of reducing the size of the state is now forbidden. Labour has pledged to abolish the non-domicile scheme, impose VAT on private school fees, and eliminate the carried interest tax break used by private equity firms. They have also expressed intentions to restore the lifetime allowance on pensions, but previous contributions may require protection. Chancellor Jeremy Hunt has tempered expectations of tax cuts, focusing instead on inflation and the need to avoid injecting billions into the economy. The UK’s current tax burden is the highest since the post-war era and is predicted to reach 38% of GDP by 2027-28. These increased tax revenues primarily come from “stealth” taxes, such as freezing allowances and tax thresholds from April 2022 to 2028. This approach, known as “fiscal drag,” is particularly effective during times of higher inflation. The threshold for the 45% tax rate has also been lowered to £125,000, resulting in more individuals paying higher rates of tax. Other freezes and cuts include inheritance tax, capital gains tax, and the dividend allowance. Moreover, higher interest rates mean more people will be subject to tax on their savings interest.

The Economist highlighted that US stocks are currently at their most expensive levels in decades. Historically, stocks have returned an average of 6.4% per year (after inflation), while bonds have only returned 1.7%. However, the appeal of buy and hold investing based on historical returns is no longer as straightforward. What matters now is prospective returns, and in that regard, shares appear more expensive when compared to bonds than they have in decades. As stocks are riskier than bonds, they need to offer a risk premium or higher return. Estimating the return on bonds is relatively simple, whereas gauging stock returns is more complex. However, a quick proxy can be obtained through the “earnings yield” (expected earnings for the upcoming year divided by share price). Over the past year, this premium has significantly decreased. Expected earnings and Treasury yields are around the same levels as in October when share prices hit a low point. Since then, share prices have soared, reducing their earnings yield and bringing it closer to the “safe” Treasury yield. There are three potential explanations for this trend. Some investors may believe that earnings are poised for rapid growth, potentially due to an AI-driven productivity boom. Others may think that earnings are less likely to disappoint, justifying a lower risk premium. Lastly, some investors may fear that Treasuries have become riskier. Unfortunately, none of these options are particularly favorable, and the second theory revolving around “animal spirits” is the most concerning. The compressed premium likely reflects a bet on a soft landing scenario where inflation remains low without triggering a recession, although this outcome is uncertain. However, it is worth noting that the previous year was the worst for bonds in over a century, and investors may still be recovering. Furthermore, the preference for stocks at any price could indicate a belief that structural inflation has increased. Higher bond yields may also be a lasting phenomenon as governments issue more debt to cover various expenses, and central banks reduce their buying activities.

Joachim Klement explored whether the Phillips Curve has become steeper. The Phillips Curve, dating back to the 1960s, describes the relationship between inflation and unemployment. One would expect lower unemployment rates to lead to higher inflation due to increased demand, while combating inflation usually results in increased unemployment. To analyze this relationship, Klement examined the 10-year correlation between inflation and unemployment. The correlation is typically negative (below -0.4), indicating that unemployment and inflation are inversely related. However, over the past two decades, this negative correlation has rarely been observed. In recent years, the correlation has once again become negative. This raises the question of whether the Phillips Curve has resurrected and become steep enough to be useful for policymakers. A recent study suggested two factors contributing to a steeper Phillips Curve: deglobalization and digitalization. When a country becomes more globalized, it exposes itself to foreign labor, weakening the link between inflation and unemployment. Conversely, increased digitalization enables businesses to respond more flexibly by replacing workers with machines. This increases price flexibility, resulting in greater fluctuations in inflation in response to small changes in employment or consumer demand. The aftermath of the pandemic has led to rising digitalization, making prices more flexible and steepening the Phillips Curve. Meanwhile, trade intensity has experienced a slight increase, leading to a somewhat flatter Phillips Curve. The net effect is a slight overall steepening. In the eurozone, a one percentage point increase in the output gap (the shortfall from peak economic capacity) results in approximately 0.5% higher inflation rates, while the UK sees a 1% increase. Klement remains skeptical about the steepness of the Phillips Curve and its usefulness as a theory for policymakers, suggesting that it may be flattening once again.

Lastly, we saw some positive news about UK GDP.

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