Month: May 2017

With Congress poised this week to approve a deal to fund the government through September, the first major bipartisan legislation of Trump’s presidency, after lengthy negotiations (which have appeared to signal numerous ‘folds’ by President Trump), apparently frustrated by the lack of tryannical powers that a simple majority grants him, President Trump has lashed out this morning at disagreeable Democrats, and in particular Senate Democrats.

The reason for the plan negotiated between the Republicans and Democrats is that we need 60 votes in the Senate which are not there! We….

— Donald J. Trump (@realDonaldTrump) May 2, 2017

But Trump has a solution.

either elect more Republican Senators in 2018 or change the rules now to 51%. Our country needs a good “shutdown” in September to fix mess!

— Donald J. Trump (@realDonaldTrump) May 2, 2017

We’re not so sure there is such a thing as a “good” shutdown of the US government – and with what will be over $20 trillion in debt and a declining GDP by that time, one wonders which ratings agency will have the balls to downgrade the world’s reserve currency this time?

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One year after Och-Ziff Capital settled a bribery case that led to jump in redemption requests and an exodus in high profile executives, on Tuesday the hedge fund reported that it suffered record net withdrawals in the first four months of the year, extending several straight quarters of outflows.

The firm reported net redemptions of $4.8 billion in the first quarter and an additional $2.1 billion from April 1 and May 1. At the same time, assets under management declined from $37.9 billion as of December 31, 2016 to $32 billion as of the beginning of May, a record $5.9 billion decline, and a 24% drop from a year earlier.

As discussed at the time, and as Bloomberg reminds this morning, the redemption wave started when the hedge fund settled a five-year bribery probe and saw founder Dan Och singled out by regulators for ignoring red flags and corruption risks. Och-Ziff agreed to pay more than $400 million in September to settle U.S. charges that it paid bribes to gain business in Africa. Its OZ Africa Management GP unit pleaded guilty to conspiring to bribe officials of the Democratic Republic of Congo.

This led to client withdrawals of over $8 billion.

As Bloomberg adds, the bulk of this year’s withdrawals occurred on Jan. 1, when the company fulfilled redemption requests for the end of 2016. With the decline in assets, Och-Ziff’s revenue from fees plunged by about a fourth in the period compared with a year earlier. Management fees were down 44% to $80.8 million, even as performance fees rose almost 70% to $51.6 million.

Pradoxically, the multi-strategy OZ Master Fund rose 4.1% in Q1, and the OZ Credit Opportunities Fund was up 3.2% but even that was not sufficient to placate investors who juts want to recover their funds once lockups terms expired.

Some highlights from the call, courtesy of Bloomberg, suggest that a trace of optimism may be returning:

• OCH: ONE QUARTER AWAY FROM END OF SETTLEMENT IMPACT ON FLOWS
• OCH: AFTER NEXT QUARTER INFLOWS WILL DEPEND ON PERFORMANCE
• OCH: WE THINK INVESTORS ARE COMFORTABLE WITH OUR PRICING
• OCH: WE BELIEVE WE’RE IN A POSITION TO DO WELL GOING FORWARD
• FIRM DOESN’T SEE ANYTHING ABNORMAL IN EMPLOYEE TURNOVER LEVELS
• HEDGE FUND SAYS IT FEELS GOOD ABOUT RETENTION OF WORKERS

However it remains to be seen if a turnaround is in the cards. Meanwhile, the biggest losers are shareholders who have seen OZM stock drop some 27% in just the past four months to $2.41.

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The CBOE VIX Index closed today at 10.11 (having traded with a 9 handle briefly intraday), which got ConvergEx's Nicholas Colas wondering what a single-digit reading may indicate about US stocks. 

Three historical periods back to 1990 feature a sub-10 VIX: December 1993, January 1994, and Dec 2006/Jan 2007. 

In each case, US equities were modestly lower (down 2 to 6%) one year later and in 2 of the 3 instances they were down 2-6% in three months’ time.  More importantly, the following years (1995 and 2008) show a remarkable dichotomy of returns (up or down 37%). 

So what has taken us down to these VIX levels?  In today’s note we call out 10 different notional market “Puts” that each tend to dampen actual (and therefore near term forecast) volatility.  These include Fed/ECB puts, a Trump/Republican policy put, a passive money flow put and a corporate cash put.  Now, if you’re looking to understand when volatility returns (and it always does), this “Top 10 Market Puts” list a good starting point.  When one or two begin to unwind, that’s when volatility will return.  And not before.

*  *  *

“It’s quiet out there… too quiet.”  That old line, its origins lost to history, neatly sums up how many equity traders feel right now.  Global equities continue their remarkable rally in the most unremarkable of ways.  Slow, and steady and boring.

The CBOE VIX Index briefly broke 10 today, essentially half of its long run average of 19.6, and closed at 10.11.  In its unofficial role as the primary forecasting tool of near term US equity volatility, that is the equivalent of a Los Angeles weather forecast.  80 degrees and sunny…  Next weather update in 5 days.

I got to wondering just how many days the VIX has closed below 10 and what that means for future equity returns.  The answers:

• The VIX has closed below 10.0 a total of nine times since 1990. There are three clusters on that timeline: late 1993 (December 22, 23, 27 and 28 1993), late 2006/early 2007 (November 20/21 with December 14 2006 and January 24 2007), and a standalone January 28 1994.
• Three, six and twelve month S&P 500 price returns after December 28 1993 were: -2.3%, -5.3% and -2.1%. (Worth noting – S&P 500 total returns for 1994 were +1.33%, but 3 month Treasuries returned 4.0%).
• Three, six and twelve month returns after January 28 1994 were, of course, similar at -6.2%, -5.1% and -1.7%.
• Three, six and twelve month returns after January 24 2007 were +2.8%, +4.9% and -6.1%. The following year was the bad one, with total returns for the S&P 500 of -36.6%.

The takeaway from these examples is clear: in the unusual instances (just 0.13% of the days since 1990) when the VIX closes below 10, one year forward returns have all been negative.  In one case (2007 into 2008) the following year was terrible.  In the other case (1994 into 1995) it was great – up 37.2%.

If you want to see a history of S&P 500/3 month T-bills/10 year Treasury note returns (very useful when looking at historical trends such as these), click here.

Important: the upshot of this quick analysis is this: a VIX close below 10 is historically correlated with a one year pause in S&P 500 returns.  The year after that is where things get dicey.  You could get a 1995 (+37%) or a 2008 (down 37%).

Now, 3 (2 and half, if we’re being honest) examples isn’t a great sample size.  To round out the discussion we need to come to some conclusions about WHY US equity volatility is so low.  And what might change that.

Here are 10 equity “Puts”:  commonly held investor beliefs about current market dynamics that help explain both low volatility and the march higher for US and global equities.

#1) The Fed Put.  Ever since Alan Greenspan came to the US equity market’s rescue after the October 1987 crash, there has been a school of thought that says the US Federal Reserve views equity markets as a “Third mandate” along with price stability and full employment. If markets falter, the Fed will pass on a June rate increase and perhaps those scheduled for later in the year as well.  Or so the logic goes…

 

#2) The ECB Put.  To the degree to which the European Central Bank has mimicked the Fed’s policies of ultra-low interest rates and the purchase of long dated bonds (quantitative easing), equity investors may well feel that there is also an ECB “Put”.

 

#3) “Long End of the Yield Curve” Put.  If global economic growth is about to take a step function higher (as indicated by rallies in US, EAFE and Emerging Market equities) no one seems to have told sovereign debt markets.  The US 10 year note for example, yields all of 2.3% and the 10 year German Bund pays a 0.3% coupon.  Those low rates help support equity valuations, and if global growth falters those rates will go lower still (and continue to help valuations).

 

#4) “Trump/Republican Washington” Put.  At some point before the mid-term US elections in 2018, President Trump and the GOP – controlled Congress should be able to pass tax reform.  That gives equity investors the chance to see earnings estimates rise for 2018 and beyond, supporting current valuations.

 

#5) “Passive Money/ETF Flow” Put.  Year to date money flows into equity US listed Exchange Traded Funds total $121 billion, a pace that will break all prior records if it continues through the end of 2017.  Moreover, those flows are remarkably consistent whether you look at the last day, week, month, quarter to date or calendar year.  As long as those trends continue, why worry about a market correction?

 

#6) “Offshore/Corporate Cash” Put.  US public companies continue to operate at near-record profit margins, but they are still more likely to buy back their own stock or hold cash offshore rather than invest in their business with those cash flows.  That leaves them less prone to financial stress during an economic downturn and therefore reduces their stock price volatility across the business cycle.  Also worth considering: if corporate tax reform does come through, these same companies may be able to repatriate some of their offshore cash holdings for buybacks (which would also reduce price volatility, everything else equal).

 

#7) “Lower Sector Correlation” Put.  Since the November US elections, sector correlations within the S&P 500 have dropped from +90% to 55-60%.  Should this continue (and absent a major correction, it should), overall S&P 500 volatility will remain lower than when correlations were higher.

 

#8) “Earnings Beats GDP” Put.  As it stands right now, the S&P 500 will post close to a 10% earnings growth rate for Q1 2017.  Part of that is from smaller losses in the Energy sector, and part is actual earnings growth in Financials, Materials, and Tech stocks.  All of it is enough to allow analysts to expect Q2 2017 earnings growth to run 8%, even though Q1 US GDP growth only showed 0.7% growth when it was released last Friday.

 

#9) “Receding Nationalism” Put.  Now that equity investors seem certain Marine Le Pen will not be the next French president, the prospects for a “Frexit” seem distant.  Polls currently have her at 40% of the vote versus Macron’s 60%.  See here for a good poll tracker: http://ift.tt/2pBjCwM

 

#10) “GDP Bounce Back” Put.  After a lackluster Q1 GDP print, the closely watched (and accurate for Q1) Atlanta Fed GDP Now model has a 4.3% starting estimate for Q2 2017.  Blue chip economists are sitting closer to 2.7%, but all agree for the moment that Q2 will be far better than Q1.

I could go on, but you get the point: there is an overwhelming market narrative that equates to “Don’t worry, be happy”.  That should be no surprise.  You don’t end up with a 10 handle VIX very often, and when you do it is the result of a unique set of circumstances.

I will close where I began, with the possibility of a single digit VIX reading.  Historically, that signals the possibility of a pause in equity returns.  This means at least a few of our 10 “Puts” will not actually work as anticipated.  But the real question is not 2017 – it is 2018.  Will next year resemble 1995 (+37%) or 2008 (-37%).  Again, that comes down to how many of these “Puts” survive the next 12 months.

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Another day, another jawboning escalation out of North Korea, which on Tuesday accused the US of pushing the Korean peninsula “to the brink of nuclear war” after two strategic U.S. bombers flew training drills with the South Korean and Japanese air forces in another show of strength. As Reuters reports, the two supersonic B-1B Lancer bombers were deployed amid rising tensions over North Korea’s pursuit of its nuclear and missile programs.

North Korea said the bombers conducted “a nuclear bomb dropping drill against major objects” in its territory at a time when Trump and “other U.S. warmongers are crying out for making a preemptive nuclear strike” on the North.

“The reckless military provocation is pushing the situation on the Korean peninsula closer to the brink of nuclear war,” the North’s official KCNA news agency said on Tuesday.

“Any military provocation against the DPRK will precisely mean a total war which will lead to the final doom of the US.”

The US air force said in a statement the bombers had flown from Guam to conduct training exercises with the South Korean and Japanese air forces.

Yesterday, the DoDBuzz website reported that two Air Force B-1B Lancer bombers flew near the Korean Peninsula Monday, days after North Korea conducted another ballistic missile launch, Pacific Air Forces officials tell Military.com.

The bombers departed Andersen Air Force Base, Guam, to conduct “bilateral training missions with their counterparts from the Republic of Korea and Japanese air forces,” said Lt Col Lori Hodge, PACAF public affairs deputy director. Hodge did not specify how close the bombers flew to the Korean Demilitarized Zone, known as the DMZ, but said they were escorted by South Korean fighter jets.

 

When asked if the bombers were carrying weapons, the command wouldn’t disclose, citing standard operating policy. In September, the service put on a similar show of force over South Korea, deploying B-1B bombers alongside South Korean fighter jets after another nuclear test from North Korea. The U.S. military has maintained a deployed strategic bomber presence in the Pacific since 2004.

 

While Hodge said the training was routine, the recent flyover marks another in a series of events the U.S. has taken to deter North Korea’s Kim Jong Un from additional ballistic missile tests — the latest which occurred April 28.

Ironically, the flight of the two bombers on Monday took place roughly at the same time as Donald Trump said he would be “honored” to meet North Korean leader Kim Jong Un in the right circumstances, and as his CIA director landed in South Korea for talks. South Korean Defense Ministry spokesman Moon Sang-gyun told a briefing in Seoul that Monday’s joint drill was conducted to deter provocations by the North.

Also overnight, Reuter reported that the U.S. military’s THAAD anti-missile defense system has reached operational capacity in South Korea, although they added that it would not be fully operational for some months. China has repeatedly expressed its opposition to the system, whose powerful radar it fears could reach inside Chinese territory. Foreign Ministry spokesman Geng Shuang again denounced THAAD on Tuesday.   “We will resolutely take necessary measures to defend our interests,” Geng said, without elaborating.

Asked about Trump’s suggestion he could meet Kim, Geng said China had noted U.S. comments that it wanted to use peaceful means to resolve the issue. Trump has been recently been full of praise of Chinese President Xi Jinping’s efforts to rein in its neighbor. “China has always believed that using peaceful means via dialogue and consultation to resolve the peninsula’s nuclear issue is the only realistic, feasible means to achieve denuclearisation of the peninsula and maintain peace and stability there, and is the only correct choice,” Geng told a daily news briefing.

It was widely feared North Korea could conduct its sixth nuclear test on or around April 15 to celebrate the anniversary of the birth of the North’s founding leader, Kim Il Sung, or on April 25 to coincide with the 85th anniversary of the foundation of its Korean People’s Army. The North has conducted such tests or missile launches to mark significant events in the past. Instead, North Korea conducted an annual military parade, featuring a display of missiles on April 15 and then a large, live-fire artillery drill 10 days later. So far the joint US-Chinese deterrence appears to be working.

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Much to the likely chagrin of the mainstream media, and Democratic Party blame narratives everywhere, Politico reports that the leaders of the Senate Foreign Relations Committee have reached a decision that’s sure to disappoint Russia hawks: They’re not taking up a Russia sanctions bill anytime soon.

“We're not going to do a Russia sanctions bill,” Corker told POLITICO on Monday.

Instead, Committee Chairman Bob Corker of Tennessee and ranking Democrat Ben Cardin of Maryland have agreed to move forward on a measure to counter Russian influence in Eastern Europe without using sanctions as well as an Iran sanctions bill.

“The ranking member and I are in strong agreement on a pathway forward and that's what we're going to do. We're going to do an Iran sanctions bill. It'll be done toward the end of this work period. We're also working together on a bill to push back against Russia in Europe and what they're doing, and those are the two courses of action that we're taking.”

The measure to counter Russian influence is expected to draw from a bill put forward by Cardin in January but will strip the measure of its sanctions. The Iran sanctions bill was introduced in March by Corker and has bipartisan support. It’s in retaliation for Iran’s ballistic missile development, support for U.S.-designated terrorist groups and human rights violations. Cardin’s sanctions bill is co-sponsored by 10 Republican defense hawks, including Sens. John McCain of Arizona, Lindsey Graham of South Carolina and Marco Rubio of Florida. Cardin spokesman Sean Bartlett confirmed the agreement in an email.

“Senator Cardin stands by the series of proposals he's laid out on Russia but looks forward to working with Chairman Corker on this bill as an initial step to hold Russia accountable for its destabilizing activities,” Bartlett said.

Rubio, a member of the Foreign Relations panel, indicated Monday he was unhappy with the decision to table the Russia sanctions measure for now.

“I think anytime is a good time for Russia sanctions given everything they've done,” Rubio said.

Of course the timing of the Senate's shift away from the 'Putin is Hitler' narrative, given President Trump's phone call with the Russian president today, is intriguing.

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Via TheAntiMedia.org,

Less than two months after announcing it would begin using artificial intelligence tools in its marketing arm, Facebook is now being accused of letting advertisers target emotionally vulnerable children.

According to The Australian, a 23-page leaked document obtained by the outlet — marked “Confidential: Internal Only” and dated 2017 — reveals that the social media giant used algorithms to sift through the posts, pictures, and reactions of 6.4 million “high schoolers,” “tertiary students,” and “young Australians and New Zealanders…in the workforce” with the aim of learning about their emotional state.

The news outlet says the algorithms essentially looked for “moments when young people need a confidence boost” — moments when kids feel “worthless” or “insecure” and are perhaps more open to an advertiser’s message.

Facebook says the data amassed by the algorithms was never used for targeted ads, but merely “to help marketers understand how people express themselves on Facebook.” Still, the company acknowledges a “process failure” and says an investigation has been opened to correct the mistake.

That’s a good thing because Facebook’s real-time monitoring of kids might actually be violating the Australian government’s ethical standards. The Australian points out that the Australian Code for Advertising and Marketing Communications to Children defines children as age 14 and under and says any information that could potentially reveal a child’s identity must be obtained through a parent or legal guardian.

The Australian Association of National Advertisers has already gone on record stating Facebook’s activities appear to run contrary to the government’s ethical standards.

Last year, ProPublica conducted an investigation into Facebook’s marketing practices and subsequently published a report accusing the company of allowing advertisers to target ads based on ethnicity.

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• Trump Gambles on Big Health Victory (WSJ)
• Provocateur-in-Chief Trump Pokes His Own Party’s Power Centers (BBG)
• White House Preparing to Replace Top Banking Regulator (WSJ)
• Trump’s Trade Warrior Is the Most Unpopular Economist in the Class (BBG)
• Erdogan says to discuss Syria operations with Russia’s Putin, Trump (Reuters)
• Thaad Missile-Defense System Is Up and Running in South Korea (WSJ)
• Infosys to Hire 10,000 American Workers After Trump Criticism (BBG)
• Hollywood writers reach tentative deal with studios, averting strike (Reuters)
• United’s Munoz, Other Airline Executives to Testify in Washington (WSJ)
• Coal Country Is Back, Along With Signing Bonuses and Pay Raises (BBG)
• Theranos Settles Lawsuit With Partner Fund (WSJ)
• Murdoch Seeks to Dent Google’s Ad Dominance After YouTube Revolt (BBG)
• Goldman Sachs Embraces Banking’s Bland Side: Lending Money (WSJ)
• Why Investors Will Watch TV Battle Between Macron, Le Pen (WSJ)
• Ackman to `Probably’ Shun Pharmaceuticals After Valeant Loss (BBG)
• San Francisco Eases Home-Sharing Curbs (WSJ)
• A Homebuying Calculator for Millennials: Does That Add Up? (BBG)
• AllianceBernstein Ousts C.E.O. and Shakes Up Board (NYT)
• A Pool Table in Philadelphia Shows Nasdaq’s Thirst for Talent (BBG)

 

Overnight Media Digest

WSJ

– The sexual harassment scandal that has engulfed Fox News for nearly a year claimed another casualty with the resignation of Bill Shine, the network’s co-president and one of its longest-serving executives. on.wsj.com/2oS5mTv

– Theranos Inc settled a lawsuit alleging the company and its founder, Elizabeth Holmes, defrauded a San Francisco hedge fund into making a $96.1 million investment through “a series of lies,” the company said Monday. on.wsj.com/2oS1d1Q

– Home-sharing sites Airbnb Inc and Expedia Inc’s HomeAway have reached a settlement with San Francisco that makes it easier for rental hosts to register with the city and helps the companies avoid costly fines. on.wsj.com/2oSisA3

– IAC plans to buy Angie’s List Inc combining the consumer-review site with IAC/InterActiveCorp’s HomeAdvisor and forming a new, publicly traded company for a deak valued at more than $500 million. on.wsj.com/2oSqHvY

– Drug company Valeant Pharmaceuticals International Inc said it has made $220 million in unscheduled debt payments, its latest effort to chip away at the multibillions of dollars its owes. on.wsj.com/2oSjfkv

 

FT

Bill Shine, co-president of Fox News Channel, has become the latest executive to resign in the wake of a sexual misconduct scandal at the cable channel.

The French parent of asset manager AllianceBernstein fired its longtime leader, Peter Kraus, replacing him with a new chief executive and new chairman, and overhauled the firm’s board, according to a filing on Monday that offered little explanation for the unexpected changes.

Cisco Systems Inc said on Monday it intended to buy privately held Viptela for $610 million in cash and assumed equity awards. The deal is expected to close in the second half of the year pending regulatory reviews.

 

NYT

– A Greek official said on Tuesday that his country had reached a deal with its creditors that would allow it to receive critical emergency funds in return for promises to raise taxes and cut social spending. nyti.ms/2oSjyMa

– Fox News forced out one of its most senior executives on Monday, the latest aftershock of a sexual harassment scandal that has engulfed the television network and pressured its owners, the Murdoch family, into a painful and protracted public housecleaning. nyti.ms/2oSj1tJ

– Fox News faced a fresh legal challenge on Monday after Diana Falzone, a reporter at the network, accused it of discriminating against her on the basis of her gender and her fight against a chronic disease. nyti.ms/2oSkxf8

– Screenwriters and entertainment companies held contract talks in the final hours before a strike deadline on Monday, as union loyalists flooded Twitter with messages of resolve and as the rest of Hollywood held its collective breath. nyti.ms/2oSfoni

– In a move that highlights the increasing pressures faced by stock pickers on Wall Street, Peter Kraus, the chief executive of AllianceBernstein Holding, was ousted by the money manager’s controlling shareholder on Monday. nyti.ms/2oS6LZV

– Airbnb agreed to settle a lawsuit against the city of San Francisco, putting to rest litigation that could have hampered the company’s efforts to expand and go public. nyti.ms/2oShHad

– President Trump continued his outreach to rogue leaders, declaring he would meet North Korea’s dictator, Kim Jong-un, provided the circumstances were right, even as the Philippine president, Rodrigo Duterte, brushed aside the president’s invitation to visit the White House, saying he might be “too busy.” nyti.ms/2oRZnxE

 

Canada

THE GLOBE AND MAIL

** In an effort to pass legislative agenda, Liberal House leader Bardish Chagger announced that her government will make more use of time allocation, a practice that limits debate on specific bills or motions that will force votes and move the process along. tgam.ca/2qnL1VH

** Pembina Pipeline Corp, known for its oil sands pipelines and natural gas liquids businesses, is buying Veresen Inc in a C$9.7 billion deal, the fourth major takeover in Canada’s energy infrastructure sector in just over a year. tgam.ca/2qnMMlO

NATIONAL POST

** Defence Minister Harjit Sajjan is being accused of falsely downplaying his role in Afghanistan in an attempt to thwart an investigation by the ethics commissioner, just days after he publicly apologized for falsely embellishing his role. bit.ly/2qo1nO7

** After Kevin O’ Leary’s shock withdrawal from the Conservative Party’s leadership election last week and his endorsement of rival Maxime Bernier, there’s a growing consensus among close observers of the contest that it’s Bernier’s to lose – unless several campaigns mount a joint offensive in support of another specific candidate. bit.ly/2qnToRt

** Alternative mortgage lender Equitable Group Inc announced that it has lined up C$2 billion in standby credit in a bid to stem any contagion from troubled competitor Home Capital Group Inc which continues to experience a partial run on its funding. bit.ly/2qnUe0v

 

Britain

The Times

* Velocity Composites is set to float on the junior market of the London Stock Exchange. bit.ly/2p2F0dn

* Lloyds Banking Group has shrugged off concerns that its practice of booking revenue upfront from customers who have interest-free periods on their credit cards is a “ticking time bomb”. bit.ly/2p2CJPa

The Guardian

* Philip Green and his wife are among the UK’s richest couples – although their wealth has fallen by 433 million pounds ($558.44 million) over the past year following the collapse of BHS, according to an annual wealth ranking. bit.ly/2p2FZu1

* The future of Britain’s power supply has been jeopardised by Brexit and the government must act urgently to ensure nuclear power stations stay open, the influential committee for business, energy and industrial strategy has warned. bit.ly/2p2rVAH

The Telegraph

* More than two dozen UK organisations, including the British Film Institute, Odeon Cinemas, Sky and the Premier League, have lined up against the European Commission’s planned copyright overhaul. bit.ly/2oR5YbP

* Loch Lomond Group, whose brands include Littlemill and Glen Scotia, said the partnership with the state-backed agriculture and food & beverage giant Cofco would pave the way for its whiskies to be sold across China. bit.ly/2oRhunB

Sky News

* Former Tory treasurer Lupton is to become the first chairman of Lloyds Banking Group’s non-ring-fenced bank, according to Sky News. bit.ly/2oRcgIo

* Institutional Voting Information Service, which is part of the fund management industry’s leading trade body, has issued a ‘red-top’ warning to Bovis investors ahead of shareholder meetings on Tuesday, according to Sky News. bit.ly/2oR5bHQ

The Independent

* The proportion of UK female high earners has not changed for the past six years, despite initiatives to shrink the pay gap between men and women, according to research from global law firm Clyde & Co.ind.pn/2p2s7zV

* Brexit negotiations should not divert the UK government’s attention from the challenges businesses are facing at home, the British Chambers of Commerce has warned. ind.pn/2p2JznQ

 

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London Property Bubble Vulnerable To Crash

– London property market vulnerable to crash
– House prices in London are falling
– London property up 84% in 10 years (see chart)
– House prices have risen over 450% in 20 years
– Brexit tensions as seen over weekend and outlook for U.K. economy to impact property
– Global property bubble fragile – Risks to global economy
– Gold bullion a great hedge for property investors

by Jan Skoyles, Editor Mark O’Byrne

For the bargain price of 36 AED (£5) I can buy Global Property Scene magazine, here in Dubai. This month it is running the headline ‘ Could Brexit be the making of the UK Property market?’

Property here in Dubai is a big deal, everywhere you look there are cranes and in the middle of the Malls developers have spent a small fortune placing a stand with a 3D model of their latest development.

The Emirate is looking to position itself as the financial safe haven of the Middle East and with that, they know, comes a solid property market.

London property has long been the poster child for countries such as the UAE who are looking to develop what has for a while appeared to be an indestructible real estate market.

Since 2011 London house prices have climbed by 65%. Between 2006 and 2016, average house prices in the capital grew from £257,000 to £474,000 or by a very substantial 84.4%. These large gains were ‘built’ on the back of the very large appreciation that was seen in prices between 1996 and 2006 (see chart below).

Average house prices in London in 1997 were below £85,000 meaning that in 20 years prices have risen over 450%.

This has created an air around the city’s property markets – residential and commercial – that they are invincible and that they are a safe haven.

House Prices: UK & London Average (KPMG, March 2017)

But London property values might not be as invincible as the world thinks.

UK’s Land Registry data for three London boroughs shows transaction volumes in London — the number of houses being bought and sold — are at an all-time low. Back in December asking prices in London dropped 4.3% in December with inner London down 6%, more exclusive areas dropped by as much as 10%.

The slump continued into the first quarter this year, a survey by the Royal Institution of Chartered Surveyors found that more agents than not reported price drops in March. London is now one of the five-slowest growing cities in the UK.

London property has for some time had many of the signs of a bubble. However, it is always very hard to pinpoint when a bubble might burst. We are certainly seeing signs that the overheated market is beginning to cool. Of course, all ‘good’ things must come to an end, but what is driving this particular scenario?

In a world of uncertainty what is tipping which scale can be confusing, but there are some factors at play here that are most likely responsible for the downturn we are witnessing.

Does a downturn or bursting of the London property market matter for the wider UK, or the world? Certainly, as with previous bubble bursts, these things are mere tips of much more dangerous icebergs.

Is the market even affordable?

UK house prices are nearly 8.5 times average earnings, a level that the ratio has not been seen at since the last property boom. Yet, on average it has never been financially easier to get a mortgage – with interest rates at record lows in recent years debt servicing levels remain affordable… for now

House Prices to Earnings (KPMG, March 2017)

While KPMG’s research suggests that the house-price-to-earnings ratio is currently below the peak-to-peak trend, it is concerning that it has reached now back at all time record highs.

So as long as interest rates stay ultra ultra low, new borrowing could keep the property market going and keep UK house prices buoyant at least for a while longer.

Since 2013 the average value of London property has risen rapidly relative to rents. For first time buyers and working immigrants the decision to buy comes down to rent prices versus the cost of borrowing, this drives house prices.

So when buyers are optimistic about future house prices, they are generally happy to cover more expensive interest rate payments over rent, if they expect to see a return. This, combined with dinner party conversation over the infallibility in the London housing market, pushes buyers to buy property today terrified in the belief that prices will only get higher.

If record high rents begin to fall – which seems probable given the many global geo-political, financial and economic risks and indeed the risks posed by Brexit to the UK economy – then first time buyers and indeed buy to let investors might decide to hold off buying.

Also, as earnings are not increasing in line with ether inflation or house prices, factors such as Brexit and interest rates (both of which are wrapped up in uncertainty) are beginning to cast a shadow over the London property market. Something which could be disastrous for the UK economy.

Brexit blues dim London property

During the UK’s EU referendum, there were lots of on-the-street interviews with voters arguing that a post-Brexit world would impact the country’s property market. Post-Referendum we are still in a weird limbo as we await to see the result of Brexit negotiations.

In the meantime the rest of world’s financial markets and investors speculate over various uncertainties. This in turn will inevitably impact real estate prices.

The most immediate data we have that shows the impact of Brexit is the slowing of immigration into the UK by those looking to study or work. This was the case even in the run up to the referendum.

This fact is one of the contributors to the cooling off in London house prices. There is a slow-down in demand for not only property to buy but also to rent. Potential buy-to-let purchasers are seeing a slow-down in demand, which reduces the return on their investments.

But international investors (as opposed to immigrants) might not be put off just yet by the London property market. To those holding US dollars or euro, the capital’s real estate might seem to be quite the bargain. In dollar terms property is 16% cheaper 11% so for euro buyers than they were before the referendum due to the sharp fall in sterling. Providing they are comfortable with the considerable currency risk.

As was seen over the weekend and still very high tensions between the May government and the EU, Brexit uncertainties are set to continue. It is the impact of these, and likely further weakening in the pound, which may create further issues for the UK economy.

Is Brexit really an issue?

There is no doubt that Brexit has created some uncertainty in the UK housing market. The recent property prices speak for themselves. Should the Conservatives win the majority in the June election there could be less uncertainty although the negotiations with the EU are likely to be long and hard. There is no guarantee that they will be successfully wound up in even two years time and there is the real risk that they  lead to a significant deterioration in relations between the UK and EU powers and leading EU nations.

A bigger concern for the UK housing market is interest rates. The cost of borrowing has been at record lows for several years. Central banks’ easy money policies, including the Bank of England, have meant that we have seen property prices increase around the world.

The era of record low interest rates was always going to come to an end and the finale is now on the horizon. The Bank of England warned back in February that the post-Brexit value of the sterling which is expected to send inflation to 2.7% this year, will prompt a hike in interest-rates.

If it costs more for buyers to borrow money then this quite simply means that there is less money to be spent on property. The market is already built on the sandy foundations of massive debt suggesting that this is a house of cards that can’t take another layer.

Even where there is real money playing a role, the amount required for a deposit is rapidly becoming unobtainable. First-time buyers are dropping like flies given the increase in deposit amounts; first-time buyer deposits have reached £34,000 across the UK, and nearly £100,000 in London.

In the last few years buyers (both property investors and first-time buyers) have been enjoying the merry-dance of borrow money at a low yield and spending it on the higher-yielding property market. And this isn’t just happening in London, it is happening across the global property market.

The dance has been going on for some time, but it looks as though the jig is about to come to an end, soon these same savvy investors might find themselves with an expensive lump of debt to service, a falling yield on rents and an asset which is worth far less than they had expected.

A problem only to be borne by foreign investors?

Back in January Catherine Mann, the OECD’s chief economist, spoke of vulnerabilities in asset markets. In regard to the UK property market she said this would be good for the country if the fall in prices was borne by foreign investors.

“[What’s] interesting in terms of the implications for the UK economy is who bears the burden – who bears the adjustment cost. If it’s a non-resident then lower house prices could actually be good for the UK.”

However, it is next to impossible that the UK will not feel the pain of the property bubble bursting. Aside from those buyers who will likely be left facing negative equity, unserviceable levels of debt and possible bankruptcy we also need to consider the impact of those who are still borrowing to buy property.

Local councils in the UK aren’t known for their investing prowess.

You just need to look at the Icelandic banking scandal that resulted in UK council being bailed out, for an example. This time around the councils have decided that their local property markets are ones worthy of a punt or two. They may well have been witnessing the optimism that remains amongst estate agents, with more respondents to the RICS survey than not saying they expect prices to climb in the next year.

Local councils are so confident about the strength of the property market that they are borrowing from the Public Works Loan Board (part of the Treasury). Most recently the Isle of Wight has borrowed a whopping £100 million in order to bet on property. Lord Oakshott, Chairman of Olim Property told the Financial Times, “English councils punting on property is an accident waiting to happen.”

“There are real echoes here of Northern Rock, where many punters were lent all the purchase price of a property, and the Icelandic bank scandals, where councils played a market they didn’t understand for short-term income gain.”

Councils overextending themselves (as we saw with Iceland) is not a cost that is later borne by foreign investors. It is borne by those who have to bail them out – the tax payer. We have been here before.

What about supply?

The RICS Chief Economist referred to the ‘flat trend in transaction levels.’ We can spend as much time as we want referring to buyers’ deposits, cost of borrowing and the impact of Brexit but we only do so in reference to demand. This over-heated market was also driven by levels of supply.

A small drop in prices, at levels mentioned in the beginning, means that supply is also likely to slow-down as owners fear they won’t get much return on their investment if they sell now, instead hoping to sit it out and wait for a correction.

Hometrack data shows supply is not keeping pace with sales in Birmingham and Manchester, despite prices set to increase. In London, a stall in prices is more or less inevitable as buyers aren’t purchasing houses at the same rate they’re being put on the market.

A brief check on a major property website by ZeroHedge found that there might be call for nervousness among sellers and estate agents. Despite discounts on Kensington and Chelsea properties by as much as 40% on those that have been listed for over a year, the number of listings appears to have doubled and little seems to be shifting.

Conclusion – Gold good hedge for property investors

Since the Second World War, UK house prices have only crashed three times, the second time was just ten years ago, then again in 2009 when they hit rock bottom. Since 2013 they have been unstoppable, especially in London.

The belief that they are unstoppable comes from the same drunken optimism the credit crisis came from – one of immortality and the mass delusion at nothing could threaten the property boom we were seeing. Data is now slowly revealing a different picture from the one so many people have been imagining for the last few years.

The property market is certainly seeing a serious cooling down and the question is whether this is the start of serious correction or a crash.

This is not just an event that will be kept local to London. Other “international cities” and major property markets such as Singapore and New York looks bubbly and vulnerable to sharp corrections.

Now would be a pertinent time for investors to review their portfolio allocation to property markets. Even if you do not hold property other than your own home, the bursting of the bubble will no doubt impact the global financial system, not to mention the national economies to which they are so intrinsically tied.

If property market corrects sharply or crashes, companies, councils and irresponsible lenders will need to be bailed out. Who will be footing the bill? We will. For reasons already explained by events played out during the financial crisis,  it would be prudent for readers to consider how much exposure they have to not only the property market but also the banking system and the banks that have considerable exposures to property markets.

It is difficult to hedge property investments effectively. However, in our modern globalised world where interest rates and economic cycles are increasingly correlated, gold will likely become an excellent hedge for property investors in the coming years.

Property prices look over valued in many markets internationally today and in the event of price falls, gold is likely to act as a hedge and preserve wealth as it has done throughout history.

Investors should decide on a reasonable allocation to gold bullion, held in allocated and segregated storage in less debt laden jurisdictions.

Owning these assets outside of the digital and the financial system, away from the shaky, debt-fuelled banking system funding the overheated property markets will soon be seen as prudent.

Related Content

Insight – Is London’s Property Bubble Set To Burst?

London and UK Property Bubble Beginning To Burst

Global and London Property Bubble Set To Burst – UBS and Deutsche Warn

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