UK Housebuilders: Stocks Stomach Stagflation Concerns 

It has been a trying start to 2022 for UK housebuilders, with some major companies in the sector down over 25% YTD. This article examines how UK housebuilders might navigate a low growth, high inflation (stagflationary) environment. 

In England and Wales, the ratio of house prices to residence-based earnings – a widely followed housing affordability metric – is now at 8.92, its highest level on record. The reason for the high house prices is threefold: 

  • government support of household income through the pandemic, 
  • very low interest rates, and 
  • the higher cost of building materials 

The issue for housebuilders is that with inflation racing ahead at 9% YoY in April, the Bank of England has been jolted to raise rates as a response, with the Bank Rate rising to 1.00% and the 2year fixed rate for an 85% LTV mortgage moving up to 2.21%. Inflation encourages the Bank of England to raise rates in order to encourage saving and deter spending. As monthly repayments on current and future mortgages increase, banks will reduce the total amount they are willing to lend an individual with a given repayment ability. This is because as rates go up, the amount paid per month on the same overall loan increases, making repayment harder at a given income level. This is particularly complex in the UK given the low level of aggregate household cash flow each year. 

The UK government is also now acting to curb inflation by reducing its deficit-financed spending. Winding down pandemic era support schemes is bad for housebuilders as they were beneficiaries of these schemes, including the Help to Buy Equity Loan scheme and the Mortgage Guarantee Scheme, which acted to support home purchases. The government has not announced plans to extend or replace the current supports, the last of which are set to sunset in 2023.  

In combination, these measures will make already unaffordable homes simply out of reach for many. This should have a weakening effect on the price of housing. 

The second issue is that inflation squeezes household income elsewhere, so the percentage of income individuals can spend on housing decreases. As the price of food, transport, and heating continue to rise, prospective home buyers will have less income than they could save or (hypothetically) put towards a mortgage every month. This will act to further put downward pressure on the ratio of residence-based earnings to house prices.  

Inflation also hurts housebuilders because it increases their cost of building. With the materials required to build a house being a major driver of total construction costs, the recent increase in commodity prices will hurt homebuilders’ ability to keep costs in check. 

From the point of view of the housebuilders, the silver lining is that the increase in wages across the sector has not nearly kept pace with either HPI or CPI. If, however, HPI growth ever does reverse, then continued wage increases would instantly cut into margins. 

A second-order effect of high inflation could be a lower growth environment and unemployment. This would be the case if high inflation caused certain policy responses. 

  • First, heightened inflation could cause the Bank of England to tighten to an extent that it slows GDP growth. This is already happening. 
  • Second, high inflation could also lead to a low growth environment if the UK government cuts deficit-financed spending to such a degree that it similarly caused a reduction in aggregate demand. This may come next as higher interest rates discourage deficit spending. 

Of course, in reality, it looks like a combination of both levers will work to push growth down in the near- to mid-term. 

Carraighill published a research note in March on the effect of a high inflation and low growth (stagflationary) environment on housebuilders. The conclusions were not kind to the sector. In historic episodes of stagflation, CPI has outpaced house price growth. We modelled stagflation as real GDP growth of between -2% to 3% and CPI prints over 5%. 

The difference between house price growth and CPI as a very rough approximation for builders’ margins. Of course, if input costs for builders – which are commodity heavy – rise faster for builders than CPI – as commodity prices have been recently – then the picture will become bleaker for builders’ margins than the modelling predicted. 

The note also looked to understand the effect of stagflation on completions. We used the AMECO dataset which looks 36 developed countries (mainly in Europe) from 1960 to 2003 to investigate the change in the level of dwelling investment as inflation and the rate of real GDP growth vary. The results showed that total dwelling investment is low in periods of stagflation. Taking total dwelling investment as a proxy for completions, we can predict that much of the current guidance from UK homebuilders is potentially too optimistic, given the prospects for inflation and growth in the near term.  

There are, however, counter arguments to the bearish case outlined above. The most prominent of which centers on the claim that since the GFC, there has been chronic underbuilding in the UK. This lack of supply, the proponents of the argument go on to claim, has been the major determinant of high prices, not low interest rates or government support. As a result, they believe that the coming normalisation of interest rates and the pullback of government support will only have a muted impact on house prices. 

While it is true that supply is tight in the market and that there was underbuilding following the GFC, it is simply empirically false that the amount of undersupply has been the main fact in determining house prices in 2021 or 2022 so far. 

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