The Mortgage Event

Barry Naisbitt

Chief Economist

Abbey

The Economy – An Overview

Barry NaisbittChief Economist, AbbeyOctober 2005

2How the UK economy looks in October 2005 The ‘hot’ topic of current economic debate is the possible effect of the recent rise in oil

prices on the economy - but there are important underlying trends.

Tightening monetary policy between November 2003 and August 2004 played a part in slowing consumers’ spending growth. In turn, this has slowed overall economic growth and there have been some small rises in unemployment.

The household sector has record debt. Higher interest rates have reduced the speed at which debt is growing.

House price growth has slowed and (so far) there has been a ‘soft landing’ in the housing market.

Inflation has now risen above its 2% target. In part this is due to rising oil prices but there have also been increases in food and utilities prices.

This year the economy has not developed as the Chancellor had expected:

- GDP growth is likely to be around 2%, not 3 – 3.5%.

- Inflation is above 2% target and is likely to stay so in the rest of this year.

- Slower growth means lower tax receipts, so public finances have worsened.

3Current Economic News•Consumers’ expenditure growth has slowed significantly

Q1 (at +0.1%) saw the slowest quarterly growth for 4 years. Q2 (+0.2%) was only a little faster. Retailers have called for lower rates to boost activity.

Recent retail sales figures hint at only a gradual improvement.

Quarterly Consumers’ Expenditure Growth (%)

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1

Source –Office for National Statistics

4Current Economic News•Economic growth has slowed as a result

The slowdown in consumers’ spending has reduced the pace of overall growth. The economy is still expanding – output last fell in 1992 Q2.

Growth this year is likely to be about 2%, down on 3.2% last year.

Quarterly Economic Growth (%)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1

Source –Office for National Statistics

5Current Economic News•The number claiming unemployment benefit is now rising

Claimant count unemployment has risen by 48,500 over the past six months. This is not a large rise but marks a change from the past decade of falling

unemployment. Employment, however, is still rising.

Monthly Change in Unemployment (Claimant Count, 000s)

-15

-10

-5

0

5

10

15

20

Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

Source –Office for National Statistics

6Current Economic News•Inflation is above its 2% target

CPI inflation in August was 2.4%, above target and highest since Nov. 1996. Transport costs (oil related) have seen the biggest jump – underlying inflation

remains low and headline RPI inflation has edged down.

Inflation Rate (%, RPI and CPI)

0

1

2

3

4

2000 Jan 2001 Feb 2002 Mar 2003 Apr 2004 May 2005 Jun

RPI

CPI

Source –Office for National Statistics

7Current Economic News•Household debt is at a record level

Households owe over £1 trillion – a record level. Most of this (70%+) is mortgage debt. But the value of households’ assets outweigh their debts.

Overall, debt is around 150% of income, a record level, and rising.

Household Debt – Income Ratio (%)

40

60

80

100

120

140

160

1987 Q4 1991 Q4 1995 Q4 1999 Q4 2003 Q4

UNSECUREDDEBT TO INCOME

SECURED DEBTTO INCOME

TOTAL DEBT TOINCOME

Source –Office for National Statistics

8Current Economic News•Monthly house price growth rates have reduced

While monthly house price changes are volatile, the scale of increases has become smaller, with some monthly falls recorded.

In turn, this reduces annual house price growth, which is now below 5%.

Monthly Change in House Prices (average of all published monthly information, %)

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

Source – ODPM, Halifax, Nationwide, Hometrack, Rightmove

9Current Economic News•So annual house price growth has slowed

Using the Government’s index, the drop in monthly house price growth has slowed annual growth from 14% in July 2004 to 4% in July 2005.

This is in line with our expectation for 2% annual growth by end year.

Annual House Price Growth (%, ODPM)

Source –Office of the Deputy Prime Minister

0

2

4

6

8

10

12

14

16

Jan-04 May-04 Sep-04 Jan-05 May-05

10Current Economic News•After a sharp dip in ’04 H2, activity shows signs of stabilising

The number of loans approved for house purchase fell sharply in mid-2004. Activity has steadied in recent months.

Remortgage activity has been less volatile than house purchase.

Number of Mortgage Approvals (000s, seasonally adjusted)

70

80

90

100

110

120

130

140

May-03 Nov-03 May-04 Nov-04 May-05

HousePurchase

Remortgage

Source –Bank of England

11How is the economy likely to develop in 2006? Recent rises in oil prices have added an extra element of uncertainty to the outlook.

If oil prices moderate, inflation should drop to 2% (or below) during ‘06.

High oil prices are likely to lead to slower global economic growth. UK growth is likely to be below trend again in ’06, creating a risk of higher unemployment.

If the Bank of England sees growth undershooting its forecast but inflation overshooting its target, it will have a difficult call to make. Financial markets imply that there will be scope for a further rate cut.

Despite the uncertainties, the overall economic picture remains one of gradual change and a growing economy.

So the housing market looks likely to continue to be subdued – some of the issues affecting activity in 2005 will still be present in 2006.

I do not expect a rapid rebound in house prices – rather a continued period of very moderate house price changes.

House purchase activity has picked up during 2004 but it remains below the relatively high levels seen in the 2002 – 2004 period. Broader economic trends suggest stability rather than rapid expansion.

12Economic Outlook•Oil Prices reached $70 per barrel

The price of oil has risen by $26 per barrel (59%) since December. However, in inflation adjusted US $ terms, it is still 27% below the peak

reached in the early 1980s.

Actual and Inflation Adjusted Oil Prices ( West Texas Intermediate, $ per barrel, indexed to 2005 US$ prices)

0

20

40

60

80

100

120

Jan-70 Oct-75 Jul-81 Apr-87 Jan-93 Oct-98 Jul-04

InflationAdjusted(real)

ActualPrices

Source –Reuters, Office for National Statistics

13Economic Outlook•The Bank of England expects inflation to reduce next year

The Bank expects inflation to peak soon and fall below target in ’06H2. August CPI inflation was 2.4%, higher than the Bank expected, reflecting

higher oil prices.

Median CPI Inflation Projection based on Interest Rates at 4.50% (%)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07

MPCForecast

CPI

TARGET

Source –Office for National Statistics, Bank of England

14Economic Outlook•Commentators have been reducing their growth forecasts

Since the start of the year the consensus forecast for growth in 2005 has been reduced from 2.5% to 2%. In March the Chancellor forecast 3 – 3.5%.

Growth in ‘06 is expected to be only slightly stronger than ’05.

Consensus Forecasts for UK Economic Growth (made by month, %)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Jan-05 Mar-05 May-05 Jul-05 Sep-05

2004

2006

2005

Source –Consensus Forecasts

15Economic Outlook•The Bank of England lowered interest rates in August

Interest rates were lowered by 25 basis points in August, to 4.50%. The reduction will improve affordability and support housing market activity

and house prices – rates are now lower than a year ago.

Base Rate (%)

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

1997 Jan 1999 Jan 2001 Jan 2003 Jan 2005 Jan

Source –Bank of England

16Economic Outlook•The most recent slowdown has been in home mover numbers

The recent slowdown has been in the number of home movers. First time buyer numbers peaked in 2002 and have drifted down since then.

Economic outlook suggests stabilisation into ’06, rather than further falls.

Number of First-time Buyers and Home Movers (Rolling year, 000s)

0

100

200

300

400

500

600

700

800

900

1000

Mar-96 Sep-97 Mar-99 Sep-00 Mar-02 Sep-03 Mar-05

Movers

First-time buyers

Source –Council of Mortgage Lenders

17Economic Outlook•The mortgage market is stabilising

If activity has seen a drop to a new, lower level, we would expect annual growth rates to dip sharply and then gradually stabilise.

This is what has happened to the total value of new lending.

Annual Percentage Change in the Value of Mortgage Approvals (%)

-40

-30

-20

-10

0

10

20

30

40

50

31-Jan-03 31-Jul-03 31-Jan-04 31-Jul-04 31-Jan-05 31-Jul-05

Source –Bank of England

18Summary of Economic Outlook UK economy has shown continuous growth since 1992 – it has avoided recession

where other countries (e.g. US, Germany) have not.

One result is that unemployment has fallen steadily and employment has risen.

Inflation has remained low and within its target band. The Governor of the Bank of England called the period the ‘NICE’ decade (Non-Inflationary, Consistently Expansionary). (Source – Governor of Bank of England, 12th October 2004)

The rise in oil prices has created a new economic uncertainty. A risk is that rising oil prices could push up inflation and disturbs the period of stability.

Another risk is that economic activity could under-perform expectations, with higher energy costs reducing households’ discretionary spending.

The central case outlook is for continued growth (but likely below trend) and inflation rising further before dipping. As such, the economic outlook still favours a continued ‘soft landing’ for the housing market.

The housing market looks unlikely to repeat the rapid growth of the early part of the decade, but a steady market that enables buyers and sellers to match their needs looks likely.