14 January 2014
By Nick Griffin and James Tsinidis
Across K2 International’s ‘key areas of interest’ the most controversial of our areas of secular growth / structural change is the concept of ‘reflation’. Reflation is the term we use to identify winners from the structural trend of rising asset prices. Granted asset prices have historically been notoriously cyclical due to the formation of asset price bubbles and their subsequent bursting. However post GFC, the trend towards rising asset prices has taken on a more structural element as a result of the various policies introduced in the US and elsewhere to boost aggregate demand and curb deflation. These have included cutting rates to close to zero, recapitalising banks, “quantitative easing” (QE), numerous direct government initiatives and more recently explicit forward guidance on policy rates. The jury is still out on the ultimate effectiveness of these policies in boosting demand, but what is clear is that they have succeeded in raising asset prices, specifically housing and equities. Importantly these rising asset prices, far from being an unintended consequence, have been consciously targeted to boost “animal spirits” and risk taking; and in so doing also (hopefully) aggregate demand via the wealth effect. We would also highlight that considering the scale of deleveraging required and the strained state of government finances these policies are likely to stay in place for much longer than generally appreciated.
We now have numerous examples of monetary and fiscal policy combining to target asset price inflation. These policies have combined in the US to spark a recovery in the US housing market where homebuilders, home improvement retailers and banks have already enjoyed strong equity gains. So called ‘Abeconomics’ in Japan is yet another incarnation where policies have included large scale quantitative easing, heavy infrastructure spending and tax benefits for private investing. Elsewhere the UK is a further opportunity to benefit from similar reflation, where authorities are closely following the US playbook and the housing market is likely to be a key beneficiary.
The UK housing market by mortgage approvals…. Can reflationary policies spark a similar improvement to the one seen in the US?
In March 2009 the Bank of England (BOE) cut the base rate to 0.5%, the lowest level since records began in 1694 (!) and where they still remain today five years later. To place this in context the previous lowest level was 2.0% reached during the Great Depression of the 1930’s, and again during World War II and its aftermath. Then broadly replicating US initiatives, UK authorities recapitalised the banks, initiated a program of QE bond purchases and have also provided increasingly explicit forward guidance on policy rates. These are extreme actions and represent extraordinary accommodation for asset prices.
UK policy makers have also identified housing as key to an economic recovery and have recently introduced a policy known as ‘Help to Buy’, which recognises the banks reticence to lend by providing government credit guarantees on a portion of qualifying mortgages. This is only available for purchases of under £600,000 and is still subject to the standard credit checks; nevertheless it means that buyers can potentially obtain a mortgage with a deposit of only 5%. With the UK government effectively using its own balance sheet to underwrite a further 20% of the value of the purchased home, thereby providing the lender with the security to lend. In aggregate the government expects to underwrite about £130bn of mortgages over the next three years, which if fully utilised could conservatively boost UK mortgage approvals by 10-15% per annum from current levels.
Recent data suggests that these initiatives have already begun to work, although activity levels and house prices both have significantly further to run before returning to normalized levels. After a weak 2012 UK house prices are up approximately 7.1% over the 12 months to 31 December 2013, and while London often grabs the headlines as potentially overpriced, elsewhere prices remain depressed and have only very recently showed some signs of recovery. In terms of activity, UK mortgage approvals crossed 70,000 per month in November 2013 for the first time since 2008. Again while there has been some improvement, activity levels would need to rise a further 80% to reach previous peaks.
Considering the upside just to get back to a normalised environment, let alone a growing environment, we see a number of potential investment opportunities that can benefit from this reflationary trend. Key beneficiaries currently in the portfolio include:
Lloyds (Market Capitalisation: £57.3 billion)
Lloyds is the UK's largest retail bank with a 25% share in mortgages and is set to benefit from rising mortgage volumes, better margins and lower bad debts. The stock is currently attractively priced on a price to book (P/B) ratio of 1.32 times and 2014 Price to Earnings (P/E) of 12.4x.
Countrywide (Market Capitalisation: £1.3 billion)
Countrywide is the largest estate agent in the UK with 930 branches. It also offers a range of surveying, valuation, conveyancing and financial services. It’s trading on a P/E of 15.9x (FY14e consensus) and we believe that earnings leverage to a recovery in housing activity is significantly underestimated by current consensus.
Barratt Development (Market Capitalisation: £3.7 billion)
Barratt Developments is one of the top three national house builders in the UK having started operations in 1958. The stock is trading on undemanding multiples with a P/B of 1.2x and P/E of 14.3x (FY14e consensus), which again looks to underestimate the group’s leverage to a recovery in new build activity and house prices.
Arguably the biggest risk is that asset prices and credit markets become overheated, and we revisit “bubble” conditions experienced in 2005-07, before the economy returns to growth and full employment. This would force policy makers to remove accommodation prematurely without the favourable offset of economic growth and the extreme cyclicality of the asset bubble game would have returned. We are also fully cognisant that these policies are largely untested and there is no historical template for this cycle; nevertheless we get considerable comfort from the US experience where policy makers are focused on managing these risks and where there is also growing evidence that these policies are indeed working.
Ultra low interest rates combined with direct government support look likely to spur a recovery in UK housing towards normalised levels of activity. While this may be viewed as a cyclical recovery by some, we believe the driving forces behind it are more structural in nature and are unlikely to be wound back aggressively in the short term. A measured rise in asset prices and activity is the desired outcome of these policies so it is unlikely that they will be repealed before that is achieved. In terms of UK housing we see the reflationary forces closer to the start than the end of this process and are excited about the prospects in this area for the year ahead, the three stocks mentioned in this note currently make up just under 10% of the total K2 Select International funds portfolio.
If you would like further information about the K2 International Strategies, please contact a member of our distribution team on 03 9691 6111 or visit k2am.com.au.
DISCLAIMER: The information contained in this presentation is produced by K2 Asset Management Ltd (“K2”) in good faith, but does not constitute any representation or offer by K2. It is subject to change without notice, and is intended as general information only and is not complete or definitive. Please note that past performance is not a guarantee of future performance. A product disclosure statement and additional information booklet or information memorandum or general information on the funds referred to in this presentation can be obtained at www.k2am.com or by contacting K2. You should consider the product disclosure statement before making a decision to acquire an interest in the fund.