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Brexit and house prices

Diversifying may be the answer to uncertainty

28 February 2019

3.5 minute read

An expert weighs up the current property market and portfolio diversification.

House price growth has sharply deteriorated in the last few months according to the Nationwide average house price index. The latest reading from January is a meagre 0.1% increase, which is the lowest rate since February 2013 (Figure 1). Rightmove’s measure of online asking prices shows a similar deterioration.

The slowdown in house price increases has occurred despite favourable supply and affordability conditions. When we talk about a favourable supply backdrop, confusingly we mean the opposite – there are still about 50,000 fewer new-build houses coming to the market each year today, compared to the 1980s. On the demand side of the equation, affordability is a key metric and best measured by the cost of servicing a new mortgage as a proportion of take-home pay.

Growth in real wages has been improving recently (Figure 2), thanks to nominal wages rising and inflation falling. Meanwhile, the Bank of England’s decision to hold off raising interest rates, in part due to the uncertainty of Brexit, has helped keep a lid on mortgage rates. For example, the rate for a 5-year fixed-rate 75% loan-to-value mortgage has remained stable at 2.0% over the last year and a half (Figure 3). So by these measures, it would appear home affordability has somewhat improved recently.

With such a ‘favourable’ supply and demand backdrop, it’s reasonable to conclude that the recent deterioration in house price owes much to sentiment. This assessment is consistent with a recent decline of consumer confidence (Figure 4) and the Building Societies Association’s (BSA) quarterly property tracker, which indicates that Brexit uncertainty is the primary cause for the sharp fall in housing market confidence.

The BSA’s quarterly property tracker survey shows that a net balance of -14 households think now is a good time to buy a house, down from -4 in September. The balance has been negative for seven consecutive quarters, having been consistently positive in the previous eight years. While the risk of a no-deal Brexit looms, prospective house-buyers may be tempted to wait for the uncertainty to subside. This could lead to some sellers lowering asking prices in an effort to attract buyers, which means actual year-over-year declines in house prices shouldn’t be ruled out for the coming months.

However, in the medium term, the chances are high that ‘real’ (inflation adjusted) house prices will revert to their flat long term, or increase at most by 1% per year. After accounting for fees, tax and the benefit of living in the house without paying rent, this makes the narrow return from investing in the housing market roughly comparable to the expected return of a medium risk balanced financial portfolio. The big advantage that a balanced portfolio of financial assets commands comes from the greater degree of diversification that it offers.

Nobel Prize–winning economist Harry Markowitz, the father of Modern Portfolio Theory, was the first to demonstrate that a diversified portfolio can deliver improved performance and lessened risk relative to individual assets. This notion that you’d get something for nothing is nearly unheard of in economics. And it’s why Markowitz famously called diversification “the only ‘free lunch’ in finance”. The key concept behind the free lunch is correlation, or rather, a lack of it.

Typically, the performances of individual assets aren’t perfectly correlated. If asset values don’t move up and down in perfect harmony, then a diversified portfolio will have less risk than the weighted average risk of its parts. And it means you wouldn’t be putting all your eggs in one basket. If the market in one country or region stagnates, the difference can be made up in other sectors that are booming. This makes a globally diversified portfolio more resilient to the more idiosyncratic problems faced by an economy, a city or even a street in the UK.

Diversification across asset classes similarly cushions the impact of downturns in equity markets. The more extensively diversified an investment portfolio, the greater the likelihood it mirrors the performance of the overall market.

Having typically limited tracking errors, individual balanced portfolios tend to achieve gains near the market average. This is in contrast to an individual house, which gives you far more concentrated exposure, and performance can differ significantly depending on location and other factors. Investing in a well-diversified portfolio is a matter of putting your faith in the collective ingenuity and restlessness of the world. Such an investment can be complementary to the bricks and mortar investment that you rely on for shelter from the drizzle.

Chart - House price growth has slowed down recently
Chart - Real wages have been improving recently
Chart - Mortgage rates have been stable recently
Chart - Customer confidence indicator

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