November 2021 Market Guidance

Mortgage debt key to financial stability

“Real estate is much more solid and less volatile than virtual and speculative transactions in the financial markets…” This is the common view of the real estate, and this has certainly to do with the symbol of robustness it conveys. And yet, as paradoxical as it may seem, the housing market is at the origin of most financial crises…

I remember this student I met in a bar in New York a few years before the subprime crisis in 2007. “I have found the holy grail to finance my studies”, he told me with a disconcerting confidence. He had bought a small apartment in Orlando, Florida, and planned to pay off the loan he had taken out to pay for his education… with the resale of the property. “But… how sure are you that you’re going to make a profit?” I asked him. He then showed me a site that gave the gains in dollars depending on the date of the resale of his property. This was based on the idea that the price of real estate in Florida would continue to rise by 5% every year, as it had since 1980. And when I told him that past performance is no guarantee of future performance, he replied that “that’s what you find on Wall Street financial products, but not on real estate investments”. My student friend was right until early 2007. The rest is known: real estate lost 50% of its value from 2007 to 2012. And today? The price of a square meter in Orlando – as in most other cities in the US – is doing great: since 2012, it has gone from $1,500 to $3,300. True, the US stock index has risen 15% per year, over the same period. Why should we be more worried about the rise in real estate prices than that of the stock market? For a very simple reason: real estate is paid for with money that we do not own. And in very different proportions. In Switzerland, the share of funds borrowed to finance a property is at most 80% of its value. But in some countries, such as France or the United States, it is possible to borrow 100% of the sum to “build your life” as those advertisements in France that young people in their thirties who are about to start a family so aptly put it.

Do you know which country holds the sad record of the highest household debt compared to its income? It is not the United States, where this proportion is already 100%, but… Denmark, with a ratio of 260% of debt to the median income of its population.

Household debt, a sword of Damocles

Total household debt as % of disposable income

The explanation is quite simple: Denmark is the only country in the world where banks offer their clients a negative mortgage interest rate! Can you imagine the wonder? You borrow the equivalent of 1 million francs in Danish kroner and, each year, the bank grants you a gift of 5,000 francs! After 20 years, you have erased 10% of your debt without any impact on your lifestyle. It is not surprising then that Denmark has an unprecedented debt record. It is closely followed by Norway, the Netherlands and, in 4th place… Switzerland. Here, household debt reaches 230% of income. Not bad. Mortgage interest rates in Switzerland at 0.46% are probably even more generous than the one offered to the Danes, if we compare the cost of borrowing money for mortgage to the rent for housing in Switzerland.

In a recent study, the Bank for International Settlements identified a major risk to the global economy: that of a debt trap, which it described in these terms: “as interest rates – nominal and real – fall, debt-to-GDP ratios rise, making the global economy more vulnerable to interest rate increases, thereby making it more difficult to raise them. In other words, low interest rates beget lower interest rates.”

This is exactly the situation we are in today: around the world, debt rates, both public and private, are rising. Central banks have taken control of the entire interest rate curve. By reducing key interest rates to the floor or slightly below. And by making sure that long-term interest rates follow suit, thanks to their most generous policy of liquidity injections through bond purchases. Today, some central banks – mainly in the emerging countries – are timidly embarking on the fight against inflation, but it seems obvious to us that they are not going to put both feet on the brake. On the one hand, this is cost-push rather than demand-push inflation. On the other hand, and above all, a rise in short-term rates could lead to a similar movement, albeit of lesser magnitude, on the long end of the yield curve, which would have extremely unfortunate consequences for the ability of governments, but also of households and companies, to service their debts. Central banks would thus find themselves trapped in a situation they abhor: that of having to finance government fiscal largesse by monetizing their debts.

But let’s get back to real estate and the risks it may pose to the global economy. After the housing bubble burst in 2008, the Case-Shiller index of US real estate had returned to the reasonable increase dictated by the consumer price index by 2012. Today, the gap between the housing market and the household basket is far more unreasonable than it was before the bubble burst.

Unreasonable gap between housing prices and the consumer basket

The historical study of financial crises teaches us that an excess of debt is often at their origin. And that when we refine the analysis, it is often household debt that is the cause. Since mortgage debt accounts for the bulk of household debt, follow our lead….

Including house prices in inflation

The price of real estate is therefore a good way to measure individuals’ excessive appetite for risk and … debt. We must not forget that putting 20% of equity to buy a property is akin to making an investment with a leverage of 5 times. It is like building a stock portfolio worth 100’000 dollars, putting only 20’000 dollars on the table and borrowing the remaining 80’000 dollars. Even if you are to invest in “safe” stocks such as Nestlé, Roche or Novartis, we should not forget that leverage can make an equity portfolio very risky.

At JAR Capital, we have developed a “global” inflation indicator. How is it built? Based on our conviction that the bulk of inflation is not in the household basket but in the price of financial assets, we have constructed an index that takes 70% of the consumer price index and the remaining 30% of the price of real estate. The overall inflation index that we obtain is the burgundy curve on the graph. The observation is clear: global inflation is now well above the consumer price index (black curve). Historically, whenever the measure of global inflation has exceeded the critical threshold of 4% (yellow line), a stock market crash (indicated by the black bars that measure the annual variation in percentages of the US stock market index on the right-hand scale), or even a financial crisis, as in 2008, has not been long in coming.

In the US, global inflation is rising

What is the outlook for the markets?

After “talking about talking” about tightening its policy during the summer, the US central bank is likely to take action and announce “Tapering” this month. The Bank of England will probably follow in its footsteps, or even precede it. The upward pressure on bond yields, which has already been evident for several months, is likely to continue, as is the upward movement of the dollar, given that the Fed will in all likelihood act before the ECB.

Our belief is that central banks will probably not be able to act fully against inflationary pressures. Fighting too hard would risk increasing debt servicing costs and thus making the entire financial system extremely vulnerable, given the staggering levels of government debt. In the end, a little inflation is not a bad thing to reduce the real debt burden. The potential for bond yields to rise is therefore limited.

Our economic indicators remain anchored in the recovery scenario, albeit with less vigor than a few months ago. Some fear a return of “stagflation” in 2023, a combination of stagnant growth and inflation that is not conducive to good returns on risky assets. Even if we believe that this risk for 2023 is exaggerated, we keep in mind that equity markets will have to face several headwinds: indeed, the prospects of less expansive monetary policies, concerns about the US debt, the rather rich valuations of risky assets, the risk of a bursting of the real estate bubble in China are all factors that lead us to a certain prudence in our investment management.

Dr Michel Girardin Chief Economist

Professor of Macro-Finance University of Geneva


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