What would happen if the UK housing market crashed?
04 October 2018 | Markets and Economy
Bank of England Governor Mark Carney recently warned that in the event of a "No Deal" Brexit, UK house prices could fall by up to 35%1. Although this appears extreme to us, and is certainly not our base case, Governor Carney’s remarks got us asking the question: "What would happen to the UK economy if house prices fell significantly?"
Housing and the business cycle
The housing market and the economy are intrinsically linked. In the UK, property ownership stands at over 60% and housing accounts for the largest portion of most people’s wealth2. As a consequence, rising house prices are often accompanied by increased consumption spending as households feel more confident about their future prospects and banks are more willing to provide credit. Rising house prices also typically encourage investment and the building of new homes.
However, if house prices fall, these effects work in reverse, with significant implications for the economy.
Will a housing market crash lead to a recession?
In Figure 1, we assess how the probability of a UK recession changes if house prices were to fall significantly.
Our recession probability model uses a selection of variables targeted at predicting a recession over the next six months, including: (i) economic leading indicators, (ii) short and long-term interest rates, (iii) equity market returns and (iv) house prices. Today, the model suggests there is a 4% chance that the UK economy will slip into recession in the next six months.
In our first scenario, we assume UK house prices fall by 20%, which is roughly what happened in the early 1990s and during the global financial crisis (2008-09). In this scenario, the implied recession probability jumps from 4% to 76%.
Figure 1: The UK economy is likely to fall into recession if house prices fall significantly
Source: Vanguard calculations
In our second scenario, we repeat the analysis for a 35% fall in house prices, as per Mark Carney’s comments. Unsurprisingly, the implied recession probability moves even higher to around 95%.
However, we believe this second scenario is extreme and unlikely. It is based on the strong assumption that interest rates will rise aggressively following a "No Deal" Brexit. But we know from the experience of the Brexit referendum two years ago that the Bank of England will be reluctant to raise interest rates if economic growth is threatened, even if inflation does rise above target.
Nevertheless, from Figure 1, we are forced to conclude that if UK house prices do fall significantly, it is more than likely that there will be an economic recession.
Outlook for UK house prices
In our base case, we do not expect a housing crash or an economic recession. Instead, we think it is more likely that the UK will be able to strike some sort of compromise solution with the EU on Brexit. In our view, this will avoid a significant decline in house prices.
But we do expect future UK house price growth to be much more subdued that in the past. Over the last 50 years, UK house prices have grown at an annualised rate of around 9%3. This is unlikely to be repeated over the next 10 years.
Housing market valuations today are elevated. And past experience tells us that starting valuations matter for future house price growth. As Figure 2 shows, lower starting housing market valuations tend to be associated with higher returns in the future, and vice-versa. In fact, this observation generally holds for most asset classes, including equities and bonds. If we were to extrapolate using this simple analysis, today’s current price-to-income ratio of around 140 is consistent with house price growth of less than 4% annualised over the next 10 years. A far cry from the 9% we’ve been used to!
Figure 2: Higher starting house price-to-income ratios have historically led to lower prospective returns
Source: Bank of International Settlements, Office of National Statistics, Vanguard calculations
In the shorter term, Brexit uncertainty, gradually rising interest rates and the phasing in of macro-prudential regulation targeted at cooling the buy-to-let market will also weigh on UK house prices.
Implications for investors
In our base case, we expect future UK house price growth to be subdued relative to the past. The risk of a significant housing market decline remains elevated given the possibility of a "No Deal" Brexit and this would meaningfully increase the probability of the UK falling into recession.
More generally, as the Brexit deadline looms closer, it would not be surprising if financial market volatility rises significantly. Given such high levels of uncertainty, it is important to have a well-diversified global portfolio in order to insure against the risk of negative growth outcomes.
Even if Mark Carney's worst fears are realised, and the housing market does crash, investors should not panic. More often than not, this is the worst time to sell risky assets. The best course of action is to be patient. In the long-run, investment success is driven by time-in-the-market rather than timing the market.
1See FT article, "Mark Carney warns of economic chaos in no-deal Brexit" (13 September 2018).
2English Housing Survey, Home Ownership (2016-17)
3Using data from the Bank of International Settlements (BIS)
Investment risk information:
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