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Matters of interest

For bond managers, house price growth is a useful indicator of future movements in the base rate.

I spend more time looking at UK housing market data than perhaps any other data when working out which direction interest rates will move in and by how much.
Firm evidence of a slowdown in the US housing market, coupled with a slight fall in UK mortgage approvals in April, sparked much media speculation that the UK housing market is in danger of collapsing. I disagree strongly with the view that we are on the brink of a sustained housing market slowdown and expect the market to remain buoyant for at least the next half year.
One of my crystal balls is mortgage approval data ­ an excellent indicator of future house price movements. The number dipped from 118,000 to 113,000 but historical correlations suggest that UK house prices should still manage doubledigit growth figures.
My other crystal ball is the Royal Institution of Chartered Surveyors¹ sales to stock ratio, which can be an even more accurate predictor of the future state of the UK housing market. This shows the number of estate agent sales divided by the number of unsold houses on agents¹ books. Crucially, the sales to stock ratio is still rising and the ratio of 0.48 released in April suggests annual UK house price growth will move from around 10 per cent now to as much as 15 per cent in six months.
Looking even further forward, the key question is whether the recent fall in mortgage approvals is the beginning of a downward trend or just a blip. Based on historical correlations, mortgage approval data below about 100,000 and a sales to stock ratio of about 0.35 indicate the housing market is slowing but there is no evidence of this now.
Indeed, UK house price growth is accelerating, if anything. The London property market is very hot. Figures from show that Greater London house prices rose by 25 per cent over the year to April. Traditionally, London is the epicentre of the UK housing market, with price gains or losses rippling outwards.

The only way to slow the housing market is for the bank to raise interest rates again. I expect rates to peak at 6 per cent or possibly higher some time in 2008, depending on whether the housing market cools.
All this creates a very challenging environment for bonds. The best defence is to position my fund¹s short duration, with a low sensitivity to interest rates, and invest in floating rate notes which benefit in an environment of rising rates.

Within the M&G optimal income fund, I am able to go a number of steps further and use wider powers to sell interest rate futures and gilts futures. I have done this over the past five months and have managed to get duration down to just 2.6 years.

Should investors in traditional corporate bond funds be worried? I do think there will be more rate rises than the bond market is currently discounting. However, there are a number of factors to encourage corporate bond investors who are in for the long haul. First, it is inevitable that rate rises will at some stage begin to take hold and the housing market will start to weaken.

When this begins to become apparent, we could see a real buying opportunity in bonds at some point next year or perhaps as early as the end of this year. Keep an eye on those crystal balls.

An ongoing positive for the UK bond market is the well documented shortfall in UK pension funds. The bond market has seen a significant inflow of money from pension funds in the past couple of years and I think this is likely to continue, with long-dated bonds standing to benefit, in particular.

Do not forget that the global default rate is close to record lows. Strong economic growth has translated into profitable companies with healthy balance sheets and very few companies have missed their loan repayments. It is difficult to see a sharp pick-up in defaults in the short term and a sudden sell-off in high yield is unlikely this year.

Richard Woolnough manages the M&G optimal income fund.


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