War, oil, growth and inflation

Good morning. Our FT colleagues report that 12 Polymarket users netted $330,000 betting on a US attack on Iran by Saturday, with about half of the bets coming in the six hours immediately before the strike. Insider trading is bad. Risking national security to make a few bucks is extremely bad. Email us your thoughts: unhedged@ft.com 

Oil and the economy

We don’t have any insight into how the war in Iran will play out. But oil prices have jumped 13 per cent to about $82 per barrel, the highest level since July 2024. Meanwhile, inflation jitters have pressured Treasuries, and stocks look wobbly. If the conflict drags on, how much worse might this get?

The consensus expectation is still that the war will be short — a month at most. If that’s right, the drag on growth from higher oil prices should be small. Analysts are expecting US GDP to be reduced by just a few tenths of a percentage point. The impact on consumer inflation would be modest, too: energy accounts for only about 6 per cent of the consumer price index, though that impact is spread very unevenly among households. And because the US is now an energy exporter, it is relatively well hedged compared to Asian and European economies. As EY-Parthenon’s Gregory Daco points out, high prices might be a stimulus for shale production, offsetting the hit to consumption. 

If the war drags on, the picture changes. Goldman Sachs suggests, as a rule of thumb, that each $10-per-barrel increase would reduce GDP growth this year by about a tenth of a percentage point. More concerning are the inflation effects. A sustained 10 per cent increase in oil prices would elevate core CPI by four basis points, and headline CPI by a meaty 28 basis points: 

In a scenario where oil prices surge to $100 per barrel or higher and are sticky at this level — perhaps because of disruption to Saudi Arabian production — the rise in inflation would be much sharper and would pass through into goods and services prices, says Daco. 

The context is important, though. This war is the fourth supply shock since 2020, joining the coronavirus pandemic, tariffs and the immigration crackdown, and there might be cumulative effects. 

Consumers and businesses were already feeling concerned about inflation heading into this year, and perceived risks of higher prices from the war could make them both too cautious about spending, notes Thierry Wizman at Macquarie Group. He adds: 

Productive resources are sucked into the war effort, eventually, and the war itself can disrupt or destroy productive capacity. Indeed, to cause inflation, actual production or transportation of goods does not need to actually be disrupted; as long as some product end-users believe that a disruption may occur, they may hoard physical products, which could be just as inflationary as an actual disruption of output. It also means that as long as there is a danger of disruption via an attack (say, on a shipping vessel), insurance companies will raise premiums to account for that, which could also be inflationary.

In war times, we have much to fear — including fear itself. 

(Kim)

Housing yields and very long-term rates

A surprising amount of financial analysis (and a surprising amount of what gets written in this newsletter) comes down to comparing prices, yields and interest rates to some estimate of what is historically normal or expected over the long term. Take US equities. One might look at an estimate of the market’s current price/earnings ratio (à la Robert Shiller) or equity risk premium (à la Aswath Damodaran) and compare it to history, and then declare the market to be cheap, fairly priced or expensive. With real estate, you might look at cap rates; with corporate bonds, spreads; with Treasuries, term premia. This amounts to “driving in the rear-view mirror”. But we hope it beats driving blind. 

A recent paper by the economists Verónica Bäcker Peral, Jonathon Hazell and Atif Mian (I’ll call them PHM) makes cunning use of a natural experiment to make an observation about the very long-term expected yield on housing in the UK — and, starting from there, about long-term interest rate expectations globally. 

The natural experiment involves leasehold apartments in the UK, which are privately “owned” through long-term leases of 100 years or more. The value of the apartments falls as the time remaining on the lease shortens, so the owners press for extensions, even when there are many decades remaining. Using a dataset from HM Land Registry, PHM compares the prices of leaseholds where the leases have been renewed to the prices of similar unrenewed leaseholds. The difference between the two prices reflects only expectations for the yield — the expected return — on the property for the period after the old lease was to expire and when the new lease will. On average, this is the expected yield on the property for a 90-year period beginning in 70 years. It is the housing equivalent of a very, very long-term forward interest rate.

PHM finds that this long-term expected housing yield has fallen steadily since the great financial crisis. Here is their chart. The shaded area represents 95 per cent confidence intervals around their estimate:

The current expected yield is 2.7 per cent. That is: UK real estate is really, really expensive and expected to stay that way. Think of this yield as a long-term expected net rent-to-price ratio of 2.7 per cent. Flip that ratio over and you get a price-to-net rent ratio of 37. The (expensive) S&P 500 has a price-to-earnings ratio of 22 — more than a third cheaper. My unsolicited and probably useless advice to my British friends: rent. 

In any case, establishing the long-term expected yield allows analysts to assess current housing yields as cheap or expensive relative to long-term expectations. PHM notes that yields are higher (prices lower) in areas with greater elasticity of housing supply, just as one might expect. So countries with saner zoning regulations can be expected to offer better deals than the UK. 

Why did the long-term expected yield fall between 2008 and 2020? PHM points out that the decline tracks the trend in long-term (10-30-year) real interest rates in the UK and globally, as well as yields on other global assets. This suggests that the fall in the housing yield is caused by a fall in the expected long-term interest rate on safe assets, which is a component of the housing yield and all other asset yields. The other components of housing yield — expected rent growth, the housing risk premium — are specific to housing and appear to be quite stable. 

If you buy this idea, it has a striking implication. Since Covid hit in 2020, long-term (10-30-year) real interest rates have risen, but the (even longer-term) housing yields that PHM have derived have been stable. Which suggests that — and this is the macroeconomic punchline — the recent increase in interest rates is not driven by a rise in long-term rate expectations. Today’s high rates are likely a “temporary deviation.” Another PHM chart (y* is their abbreviation for the long-term UK housing yield):

To put the point another way, whatever forces drove interest rates down from 2008-2020 may still be in place but are being drowned out by other factors. The key downward force, according to Atif Mian, is the savings glut caused by wealth inequality (as readers of this newsletter may remember). The short-term noise could be worries about government solvency, the hangover from the inflation spike or something else. But over the longer term, PHM suggest, we are still in a low-interest rate world. 

(Armstrong)

One good read

Cute. At first.

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