One way of assessing the downside for house prices is to ask how much further they would need to fall to achieve either a “fair” level by historical standards or a given level of undervaluation – on the assumption that markets typically undershoot on the way down.

The discussion is usually couched in terms of the house price to earnings ratio but – as explained in an earlier post – the rental yield on housing is a superior measure of valuation.

The chart below shows historical National Accounts data on the rental yield together with a current estimate based on prices having fallen 11% from their peak late last year (as suggested by the Halifax index).

The current estimated yield of 3.4% compares with a long-term average of 3.6% – a reasonable estimate of “fair value”. Assuming no change in rents, prices would need to fall a further 6% to bring the yield up to the average. The RICS survey of letting agents released today indicates that rents are still rising so a smaller decline would be possible.

Now suppose the market undershoots to the same extent that it overshot in 2007. The yield got down to 2.9% last year – 70 basis points below the average. A rise to 70 b.p. above the average would take it to 4.3%. This would involve a further 21% fall in prices from current levels, assuming unchanged rents.

The bottom line? A further 10-20% fall in prices would bring them to an attractive level for a long-term owner or investor.

The consensus expects US GDP growth to slow sharply from a currently-reported 1.9% annualised gain in the second quarter (likely to be revised up significantly next week), reflecting an unwind of tax rebate stimulus. I am more optimistic based on the lagged impact of Fed easing, energy price relief, the stocks cycle, a diminishing drag from housing construction and ongoing trade improvement.

There were glimmers of hope in business and consumer surveys last week. The first of the regional manufacturing surveys released for August – from the New York Fed – reported a significant recovery in expectations for future activity – see first chart. If confirmed by this week’s Philadelphia Fed survey, this could presage an improvement in the national ISM survey over coming months.

Meanwhile, the early August national consumer survey conducted by the University of Michigan showed a further recovery in household perceptions of the housing market: the percentage balance of respondents judging the present to be a good time to buy a home rose to a three-year high – see second chart. However, an increase in mortgage rates following the financial crisis at Fannie Mae / Freddie Mac may delay any impact on activity.

With economies weakening further near term and monetary policies on hold, will equities continue to suffer?

The outlook for equities hinges on how near we are to a trough in the economic cycle. Historical evidence suggests the best time to buy is six months before the low in global industrial output growth (table below). The previous 12 months usually sees losses, while waiting for the trough risks missing out on the upside. As explained, I think growth will start to recover by year-end, which implies equities should recover.

Assuming a later trough, how much more could they fall?

Valuations seem supportive. The world earnings yield is currently 7%, which is the highest since 1985 (first chart). However, this is misleading because earnings are above trend and are likely to fall significantly. Adjusting earnings for the cycle, the yield is about 5 ¾%, which is still well above the long-term average of 5%. The 2003 stock market bottom occurred at a yield of 6%, which would imply a further 5% fall in markets.

The dollar has been performing a bit better lately. Is this the beginning of a major turnaround?

The dollar may have bottomed but a rise in US interest rates is likely to be required for a major recovery. The dollar is certainly cheap, particularly against European currencies. And the US trade position has been improving, both in absolute terms and relative to trends elsewhere (second chart). However, the low level of US interest rates is a big obstacle to a recovery. US short rates are currently more than 2% lower than Eurozone rates, which is the mirror-image of the late 1990s, when they were over 2% higher (third chart). The dollar was then strong and only started to fall significantly after the rate gap closed. Similarly, it may take a convergence of US and Eurozone rates now before the dollar embarks on a sustained uptrend.

Markets have interpreted the Report as boosting the chances of early rate cuts. However, the key message is that the growth / inflation trade-off has deteriorated and a much deeper economic slowdown will now be required to bring inflation back to target in two years’ time.

Key points:

•    The mean inflation forecast in two years’ time based on an unchanged 5.0% Bank rate remains slightly above 2% and is essentially unchanged from the May Report.

•    The forecast based on market rates is lower than in the last Report but this mainly reflects a shift in market expectations, which are 40-50 basis points higher than in May.

•    More dovishly, the three-year-ahead projection has been reduced and is now clearly below the 2% target. However, this does not necessarily imply scope for an early reduction in rates.

•    The changes to the growth projections are more striking, with the annual change in GDP now projected to fall to zero in the second quarter of next year. The May Report showed a trough at 0.9% in the first quarter.

•    However, a V-shaped recovery is forecast in the second half of 2009 and first half of 2010 – this does not suggest a need for aggressive rate-cutting.

Mr. King was diplomatic about fiscal policy but any reduction in rates will clearly become more difficult if borrowing targets are allowed to slip further.

Will the global slowdown be reflected in lower inflation?

Headline inflation is peaking but the extent of any decline is unclear. Core rates – excluding food and energy – may continue to rise a while longer, reflecting lingering capacity pressures and the pass-through of earlier cost increases.

Why will headline inflation subside?

Mainly because of the oil effect. Oil started surging about a year ago so the annual rate of increase will start to fall sharply if prices now stabilise (first chart).

Will core inflation follow headline lower?

Core rates may continue to firm near term, particularly in emerging economies, where labour markets are tight and there is greater evidence of “second round” inflation effects. A rise in core inflation could temper relief at the fall in headline rates and block central banks from easing monetary policies.

Ultimately inflation is a monetary phenomenon – has money growth slowed in the wake of the credit crisis?

It has but not by much yet. Our global broad money measure is still rising at a 12-13% annual pace, which is above the average of recent years (second chart). This is consistent with some decline in underlying inflation in 2009-10 but possibly not by enough to satisfy central banks.

So hopes of significant monetary policy easing may be disappointed?

Policies are already quite loose. For example, G7 headline inflation is now well above a weighted average of short-term interest rates. This has disturbing echoes of the 1970s, when high inflation became entrenched (third chart). Central banks will want to restore positive real rates when credit conditions begin to normalise.

Could policies be tightened then?

US interest rates are particularly low relative to inflation and are likely to be raised if the economy recovers as I expect. However, there may be scope for modest cuts in Europe. So the most likely scenario is a convergence of rates within the G7 but with little change or even a slight rise in the average.