What caught my eye this week.

I often fret that we don’t bang the drum enough for passive investing on Monevator these days.

It’s not that we’ve changed our minds that using index tracker funds is the way forward for most investors. Far from it!

It’s more that if you bang a drum every week, you start to feel like a slave – and regular readers start to get a headache.

Monevator made its bones championing passive investing more than a decade ago, when coverage was scant in the mainstream British media. There’s a ton of articles in our archives on why and how to do it.

Maybe we should update and republish them more often, to give them a fresh airing?

The trouble with a blog – unlike with a book, say – is you never know where someone is starting from. A reader could be on their 500th article, or their first.

I should use our fancy new email system to create some kind of automatic crash course in passive investing for new subscribers. Watch this space…

For the record, though, unless you have special access, some rare edge in selecting winning active funds – or you have non-standard aims like ESG investing or a desire for an unusual return profile – than the evidence supporting index funds has only grown.

Most people accept this nowadays. Even active manager redoubts like the personal finance section of the Financial Times, which wrote this week:

In the first six months of this year, nearly two-thirds (60 per cent) of actively-managed equity funds have fallen further than the market.

Yes, you read that right.

Actively-managed funds — where you pay extra for a team of well-remunerated fund managers to cherry pick stocks they think will outperform — have actually under-performed cheaper passive funds that simply track the nearest comparable index.

There’s also an interesting table showing how active managers have performed over ten years.

Note that some of the apparent better-than-average success – such as 63% out-performance in the UK market – can typically be explained by factors such as holding more small companies than the benchmark. (And if so, this might be replicated more economically by getting broad cheap exposure via a tracker fund, and marrying it with say a 20% allocation to small caps.)

Some of the outperformance though will be genuine alpha generated by skillful stockpickers. Never think active managers are lazy or stupid!

The opposite is true, which is why they find it so hard to beat each other. (The maths also guarantees a worse than average performance, after fees).

Slim pickings

I’m an active stockpicker, remember. I don’t think beating the market is the stuff of myth and magic.

No, the difficulty is you identifying who will beat the market ahead of time.

Get it wrong – as you probably will, statistically-speaking – and you’ve wasted 30 years in more expensive funds. You will retire poorer as a result.

Who needs you to take that risk? Only active fund managers, whose big salaries depend upon it.

So much for funds – here’s some evidence this week from Alpha Architect that most of us shouldn’t be picking stocks, either. Ho hum.

Have a great weekend everyone.

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What caught my eye this week.

Britain has a problem with its workers. No, I’m not only thinking about the ones you can’t find to fix your boiler. Or the increasing number missing in action because they’re away striking for higher pay. Or even necessarily those a few of you wanted to send back to Eastern Europe for doing too good a job.

I mean the would-be workers who aren’t workers anymore.

Ian Stewart, chief economist at Deloitte, noted this week that there are 270,000 people fewer in employment than before the pandemic struck in early 2020.

The economy meanwhile is slightly larger, with a 1.2% increase in GDP.

As many people who run businesses will know, the UK’s problem right now is not a lack of job vacancies but a lack of people to fill them.

Worse, that 270,000 figure doesn’t capture the full extent of workers ‘lost’ to the jobs market.

“To work that out we need to estimate the number of people who did not enter the labour market, or decided to leave it, because of the pandemic,” says Stewart.

Since we can’t ask them all about their rationale, Stewart does some guesstimates:

It seems likely that the sharp rise, of over 250,000, in the number of people of working age classified as suffering from long- or short-term sickness since late 2019, is largely pandemic related. This seems plausible given that ONS data show an estimated 2m people suffering from self-reported long COVID at the beginning of June, of whom over 400,000 said it had limited their ability to undertake day-to-day activities “a lot”.

The pandemic also seems likely to be a major factor in the decision by more than 50,000 people of working age to retire, a change that goes against the recent trend of later retirement. […]

Student numbers have also surged, with uncertainty and dire predictions of job losses encouraging more young people to stay on in full-time education. Again, the data are unclear, but we estimate that roughly 100,000 people may be in education today for such reasons.

Finally, there is the effect of the pandemic, and of Brexit, on people coming to work in the UK and on foreign workers who were already here. The data are incomplete, but HMRC reports that between June 2019 and June 2021 the number of EU nationals on UK payrolls fell by just over 170,000. […] Some workers were likely always planning to return home however, and new immigration rules have prevented a new generation of EU citizens from moving to the UK.

Summing the increase in the number of people who are sick or retired, additional growth in student numbers and falling numbers of EU workers we get to 570,000 people.

So we have more than half-a-million fewer workers doing productive work, drawing a salary, and paying taxes. Many of whom would probably still be in work, if not for the pandemic one way or another.

That is is pretty staggering – even for someone like me who was wary of the frozen in carbonite theory that turning the economy off and on for lockdowns would not have vast economic consequences. (Which is not to say we shouldn’t have done it anyway, especially in early 2020).

Indeed those consequences have actually shown up in high inflation and lower output – as well as far higher public debt, of course – rather than directly causing joblessness.

So it seems it’s the high toll of Covid on health that’s the problem?

Well maybe. But maybe not exactly.

United in suffering

Another interesting analysis of the UK’s worker shortage was conducted this week by the always-excellent data miner John Burn-Murdoch for the Financial Times [Search result].

Burn-Murdoch sees roughly the same half a million workers missing when he surveys the UK. But he has even less time for cozy explanations such as people reassessing their lives and optionally retiring early.

Rather, Burn-Murdoch blames chronic illness:

Of the roughly half a million Britons aged 15-64 missing from the workforce, two in three cite long-term illness as their reason for not holding or seeking a job.

It would be easy to point the finger of blame at Britain’s handling of the virus, but the data suggest otherwise.

And as fans of his work would expect, Burn-Murdoch has a pretty convincing graphic to back up his case.

One of these recoveries is not like the others

Source: FT

Staggering, isn’t it? Just eyeballing the chart, only the US and arguably Turkey are remotely similar. And both of those have now got onto a better trajectory.

Of course you could offer other theories besides chronic illness.

All three of these countries entered the pandemic led by populist leaders who made decisions accordingly. Perhaps that skewed the eventual outcome?

The US and the UK both offered generous fiscal relief for workers, too. A right-leaning view might be that safety-cushioned workers haven’t felt the need to hurry back into employment.

However plenty of the other countries offered support packages.

For his part, Burn-Murdoch sounds almost apocalyptic:

With direct impacts of Covid ruled out, the most plausible remaining explanation is grim: we may be witnessing the collapse of the NHS, as hundreds of thousands of patients, unable to access timely care, see their condition worsen to the point of being unable to work.

The 332,000 people who have been waiting more than a year for hospital treatment in Britain is a close numerical match for the 309,000 now missing from the labour force due to long-term sickness.

This is the Financial Times he’s writing for remember, not The Guardian.

Again, one flagged up the long-term health consequences of making it harder for people to access care during Covid at your peril. Trust me, I got the heated reader responses to prove it.

That said I’m sympathetic to the view that it was the virus – not the lockdowns – that was to blame for much or even most of this.

For example, why should doctors and nurses have taken even more risks from a novel virus, particularly pre-vaccination? People avoiding GPs to avoid catching Covid might have been making their own rational decisions, too.

But I do feel there wasn’t enough mainstream airtime given to setting the clock on this time-bomb. Which in turn helped to push it to the lunatic fringe as the debate became polarized by late-2020.

Readers won’t be surprised to hear I also finger Brexit.

With open borders with the EU, the NHS could be rapidly recruiting to cover its strained workforce and treat more patients (if sufficiently funded, obviously).

As things stand it’s scrabbling in a hamstrung economy with the rest of them.

Jobsworths

As the owner of a blog about financial independence, I lapped up stories about The Great Resignation and people swapping joyless jobs for early retirement.

But this seems to have only happened at the margin.

Rather, a lot of more people seem to be too sick for employment. Which is a human tragedy.

Finally, let’s be wary with the ‘kids don’t want to work these days’ popular with Barry Blimps.

Besides the fact that it might be hard to blame them given the economic odds stacked against them (high house prices and rents, inflation, student debts) it’s a trope old as the hills:

https://twitter.com/paulisci/status/1549527748950892544?s=21&t=_aVclDcRxYP81xUjDp3U8w

Where do you think all our workers went? Let us know in the comments.

And have a great weekend!

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The evidence is mounting that 2022 has seen a regime change for interest rates. Quantitative tightening (QT) is the new quantitative easing (QE). Everyone should stress-test their mortgage and other debts to see how they’d handle higher rates.

There are two main things to consider:

• The cost of servicing debt (a function of interest rates, plus spurious add-on charges)

• The ability to get debt if you need it (how willing are banks to lend)

Both will likely get worse for most borrowers as money tightens.

Of course if the screw is really turned we will see second-order effects.

For instance markedly higher rates could cause the housing market to slow or unemployment to rise. That could hit your finances directly (you lose your job) or indirectly (a stock market or house price crash).

Keep going with such extrapolation, however, and you begin to sound like the economic nerd cousin of Stranger Things’ Dustin Henderson.

“High rates will crush growth even as de-globalization fuels hyper-inflation, spinning us into a stagflationary death loop that sees Jeremy Corbyn and Boris Johnson re-elected as leaders of extra-radicalized parties that wage running battles in a crumbling Trafalgar Square.”

I’d draw the line several steps before reaching – let alone acting upon – such conclusions.

It’s not that things can’t change radically. (Nor that you shouldn’t have a Plan B, just in case).

Things can definitely change a lot:

• In the 1970s it was hard to get an expensive mortgage to buy a cheap flat in a depopulating London.

• In the 2010s it was easy to get a cheap mortgage to buy an expensive flat in a booming London.

However it’s very difficult to make even short-range economic forecasts accurately.

Massive shifts? Trying to see everything proceeding as you have foreseen – ten years away – is a fool’s errand.

Rather, like judging the weather, it’s usually better to assume more of the same – summer, say, as opposed to winter, or vice-versa – and to focus on the disposition of any clouds on the horizon.

Higher interest rates

What makes doing so tricky this time – and what has roiled markets in 2022 – is that we probably are in a new season.

That’s the regime change bit, right? But I don’t yet see that we’ve fast-forwarded from a balmy June into the depths of a winter solstice.

So far quantitative tightening has mainly been felt in interest rates.

Take the five-year gilt yield as a rough-and-ready driver of rates for fixed-rate mortgages.

The yield on this gilt is back to 2014 levels:

Source: MarketWatch

Correspondingly, five-year fixed-rate mortgages have become more expensive.

Tack on 1-1.5% for the bank’s trouble of lending to you rather than Her Majesty’s government and the typical five-year fix is now above 3.5%. (Albeit you can do better if you shop around.)

That’s not too terrible, but some pundits see things getting far worse.

One analyst recently told What Mortgage:

“Given the speed of rate rises this year, as the mortgage market catches up it is not unrealistic to see the average five-year fixed rate at 5% next year.”

This is not an outlandish prediction, though I’d be surprised. While today’s rates are in unfamiliar territory for anyone who has only been saving and borrowing for the past few years, they’re still historically low.

We only have to expand out the view above to 15 years to see the five-year gilt yield above 5% in 2008:

Source: MarketWatch

You’ll remember 2008 was the watershed for a little thing called the Great Financial Crisis. Its aftermath saw yields plunge and the start of the quantitative easing that we’re now exiting, via quantitative tightening.

So 5% yields – and maybe 6-7% five-year fixes – are possible if we truly have left behind the great sloshing post-crisis money splurge.

Note though that the market does not currently see 5% as remotely likely, judging by signals such as the yield curve:

Source: Bank of England

Sure, there’s no anticipation of a return to recent ultra-low yields. But there’s no fear of 5% interest rates, either.

Indeed as of the Monetary Policy Committee’s last meeting in June, market pricing for the Bank of England’s Bank Rate was 2.9% by the end of 2022, peaking at 3.3% next year.

Is that a spike in your inflation graph or…?

The elephant in the room is, of course, inflation. High inflation that persists for longer than anticipated could see more interest rate pain inflicted than is currently priced in.

Hardly anybody saw inflation or rates being where they are now, this time last year. So the market is hardly infallible.

And trying not to see high inflation these days is like trying to tell your brain not to think of a pink elephant:

Source: Office for National Statistics

Just this week inflation hit a 40-year high of 9.4% in the UK. It has gone bananas, to use the technical term.

Market predictions for another big rate hike from the BOE hardened on the latest inflation report. However for those of us not trading day-to-day moves in the bond market, higher Bank Rates were already effectively priced in.

The key questions now – which I do not propose addressing in this post – are (1) whether inflation is still a relatively short-term spike, and (2) whether more rate hikes will do much to bring it down anyway.

There’s lots of opinion to digest out there. Call it right and you can be more confident about where mortgage rates will go.

Personally I believe inflation is more likely to be significantly lower in a year or two than higher. I still see most of the inflation as an aftershock of the stop-start pandemic, albeit with additional factors such as fiscal stimulus and war.

More importantly, the market agrees. And for what it’s worth the Bank of England still believes we’ll be back at around 2% inflation in a couple of years:

The rate of inflation is forecast to keep rising this year. But we expect it to slow down next year, and be close to 2% in around two years. 

That’s both because the main causes of the current high rate of inflation are not likely to last, and because we have raised interest rates several times over the past few months.

True, I’d take that prediction with a fistful of salt. Both on the grounds of the Bank of England’s wonky forecasting record and because I do not believe that it will do ‘whatever it takes’ to bring inflation back to 2% if it has to.

Given the already surging cost of government borrowing and the likelihood of a deep recession if rates go a lot higher, I suspect the Bank would countenance elevated inflation at, say, 3-4% for a time as more palatable.

Admittedly 3-4% is not in its mandate. But it could probably obfuscate.

What’s more, the two candidates to be our next Prime Minister appear (as best one can tell) to have different views on both balancing the books and monetary policy.

Then there’s also the ongoing friction burn from Brexit – slowing growth and adding to inflation at the margin.

Doing my own stress tests versus higher interest rates

So that’s a snapshot of the scenic features in today’s economic landscape. I concede it’s a cloudy picture. And possibly I have my finger over the lens.

But what does it mean for our mortgages?

I went into detail about stress-testing your mortgage a few weeks ago. We especially focused on rates. Please go back and read it (and the comment thread) if you’ve not done so already.

This rest of this post is the promised follow-up as to how my thinking is evolving around my own controversial mortgage.

My situation is unusual – interest-only mortgage, got it weirdly, self-employed, and (sort-of) financially independent – but hopefully my musings will be food for thought.

Or just plain voyeurism! I mean, it could be a bit of a thriller for viewers.

The fixed-rate term on my mortgage expires in February. That’s unfortunate, given Bank Rate could be peaking shortly thereafter.

With a bit of luck however five-year yields and beyond will already be dropping by then. Albeit perhaps because recession is looking more likely, which may in turn make banks more reluctant to lend cheaply.

Clearly there were easier times to refinance an interest-only mortgage. Such as most of the past four years.

 

My mortgage: naughty but nice

I got my interest-only mortgage for a variety reasons.

Most obviously, I wanted my own home!

But I also wanted to keep my tax shelters intact, rather than withdraw money from my ISAs to buy a flat mortgage-free. If I’d done that then much of my painstakingly accumulated ISA tax-shield would be lost forever.

I also judged cheap mortgage debt would help ease the pain of any unexpectedly high inflation that emerged from the near-zero rate era.

Inflation erodes the value of debt, in real terms1. All things equal this makes the debt less of a burden over time.

Look at that inflation rate in the chart above. With inflation where it is, I’m currently earning roughly 7% in real terms on my mortgage. That’s incredibly attractive, all things being equal.

But of course all things are rarely equal.

For starters, to benefit from the negative yield I must be able to make my mortgage payments. Running a mortgage that I could otherwise pay off from my investments means assuming a risk that effectively levers up my portfolio.

That is, I am borrowing to invest via my mortgage. And the cost to do so rises with higher interest rates.

This brings up the second aspect. What did I do instead with the money that I could have used to pay off my mortgage?

I have had it invested, mostly in equities.

For the first four years this was a boon. But the wheels have come off this past six months.

I’m still up on where I would have been in cash terms – without adjusting for the extra risk I took by investing and taking on debt – thanks to my gains over the first three and a bit years.

However share prices have been falling for months in 2022 even as higher interest rates make funding their ownership more expensive.

And that means investing via the mortgage doesn’t look like the no-brainer it was as recently as November.

Higher interest rates: fine, within limits

To cap it all, my income from work is severely down over the past 18 months or so.

That was by choice – I sort of drifted into living the financially independent lifestyle. As the market soared in 2021 I stopped renewing my freelance gigs. I didn’t formally decide to quit work.

Why this happened and whether it should have is for another post. The point is I’m tending to think as if I’m living off a sustainable withdrawal rate (SWR) on my assets. Even though in reality I still do have some earnings.

Of course, there’s one huge comfort when running a big portfolio alongside a big mortgage. If you really must you can sell whatever you need from the former to cover the latter.

To my mind this makes what I’m doing pretty safe. I’d certainly prefer it to paying my mortgage with a salary and no savings.

Ideally though, I want the portfolio to continue to grow to meet future demands, FIRE-style. Hence I think of my mortgage payments as coming out of my notional SWR rather than drawing down capital.

• At my current rate of 1.99%, the payments are easily covered by earnings, let alone the portfolio.

• At a rate of 4%, which I judge a good bet for February – up from the 3.5%-ish my bank is touting today – the monthly mortgage payments would still be less than a third of my vague SWR.

• A mortgage rate of 6% does get uncomfortable. Note there’s no immediate danger at all. I could continue for decades at this rate, and the chances are good that withdrawals would be covered by portfolio growth. In that case I’d still grow richer. But ‘probably’ starts to loom larger in the long-run picture.

Obviously I have other living costs besides the mortgage. Even a blogger has got to eat!

But I am presuming I’d revert to my old graduate student lifestyle if I have to – if there’s a long bear market and no income rebound – which is actually plenty swanky for me.

Would investing rather than repayment still be worth it?

The always-contentious issue of having a big interest-only mortgage while investing is tilted by higher interest rates, too.

Regular readers will remember I shared a spreadsheet for calculating the benefits (or otherwise) of investing instead of paying off a mortgage.

We’ve established in the comments over the years that this mostly comes down to personal attitudes.

However there’s no denying the allure of the interest-only mortgage fades as rates rise.

• At a 2% rate, running a £500,000 interest-only mortgage compared to a standard repayment mortgage could deliver an additional £542,000 in net worth after 25 years, assuming 7% returns.

• With a 6% mortgage rate, that (theoretical, not guaranteed) extra gain falls to just £84,000.

This are simplistic sums that ignore inflation, the jagged path of real-world investment returns, and the significantly higher risks of running a mortgage.

On the other hand, 7% returns are much lower than what I’ve achieved over the past ten years (albeit in a bull market!)

The point is that the savaging inflicted by higher interest rates on ballpark returns is clear.

My gut feeling is that at rates much above 4% I’d probably switch to repayment.

Money’s too tight to mention remortgaging

My unusual circumstances – my bank’s CEO initiated my home loan process, remember – make my remortgaging situation potentially tricky.

However I recently spoke to my bank. Its staff confirmed in a worst case I would automatically go on to the standard variable rate.

The agent also claimed I’d be able to switch to a new fixed rate a couple of months before my current term expires – without having to go through that unusual application procedure again.

But I’m still wary. I’m outside the normal Venn diagrams. And the specific employees who sorted my loan have since moved on.

Moreover this agent was not an expert, just a front-line trooper. (The call I made was recorded. I might need that in a push!)

Refinancing is a formality for most people. Even more so now mortgage affordability stress tests have been weakened. But my odd circumstances make it a bigger concern for me than higher interest rates.

The good news is the investment portfolio that backs the repayment of my loan is (for now) still well up since I got the mortgage in 2018. Even after this year’s declines.

Nevertheless in early 2022 I moved much more than I otherwise would into lower-volatility assets:

• I’m trying to increase the odds I will look like a good credit risk to the bank. In my situation that means keeping my net worth up for the remortgaging window in February.

• I want to reduce volatility on a big chunk of my portfolio just in case I want to pay down my loan. Perhaps because rates surge or the bank decides it now has a problem with me.

It may even turn out that moving on to the standard variable rate for a while won’t be my worst option come February.

Plan B if the computer says “no chance”

In general I’d always favour fixing, for the certainty of payments.

But my remortgaging window seems likely to open shortly before an inflection point for rates. It could be worth giving it six months (presuming this doesn’t impair my ability to actually fix again, due to my odd situation.)

What’s more, most fixed-rate mortgages come with restrictions on over-payments. There are none on my bank’s standard variable rate, however. That would enable me to reduce debt – and risk – quickly if I felt wobbly.

If push comes to shove – if I don’t want to make big repayments or I can’t secure a halfway decent fixed-rate residential mortgage – I’ll possibly even switch to a buy-to-let mortgage, turn my flat into an investment property, and spend a few years living abroad.

This might seem dramatic, even for a Plan B.

But remember I’m a single guy and I work from home.

Truthfully I should probably be taking advantage of the whole Digital Nomad opportunity anyway!

Five years a mortgage slave

Finally some psychological and emotional reflections.

One of the more unusual reasons why I got my mortgage was to see how I managed as an active investor carrying a lot of debt.

How would I feel with this potentially deadly obligation on my balance sheet? Could I cope? Would it change how I invested? Would it be worth it?

Well I’ve learned I don’t love it and it’s probably not good for my stock picking.

I was concluding this even before the recent market falls.

For instance I’m pretty sure I wouldn’t have sold Tesla (and various other dumb things I did in 2018) if I wasn’t discombobulated by my then-new mortgage.

And while in theory even a modest return that’s leveraged by an interest-only mortgage can deliver great returns with lower stock market risk, in practice I’m still drawn to riskier growth shares.

This reality also made it easier to shift a large proportion of my assets out of equities entirely and into what I dub my new ‘low volatility’ portfolio in early 2022.

As mentioned it has tamped down the overall volatility in my net worth, as well as making me confident I can make big or even total repayments in February 2023 if I need to.

I’m also happier focusing my now right-sized equity portfolio towards riskier equities with this buffer at my back.

Given this year’s declines, I lucked out with the timing. But if I still feel I need to keep a large slug of safer assets even after I have successfully remortgaged for another five years, say, then it could be a drag on my returns.

It might be a sign I am having emotional trouble scaling my risk profile via the mortgage as I age, as a couple of astute readers have already suggested.

Mathematically, too, a lower expected return portfolio might compare poorly versus simply paying off my debt. Especially given higher interest rates.

Running a mortgage at a rate of less than 2% and investing is a different proposition compared to higher interest rates at 4-6%, as we’ve seen above.

The historical return from shares is only 9-10% remember. The case for investing versus paying off your mortgage is weakened, even if it still makes theoretical sense in a spreadsheet.

My original plan was to run my big mortgage for the full 25 years to take advantage of the return spread and inflation.

But I’m starting to think I’ll probably pay it off sooner than I’d imagined. 

I’m in no rush to decide on this, especially now shares are cheaper. Falling share prices increase their expected returns, even absent any stock picking alpha I might rediscover.

However if and when markets recover I may well redirect future spare cash flows towards the mortgage.

I’m only human after all, it seems.

Time will tell. Stick around to see how the story ends!

1. That is, inflation-adjusted. [↩]