James Daley: It's time to batten down the hatches

The clearest sign that an investment bubble is in desperate danger of bursting is the moment you discover that those with a vested interest are the only ones still insisting that everything's going to be OK.

So, when a press release from Bradford & Bingley (the UK's largest buy-to-let mortgage lender) landed in my inbox this week, boasting that Britain's landlords are "upbeat" about the prospects for the residential-property sector in 2008, it finally became abundantly clear to me just how bad things are looking for the UK housing market over the next 12 months.

In fact, in spite of the happy headline on B&B's press release, the lender's statistics tell the true story very well. Apparently, 95 per cent of landlords are positive about rental yields in 2008. No wonder, because as house prices start to nosedive, the one upside for the buy-to-let landlord is that rents will represent a bigger proportion of their properties' values, hence bigger yields. Unfortunately, however, this will not necessarily make up for the massive fall in capital values.

Many landlords especially those with just one or two properties who have taken their first steps into the market over the last year are now badly exposed. Rental yields have fallen so low in many parts of the country over the past couple of years under 5 per cent in parts of the South-east that landlords have been tempted to opt for lower mortgage interest rates, but with higher fees, sometimes running into tens of thousands of pounds. This means that while their rent will cover their mortgage payments, the extra fee ends up lumped on to the rest of the mortgage, in the hope that house-price growth will eventually pay for it.

Such a model works just fine when house prices are perpetually rising. But that's no longer the case. Furthermore, the small falls in residential property values, that Halifax and Nationwide have recorded over the past few months, are just the start of it. Don't be surprised if your house is worth 20 per cent less than you think it's worth by next summer.

Unfortunately, lenders' insistence that the housing shortage in the UK will always prop up prices is simply not true. Britain was faced with a similar situation during the last housing crash 15 years ago. When bad sentiment grips a market in this case, exacerbated by the credit crisis supply-and-demand patterns shift dramatically. In the long, long run, the lenders will probably be proved right, but it is quite possible that the housing market remains depressed for several years, regardless of the long-term supply constraints.

For new buy-to-let investors, there are now certainly much more attractive opportunities elsewhere, while for those who still want to buy in the UK, it will now be that much harder to get appropriate financing in the wake of the credit crisis. The lack of new buyers could have a disproportionately bad effect on the market.

Another bubble that is about to burst is the mining sector. Reading Ian Henderson, the manager of JP Morgan's Natural Resources fund, saying that we are at the beginning of a 100-year bull market in commodities was all the proof I needed that this market, too, is in for a nasty shock over the next few years. Again, the claim by Henderson and others, that demand from Asia will continue to drive up commodity prices, is probably correct in the long term. But that does not mean sentiment cannot get the better of the market over the next few years.

Chinese inflation is currently running at 7 per cent, and there are concerns that the country's economy is now overheating. If the Chinese economy caught a cold, a global recession would almost certainly follow and commodity prices would come down with most other asset classes.

Caution is the watchword, then, in 2008. Save more, spend less and invest defensively. The economic storm will pass, but conditions are certain to get much tougher before they improve. Merry Christmas.

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