In December 2012, Ben Bernanke, then chairman of the Fed, reached into the central banker’s bag of tricks and pulled out something spectacularly novel – forward guidance.
In August 2013, the Bank of England followed suit. The original policy pegged the key lending rate to a 7% unemployment rate. However, after last week’s inflation report, it is fair to say that forward guidance simply means low interest rates for the near future.
BoE policymakers will now base their interest rate calculations on how robustly wages grow, how quickly productivity recovers, the sustainability of the recovery, and how it intends to wind down its quantitative easing programme, which has seen a stimulus injection of £375bn into the economy to date.
The Bank said that no interest rate rise would happen before the 2015 election, that it would rise only as high as 1.9% by 2016, and that the rate rise would be conditional on the robustness of the recovery.
Put simply, forward guidance is the use of communication about future central bank actions to influence present behaviour. If a central bank can convince markets that it will leave interest rates low for quite a while, allowing a faster recovery in the future than it might normally tolerate, investors have an incentive to start investing more in the present, to reap future rewards.
During the course of 2013, the UK went from being one of the rich world’s growth laggards to being one of its stronger performers. This “recovery” is clearly not that significant as base rates are to remain at historically low levels of 0.5%; however, this has been a very British recovery; with the consumer and housing markets in the lead.
I still do not fully understand what the essential driver of the recovery is, nor do I know how strongly the upturn will continue, but my concern is that the UK is being forced to milk domestic demand at unsustainable levels to compensate for the policy failures – and resultant stagnation – of the eurozone. While growth from an historical perspective is extremely modest, a strong rebound in capital spending and consumer income is required for this to become a sustainable recovery. While it would be dangerous for investors to regard such low rates as a reason to shift into equities, I do not believe that the same holds true for commercial real estate.
From a purely UK commercial real estate perspective, this can only be beneficial. Lower interest rates, at a time when lending institutions are competing strongly with one another, with higher LTVs and resulting lower margins, mean that the equity holder can be euphoric and take risks that were not possible two or three years ago. Of much more fundamental importance is that lower interest rates, within a low-inflation environment, enables poor secondary and tertiary assets to be included in the yield tightening – before interest rates start to rise. This is noteworthy, as in previous recoveries the economic recovery required interest rate rises prior to the recovery of tertiary assets.
Low interest rates generally result in a weaker currency, yet sterling has continued its strong trend against other major currencies, despite last week’s report forecasting continued low interest rates. Still, this is understandable against a backdrop of weaker growth expectations for the US and European economies.
It is worth highlighting that despite yield compression during 2013, London remains good value in global currency terms. To illustrate, City of London capital values are still 40% lower than the 2007 peak for investors buying in Chinese reminbi, while the recent turmoil in the emerging market asset classes reminds us of the important and fragile role credit plays in the financial markets. With quantitative easing coming to an end and bond yields softening, emerging market investors may be encouraged into allocating more capital into commercial real estate as bonds mature.
This year has continued where 2013 left off – with strong index performance and investment transactions. Clearly, quantitative easing has not created financial or wage inflation, though it may have led to asset price inflation; in other words, bubble territory. There are plenty of positives to look at; nonetheless, I would be backing only those with the ability to both stock-pick and asset-manage successfully.
Michael Heller is fund manager at Gowers Fund Management
