The slump in oil prices, a soaring Swiss franc, Grexit, Brexit, eurozone QE, Islamic State, Putin’s Russia, Ebola… and it’s just the beginning of February.
Yet despite economic concern rearing its ugly head, UK corporate real estate remains an attractive asset class.
The European Central Bank’s decision to extend its asset purchase programme was above market expectations owing to its open-ended nature: the bank will buy €60bn (£45bn) of assets per month until inflation returns to acceptable levels.
This is intended to stimulate the economy and credit creation by lowering interest rates and to encourage investors and banks to take more risk and finance the private sector. Good news for most asset classes, as it will keep yields down for a long time. Sovereign and corporate spreads should tighten further, while real estate is likely to rise on higher valuation and rental growth prospects.
However, QE does not address the major structural factors holding back the eurozone economy. Growth is very weak in France and Italy, businesses are reluctant to invest, labour markets remain inflexible and governments have been slow to undertake much-needed economic reforms. Until these issues are addressed, despite QE, we are likely to continue to see disappointing growth in the euro area economies.
Other concerns about the effectiveness of QE remain. The ECB has left it much longer than the UK and US to launch QE, and the experience of Japan in the 1990s and 2000s suggests that delaying policy responses allows economic and financial problems to become embedded. Also, longer-term interest rates in the eurozone are already very low, which reduces the scope for QE to influence financial markets by pushing down bond yields. There may be some benefit to European growth from a weaker euro, although this will also result in higher import prices, squeezing consumer spending.
Further, the eurozone context is very different to that of the UK and US, in ways that would suggest a smaller chance of success. Finance markets, a principal channel through which QE lowers borrowing rates, are much less important for European firms than elsewhere. Buoyancy in the housing market, a channel that has helped to improve consumer confidence in the UK, contributes less in an area where fewer people own houses. As a relatively closed economy, the eurozone will struggle to achieve meaningful results.
However, this will have direct implications for UK pension funds. By buying European sovereign debt, the ECB will increase demand for sovereign debt in the UK as investors, formerly holding European debt, look for alternative sources of yield.
This can only help to keep UK gilt yields lower for longer and may even reduce them further. Any lowering of gilt yields will increase the value placed on pension liabilities and may cause deficits to increase in the absence of corresponding asset rises. Once again, despite interest rates in the UK being at historical lows, it is possible that they will drop further, causing more problems for pension funds relying on assets other than government bonds to bridge their deficit gap.
Market participants may have become accustomed to the low level of observed, or “realised” volatility in financial asset prices in the recent past, and expect it to persist. If implied volatility is largely a backward-looking measure of variability in asset prices, however, it might not be a useful predictor of future volatility at the current point in the interest rate cycle. Behavioural finance would suggest that market participants may have under-priced the likelihood that volatility will rise. Indeed, looking at the FX market this year alone highlights how easy it is for investors to misprice forward volatility.
We are not in a conventional cycle, with the prospect of asset growth in a deflationary low-interest-rate environment. UK CRE must now be viewed as a fixed-income investment (with the added kicker of rental growth). Indeed, in 2014 gilts and UK CRE produced an annual capital growth of 13%, with property delivering a stronger income return. Fifty-year gilt rates with inflation priced in yield a negative return, indicating that financial markets are struggling to cope with the sheer volume of cheap capital being provided by central banks globally.
Over 2014 the spread between prime and secondary property compressed from more than 5% to less than 3.5% today. Ten-year gilt rates are at record lows, yielding less than 140 bps and providing a 4% spread between the All Property Index and 10-year government money. The convergence between prime and secondary will continue in 2015, but the All Property yield will be reignited, with further compression to be seen.
Michel Heller is a fund manager at Gowers Fund Management
