Global markets may have swung wildly over August, but we think that the recent sell-off in stocks and commodities is not a sign of imminent global recession.
Ironically, it may prompt the US Federal Reserve and the UK Monetary Policy Committee to postpone raising interest rates for a while longer. Should UK commercial real estate investors be concerned about the recent run of market volatility, or should we be celebrating the influence this is likely to have on central bank policy?
We do not believe the extreme volatility in global stock and commodity markets is a sign of a global recession. The weakness is the result of a combination of factors – concerns over weakening economic growth in China and the surprise devaluation of its currency, as well as falling commodity prices. Because China has been an engine of growth for the global economy over the past decade, markets were rattled by signs that growth has slowed more sharply than expected.
Investors also have been uneasy about the possibility that the Fed may soon raise short-term US interest rates. However, the underlying drivers of economic growth in most countries are positive. Central banks around the world have cut interest rates, and lower commodity prices – especially oil prices – can help to spur consumer demand.
We believe the Fed is less likely to raise short-term interest rates in September as a result of recent events. US economic growth has been solid and unemployment has fallen, which would argue for the Fed to begin raising short-term interest rates soon. Collapsing commodity prices and currency devaluations, however, suggest that the rate of inflation—a key metric for Fed policymakers—may fall further.
Moreover, the Fed typically takes global financial conditions into consideration, and is more likely to hold off on a rate increase as long as markets are highly volatile. We believe that Mark Carney will not adjust UK interest rates before his counterparts in the Fed do. UK commercial real estate will most certainly benefit from rates staying lower for longer.
Strategically, we believe that the recent market volatility will add support to UK commercial real estate as global institutions raise allocation targets for UK commercial real estate. Despite the recent correction in bond markets, investors are still facing negative nominal yields for government bonds. Neither real nor nominal bond yields in negative territory are able to play the traditional role for income generation. At the same time, downside risks are on the horizon for global equities, with the CAPE (cyclically adjusted price-earnings) ratio for global indices implying that stock values are particularly expensive.
The backdrop to this is that UK commercial real estate becomes a very attractive asset class for investors looking for bond substitutes: income generation with managed volatility. During the credit crisis many investors recognised the wealth preservation attributes of commercial property and were attracted particularly to central London. As this segment of the market has become more sophisticated, investors are becoming more aligned to the traditional view of real estate as an income generator.
The UK IPD All Property yield of 5.1% in July provides a significant premium to the other fixed-income asset classes, with a preferentially skewed risk-return ratio to the upside.
Concluding that we remain bullish on UK commercial real estate despite the recent market turbulence is pretty obvious. However, we are concerned that investors are systematically mispricing risk. The gap between prime and non-prime yields has fallen by roughly a third since the start of the year to 115 basis points. While the gap between prime and non-prime yields is still 60bps higher than the lows the IPD witnessed in mid-2007, the cost of capital as a result of quantitative easing has changed dramatically. This change has impacted on the pricing of secondary assets relative to prime signifying overbought territory.
The spread is infinitesimal compared to that of the 10-year gilt/prime property spread of more than 3%, and this alludes to a mispricing of risk. The investment characteristics of prime property are closer aligned to bonds than to secondary property. As a result, if prime property is even slightly overpriced then secondary property is looking very expensive. Conversely, if gilts are priced correctly, we can expect tighter yields for prime.
Michel Heller is fund manager, Gowers Investments
