COMMENT The bold monetary and fiscal response to coronavirus is likely to be written into the history books. Between the start of the Covid-19 crisis in February and the end of September, the European Central Bank’s balance sheet expanded by more than €1.7tn to €6.5tn (£5.9tn) while the Federal Reserve’s ballooned by $2.9tn to $7.1tn (£5.5tn). In addition, fiscal stimulus programmes in the US and Europe already exceed $4tn with more in the pipeline.
This combination of fiscal and monetary response has led to a material increase in money supply (M2) since February, rising by 10% in Europe and 20% in the US. Because of the historical, positive correlation between “printing money” and inflation, these figures are important to monitor.
In fact, the last time there was a supply spike of this magnitude was during the 1970s – a period of double-digit inflation rates. While governments today have more tools to keep inflation at bay, this increase in the velocity of money should heighten awareness that inflation may be in our not-too-distant future.
Good versus bad growth
Looking at the post-Covid era, the difference in the outlook for inflation may lie in the combination of central bank balance sheet expansion, the extraordinary level of fiscal stimulus, and the Fed’s stated willingness to accommodate greater inflation.
Moreover, a softening dollar, global supply chain disruptions and the impact of a Fed pivot to let the inflation rate target run higher could put upward pressure on consumer prices, particularly for imported goods and services. As long as the economy remains debilitated, inflation concerns are likely to stay subdued, though – an issue that investors should keep a close eye on.
In inflationary environments, real returns for risk assets suffer, which is why assets such as gold and Treasury inflation-protected securities become attractive. Investors may also hedge against inflation, however, by adding selective commercial property types to their portfolios. To understand how real estate can help, consider the two likely future scenarios of “good” and “bad” growth.
In a “good” growth scenario, economic activity returns to historical norms with a growth rate between 1.5% and 1.8%, resulting in modest but sustained inflationary pressures. Other features of such a scenario would be a weaker, but stable, US dollar and gradual strengthening of the euro and pound sterling, ongoing and relatively orderly unwinding of Britain from the European Union, and stabilisation of commodity and energy prices.
Under a “bad” growth scenario, unemployment levels would remain elevated and the output gap would persist, the dollar would continue softening, supply chain disruptions would exacerbate shortages and discretionary consumption would be narrowly spread over a smaller segment of the population.
While we don’t know which of these scenarios will emerge, our 30-plus years of data for the US and UK shows the correlation between inflation and commercial real estate assets is quite robust relative to bonds or equities. In particular, residential and office assets have the highest positive correlations, primarily due to the short-term nature of leases in the former and strong earnings growth of white-collar employers in a service economy in the latter.
Hedging bets
All else being equal, the “good” growth environment should be one of improving vacancy and increasing occupancy, with occupier fundamentals starting to improve during the second half of 2021. In this scenario, industrial properties with tenants benefiting from economic tailwinds would likely be able to capture rents in excess of inflation. We would expect earnings to increase and positively impact valuations in lodging, multi-family and offices, with exposure to industries with lower elasticity of demand to match and perhaps exceed inflation.
In a “bad” growth environment, slack demand would likely pressure rents downwards and we would favour property types offering income-protection capabilities. In this scenario, we would expect certain multi-family (excluding luxury) and “essential” retail properties to keep in step with inflation and add value to portfolios.
What this means for inflation – and whether anticipated outcomes will align with historical norms – is unclear. But as governments and economies adjust to the prospect of a more relaxed approach to inflation, opportunities in real estate should be a critical topic in any discussion about inflation.
Indraneel Karlekar is global head of research and strategy at Principal Real Estate Investors
