UK Market Commentary: Q2 2022

Hopes of a sharp slowdown in inflation over the next 12 months have evaporated.  Schroders now expects inflation to average 9% in 2022 and 6% next year.  In part this is due to a further spike in gas prices as Russia has reduced supplies to Europe in retaliation for sanctions.  However, it also reflects an acceleration in the price of services, suggesting that faster inflation is no longer confined to imported energy and food.  That is a red flag for the Bank of England which wishes to avoid a wage-price spiral and we forecast that it will raise base rate to 2.25-2.5% by mid-2023.  The combination of rising prices and interest rates means that economic growth is likely to be fairly modest over the next 18 months and there is a risk of a recession, if the squeeze on real household incomes intensifies.

The prospect of weak economic growth and higher interest rates has led to a sharp fall in both equity and bond prices.  The yield on 10 year UK government bonds and the cost of long-term debt have increased by 1.25% since the start of 2022.  As a result, the total cost of debt including banks’ margins now exceeds prime office and industrial yields and the gap between 10 year gilt yields and the all property initial yield (4.0%) has shrunk to around 1.75%.  That is the narrowest since 2008 and compares with an average of 1.9% over the last 30 years.  Although the yield gap between bonds and real estate is not fixed and flexes according to rental growth prospects, the fact that the gap has shrunk at the same time as the outlook for the economy has deteriorated means that real estate yields are now likely to rise across the board.

Given the jump in finance costs and the increased risk of recession, we expect that many investors will now step back from the real estate market and wait for it to re-price.  At this early stage it is It is difficult to know how far and how fast the adjustment will take, but our working assumption is that capital values will fall by 10% on average between now and end-2023.  To put that in context, the peak to trough falls in capital values during the early 1990s recession and the GFC were 27% and 44%, respectively (source MSCI UK Monthly index).  We think the fall in capital values will be smaller over the next 18 months, because there is less speculative development and because investors generally  have lower levels of debt, so there is less risk of distressed sales depressing prices.

Which assets will be most defensive?  While it is possible that yields rise by the same amount across the market, hitting prime assets harder, we think that investors will probably become more, not less discerning given the uncertain economic environment and that the spreads between prime and secondary yields will widen.  That was the pattern in the early 1990s and again during the GFC.

We think the assets which are likely to be most defensive over the next 18 months are those with decent demand and supply fundamentals and good prospects for rental and income growth over the long-term.  They include bulky goods retail parks, offices with strong energy efficiency and well-being features and multi-let industrial estates.  We think that certain niche sectors benefitting from long-term structural changes will also be relatively defensive including life sciences, self storage, social supported housing and student halls.

Conversely, we think that the sectors and assets which are most exposed to rising interest rates are those with relatively fixed, or insecure income streams.  They include secondary shops and shopping centres, dedicated conference hotels, offices in secondary locations and in general, any building with poor energy efficiency.  The jump in construction costs and tightening in bank loan terms is also likely to depress prices for land and re-development projects.   We are also cautious on distribution warehouses given the high level of new building over the last three years and their high exposure to retail.  In the short-term consumers are likely to cut back on-line, as well as in-store.

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