UK Market Commentary: Q2 2022
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.
Marketing material for professional clients only
The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. The views and opinions contained herein are those of the author's, or the individual to whom they are attributed, and may not necessarily represent views expressed or reflected in other communications, strategies or funds.
Schroders has expressed its own views and opinions in this document and these may change. This information is not an offer, solicitation, recommendation or advice to buy or sell any financial instrument/securities or adopt any investment strategy. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy.
Past Performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall.
The forecasts included are not guaranteed; they are provided only as at the date of issue and should not be relied upon. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors.
Third party data including MSCI data is owned by the applicable third party identified in the presentation and is provided for your internal use only. Such data may not be reproduced or re-disseminated and may not be used to create any financial instruments or products or any indices. Such data is provided without any warranties of any kind. Neither the third party data owner nor any other party involved in the publication of this document can be held liable for any error. The terms of the third party’s specific disclaimers, if any, are set forth in the Important Information section at www.schroders.com.
For your security, communications may be recorded or monitored.
Issued in July 2022 by Schroder Real Estate Investment Management Limited, 1 London Wall Place, London EC2Y 5AU. Registration No 1188240 England. Authorised and regulated by the Financial Conduct Authority. UK004756