Quarterly Investor Report
Economy & Strategy
Keills Property Trust | 30 June 2015
Why does inflation matter?
Over the last quarter we have seen inflation (the increase in the price level of goods and services) drop to an historic low of -0.1% in May, followed by a ‘rebound’ to +0.1% in June. In truth, prices are fairly stable in the context of the last 30 years, certainly the most stable in our careers as investment managers. There is however an ongoing debate as to whether inflation will return in earnest or if it will remain at low or even deflationary levels.
The relationship between debt and inflation
Typically, where a lender sets a fixed rate of interest, that lender expects to receive a series of interest payments together with a bullet capital repayment or, alternatively, a series of interest and capital instalments, paid back over the term of the loan. In an era of high inflation, where the interest rate is fixed, the capital repaid at the end of the term is, in real terms, often perceived to be a smaller sum. Many home owners in the UK experience this effect when they take out a mortgage to buy a house. When the loan is initially agreed, it often amounts to at least 80% of the value of the property. 25 years later, when the mortgage matures, the loan repaid in nominal terms is the same but proportionally, in terms of the increased value of the house, can be much lower. Property owners as a result feel wealthy.
Deflation has the opposite effect. The loan is again fixed as are interest payments. With deflation, the asset price could actually fall over the period and so the loan could represent a larger proportion of the end value than it was when the loan was originally advanced. Lenders (and regulators) wary of this situation, are insisting that borrowers enter into traditional capital and interest loans, rather than interest only payments. Property owners in this situation feel burdened.
What about Government?
Most of Government debt is fixed in terms of interest rates and term. Any inflation therefore enables Government to pay back less in real terms than they borrowed, reducing the real cost of the debt to the Government. The Government also issue index –linked debt where the interest payment and principal, increase in line with inflation. Buyers of this (inflation linked) debt can lock into a fixed, real return over the term of the loan and this can be attractive to some investors. Since the Great Financial Crisis, investors and the regulator have generally been more risk averse, preferring low certain returns over higher, more uncertain returns. The weight of money following this policy is huge and has effectively driven down yields for ‘risk free’ assets. At the same time, many Governments have introduced Quantitative Easing into their policy mix which, at its simplest, is designed to drive down risk free yields so that comparable risky investments become attractive.
Right now, the big debate in investment markets is when Governments will stop this QE programme. In the UK there has been no new QE for well over a year (at a level of £175 billion) so we are really talking about QE in the US and Europe. Curtailing QE is expected to allow bond yields to rise to their ‘natural’ level, whatever that is. If the rise in bond yields slows down business investment, then the economy may stall.
The conclusion on the inflation debate is simply that no one really knows. We believe that a prolonged period of lower growth and lower inflation is probable.
Governments have often tried controlling the inflation beast (and in the early 1980’s that’s how it was portrayed) by using short term interest rates. Nowadays, many Governments have handed notional control over interest rates to their respective Central Bank.
Central Banks are considering raising interest rates from their current, historically low levels. With the amount of debt worldwide still in fact rising, there is a real risk that a rate hike will also cause economies to splutter. There are even questions over whether the US can afford to pay interest if rates increase. While the dollar remains the world’s reserve currency and we continue to live in Alice in Wonderland economics, such issues remain simply academic. We certainly think interest rates will remain low for longer than many expect.
Greece and Europe
Greece’s debacle with Europe would appear to be the summer’s news. This situation has far more to do with politics than economics and we watch as an interested observer. By the time we go to press a decision on Greece’s position may have been reached, but it would be brave to bet on whether Greece will remain in the Euro or not, but a change in its Government could follow. The likelihood of Europe acquiescing to Greek demands are improbable (not impossible), but there may be a way to kick the outstanding debt into the long grass, enabling both sides to save face. At the same time, the UK Prime minister, fresh from winning a surprise outright majority at the General Election, continues his whirlwind tour of Europe in a bid to win supporters to change the UK’s relationship constitution. All bets are off as to how this will pan out. What is clear, is that the Greek claim of ‘we’re all in it together’ is unhelpful at this time.
UK economy and investment markets
The essence of the recent Queen’s speech was ‘same old same old’. Expect more of the same with little radical change. The big picture remains one of steady rebalancing of the books and fiscal prudence, quite what happens when there is a real emergency when the country has this level of debt (government debt now in excess of £1.5 trillion) is anyone’s guess. Meanwhile, interest rates remain at a 400 year low level. Unemployment continues to fall with a record number of people working and as social security provision is examined further (a consequence of having to find some £12 billion of savings) we would expect the disincentives to work, to reduce further. We hope the vulnerable will be protected.
As regular readers will be aware, our investment strategy is based on the thesis that high debt levels, a forthcoming pensions crisis and ever escalating healthcare costs mean that over the next 40 years, returns will be much less than over the previous 40. Certainly, bond markets support this position. The return expected from so called ‘low risk’ assets is especially low and since bonds are used by pension funds to underwrite the known liabilities of pension funds, there has been continued demand for bonds as the population ages. The logic of this de-risking approach is clear enough but unfortunately, has not been married to a more market based approach. Why would you own bonds when doing so gives you exposure to arguably the most expensive asset class? You have matched liabilities at today’s prices, but when bond prices start to fall will this continue to be the case? No one really knows. What we do know, is that a significant bond exposure is unlikely to insulate a pension fund from future increases in liabilities, where the increase is derived from greater life longevity or unexpected inflation.
Interestingly, some of these issues have been recently aired by the OECD in their inaugural OECD Business and Finance Outlook which says “the main concern is that pension funds and life insurance companies might become involved in the “search for yield” in order to match the levels of returns promised to policyholders and beneficiaries when interest rate were higher.” We think one of the current issues is that pension funds may try to plug the gap now, just when it is most expensive to do so, leading to expensive remedies and moreover, exposure to bonds tumbling in value when yields begin to rise. Fundamentally, a problem is that many pension funds benchmark themselves (in a liability context) against bonds in some form or another. It is true, that an increase in bond yields will cause assets to fall in value. It is also true, that liabilities will fall. We simply suspect that assets will fall faster than liabilities meaning that another pension crisis develops.
In the scenario outlined above it will be of little surprise that investors are continuing to hunt yield and are finding opportunities in UK property.
Despite the dramatic change in bond yields, UK property still yields more than it did before the Great Financial Crisis and in yield terms alone, we feel it is fairly priced.
Long term investment performance comes from collecting rents. The chart below shows rental growth over the short term, which has generally been increasing. Our view is that rents will grow from time to time and right now we are in a growth phase. We do not expect this to be sustained. We also note that the absolute level of rental growth is low.
The biggest rental increase has been seen in the office sector which is dominated by the West End and City of London sub-markets. The All Property rental growth figure equates to 3.7% over the last year, pulled up significantly by the office figure of 7.8%. Retail remains the weakest sector with annual growth at 0.6%. Inflation over the last year was nil.
Both charts have been taken from the June IPD Monthly Index.
From time to time, firms of surveyors produce useful comments on the market. Two reports which caught our eye were the Savills Residential Property Focus and the DTZ’s Money Into Property. We use both firms for property management and valuation purposes.
The Savills report is interesting because with the search for yield, institutions are increasingly looking to invest in residential property. Keills, as the Trust Manager, is very aware of this and over 25 years ago, working for a large life company, the Keills team pioneered institutional investment with various Housing Associations (HA). The introduction of institutional equity into HA permitted more houses to be built and gave the institution a long, index linked income stream. Keills continues its involvement with HA through a pro bono board appointment and believes that HA will have a significant role in institutional investment in the sector. HA are highly regulated and collect rents very efficiently. Watch this space.
DTZ’s Money Into Property has been running for over 40 years and it is usually worth a read. This publication covers capital markets in 40 markets globally. DTZ estimate that global invested stock reached USD 13.6tn in 2014, 5% up on the previous year. Banks are still relatively cautious about lending and as a result, equity is replacing debt in the capital stack. The continued low interest rate environment is making income producing assets, like property, attractive to funds, but there is some concern about what will happen when rates begin to rise.