Quarterly Investor Report
Economy & Strategy
Keills Property Trust | 30 June 2014
Booming stock markets. Falling bond yields. Rising house prices. Negative interest rates in Europe. A possible interest rate rise in the UK and USA. Business confidence at the highest level for 22 years. In this topsy-turvy world where to begin?
Last year at this time, Ben Bernanke (then chief at the Fed) introduced the concept of ‘tapering’. What he meant was gradually reducing the amount of Quantitative Easing being applied in the US. Markets immediately took fright before recovering as it became clear that the QE medicine would be administered for a while yet. It is useful to pause and ask what this means.
Why are markets at record highs? Are companies making record earnings and distributing those earnings to investors? In truth earnings have risen but so have borrowings. In fact, some US companies are borrowing against overseas earnings (held as cash overseas because repatriating this would mean a big US tax bill) and then handing out pay-outs to investors. Others are using overseas cash to try and buy overseas earnings and at the same time, better their tax domicile. The point is there is a surplus of cheap money.
The continuation of QE is an indicator that economies are still not able to stand on their own two feet. The idea was that by forcing long bond yields down and keeping short rates low, investors would have to climb the risk curve. This has happened: there has been a large, one off increase in asset prices but where now? The consumer remains heavily indebted and is vulnerable to an increase in interest rates, particularly those consumers with mortgages.
In the USA and UK, economic output is now just above pre-recession levels. In both countries, employment growth has gained traction and flexible working practices have taken many people out of unemployment. Forward guidance by both the US Fed and the Bank of England, originally targeted the unemployment rates but this measure has since been watered down. Nevertheless, forward guidance continues with much back tracking later as markets over react. The difficulty in moving away from Alice in Wonderland policies is becoming very clear to policymakers globally.
The situation in continental Europe is quite different. A strong export led German economy continues but it is becoming increasingly clear that other community members are suffering and deflation may be the enemy. With interest rates now negative in Europe, policymakers are running out of effective tools to stimulate economic growth. We wonder when we will see helicopters dumping cash on an over indebted populace? Not while Germany has any say in the matter.
Meanwhile it is reported that the level of corporate debt in China has overtaken that of the US for the first time. Whilst China was undoubtedly late to the party, it hasn’t lost time in catching up and debt levels, at the corporate level, are now forecast to exceed $18 trillion by 2018. A good proportion of this relates to property debt and so the threat of some form of correction, which would impact the global economy remain, looms.
The pound in your pocket
Let us return to the original ‘where now’ question above. We find ourselves in a global economy which is being artificially kept alive by Central Bank policies of extreme largesse. When CB’s decide to stop QE, or indeed to start raising interest rates, we are very concerned about the likely impact. The question is should we be concerned? Domestically, household debt outside London remains high but may be ‘containable’. Taking an average house price, with average debt, a typical monthly mortgage payment is £666pcm, assuming mortgage interest rates of 3.5%. If we assume that interest rates rise by 1% over a year, then these mortgage payments would ‘jump’ to £728pcm, an increase of £62pcm or 9.3%. Wage increases are now roughly in line with inflation (June 1.5%) with average wages being equivalent to £24,856, increasing to £25,229 after an inflation adjustment. Essentially, a 1% increase in interest rates together with wage inflation at 1.5% means that the average mortgage holder will be £373 worse off. Mark Carney has stated that the new normal for interest rates should be 2.5%, roughly half the level familiar to most investors of the last 30 years or so. This would of course be equivalent to a 2% interest rate increase.
For stretched households the picture is bleaker. If mortgage payments account for say 40% of take home pay (not unusual in London for example) a 1% increase in interest rates together with a wage increase as above would take mortgage payments to 45% of take home pay and 50% if there is no wage increase. The prospects for discretionary spending is not good.
Investing for income
This low yield environment has meaningful implications for anyone looking for an income return. We expect property yields for long income assets to continue to fall, creating a one off increase in value which for, property, is not yet complete, but we are probably there for equities and bonds. By and large, if you are not already invested in such long income assets you may well have missed the boat. This doesn’t mean that owning them will disappoint, rather that the opportunity for an upwards pricing correction will be less, so buying for the long term still makes sense, particularly when the income received is contracted to increase, happily in line with our strategy.
Ugly or beautiful deleveraging
When the time comes to pass that Central Bankers stop QE completely there are essentially, two possible outcomes: inflation or deflation. Both offer ugly consequences. Policymakers will be keen to try to follow a deleveraging glide path that permits economic (and productivity) growth, whilst simultaneously tackling the serious government indebtedness, without stopping the economy in its tracks. There are a lot of ifs and buts here. Nevertheless, the outcome, “beautiful deleveraging”, is the Holy Grail. What is clear, is that the timescale for achieving the result is way beyond the typical economic cycle of 5 to 8 years and that economic growth could be lower while burdened by the debt albatross.
UK Property Market
Rental growth remains anaemic with the exception of London and Aberdeen, although there is evidence to show that in the South East, low vacancy rates and continued tenant demand are causing rental growth to slowly spread out from Central London.
The office sector is leading the way (the jobs recovery has been strongest here) with industrial following and retail some way behind. Even now, some 6 years after the Global Financial Crisis, there are retailers continuing to struggle, with Jane Norman and La Senza falling into administration recently. Clearly the move online, and weak retail sales are still dominant factors and we remain bearish of the retail sector.
Expect a long summer
The institutional property market in the UK is characterised by mini cycles. At the calendar year end there is always a push to get deals over the line for various reasons eg tax, crystallising profit, performance etc. A few years ago the performance measurer, Investment Property Databank, introduced quarterly performance reporting for many funds and this was meant to remove the year end rush. To our knowledge it hasn’t. Another ritual is the summer recess. It used to last for July and August. Now it feels that transactional activity dips after Easter and only recovers in late September. This year the World Cup and Wimbledon have added to the festivities and later we will see the Tour de France, the Commonwealth Games and the Ryder Cup. Put your feet up, pour a Pimms and enjoy.
Our sister company Magarch has recently varied its permission from the FCA, widening its scope of business. Magarch is able to arrange investments and approve financial promotions for professional and retail clients. A recent financial promotion, overseen by Magarch, is set to be repeated and we anticipate that this will be the first of many such appointments.
Magarch has also been busy winding up several collective investment schemes and is one of the few companies in the UK which is regulated to do this and has actually done it for a number of funds. Magarch has welcomed approaches from other managers and trustees, seeking assistance in winding up their funds.