2017 will go down as one of the least anticipated years for investors globally. Despite the heady levels markets reached at the end of 2016, there was much more to come with many markets delivering returns in excess of 20%. In fact, the UK was a laggard, with a highly respected return of circa 10%.
Bond yields, which remained at historic lows, were expected to nudge upwards as globally, Central Banks increased interest rates. The reality was that interest rates did creep up, but bond yields stayed relatively stable as investors continued to worry about somewhere safe to park funds. Meanwhile, pension funds continued to de-risk their portfolios by buying so called “risk free” assets.
Profligate borrowing continued, although Governments began to show signs of moderation with the consumer picking up the slack, aided by strong employment levels. In Germany, the historic ‘debt clock’ measuring overall Government indebtedness actually started ticking backwards for the first time in its history. The talk was all about reducing the QE experiment and entering a tighter monetary cycle.
Our website has, since its first publication, presented a link to the UK debt clock.
The US economy grew under the first year of the Trump administration, probably more to do with the state of play Trump had inherited rather than any particular policy. However, this changed at the year end when radical tax cuts were passed by both the Senate and House of Representatives. This policy should have the effect of injecting $1 trillion into the economy as QE is reversed and interest rates rise.
China too has tried to slow down growth by limiting loan availability.
What to expect of 2018?
Expect more of the same. The big picture has not changed at all, with debt levels remaining at high levels, pensions costing too much and healthcare costs escalating. Our 3 elephants remain as large as life. Our comment that pensions are costing too much, is simply an observation that investment consultants have supposedly de-risked pension portfolios through bonds, while bidding up the price of risk free assets (bonds) in the process. If bonds were eliminated from pension asset allocation, significant income increases could be generated from real economy assets such as equities and real estate. Another way of saying this is that a much smaller amount of capital may be necessary in equities and real estate to generate equivalent bond income, hence our comment that pensions are expensive. The argument against this is risk. However, we contend that only by taking on risk will there be any chance of meeting the pension promises made.
As investors grasp this argument, we expect that equities will have further to run and probably real estate too. Many investors are looking for income and for those investors there is little choice. Either buy bonds, which are unlikely to satisfy their income yield requirements, or take on risk and buy real assets like equities or real estate and its many derivations.
Effect on markets if bond yields rise
Investors use the 10 year bond yield benchmark as a useful proxy for a risk free rate of return for diversification purposes and to gauge expected returns from competing assets. Right now and in fact over the last few years, this has resulted in asset price inflation. A modest increase in bond yields will cause the price of bonds to fall, meaning that the total return from bonds could be very low, or even negative.
As bond yields rise, equities become relatively expensive. At the same time, pension fund deficits should fall, releasing cash to companies to be used for R&D or increased distributions to investors. There remains the question of who benefits from this of course; shareholders, management or employees. On past form, management would have argued for a decent slice of this, but we wonder whether the tide is changing?
Brexit remains the biggest risk to the UK economy, but there is really nothing more to say until we have some facts to digest. The existing timetable would point to a broader understanding being available by autumn 2018, enabling member states to vote on the proposals. There is however, much work still to be done and several consequences which will only become apparent when the final deal is understood.
We know that bond yields are at historic lows and that the interest rate cycle has turned upwards. Globally, we have synchronised growth as evidenced by multi decade lows in unemployment levels. US equities are expensive on some measures, but here in the UK markets appear to offer better value, perhaps given the Brexit uncertainties. We also know that global debt levels are increasing, but there is some sign of control being regained.
- Result of North Korea tensions. Hopefully things will have chilled by the time of this year’s winter Olympics.
- The Brexit outcome
- Where will bond yields be in 3 years’ time?
Watch this space………
A canter round the UK property market
At Keills, we sit down at the start of every week and discuss the economy and current prospects. We keep it fairly big picture but a few consistent messages have been re-appearing recently.
Retail property has yet to adapt to the internet and we fully expect more fallout from the ‘bricks’ retailers in 2018. Convenience and leisure may be an exception but it is too early to say. Certainly, the population group least affected would again appear to be the baby boomers who, largely unaffected, are riding into their retirement with their index linked pensions and iPads at the ready.
Related to retail is the new super-sized warehouse being used to fulfil on-line purchasing. The lot size of individual properties can often be in excess of £100 million, resulting in these assets having high specific risk in our view. It is also the case that only the largest funds can buy these large assets. Smaller ‘utility’ warehouses remain in demand.
At present we believe that offices are currently the most difficult asset for us to determine our view. On the one hand, Brexit may be hindering demand and decision making. On the other, if the Brexit outcome is positive, there may be a very strong and positive boost (particularly in London) as firms scramble to find space. Who knows?
Given all the uncertainties and the topsy-turvy, Alice in Wonderland economics that we face, the focus of Keills Property Trust on property with relatively long income from good quality tenants and with indexed or fixed uplift rents, would appear to be as valid as ever.