COSTAR GUEST COLUMN: L&G compares 1994 with 2011
By Robin Martin - Tuesday, July 12, 2011 6:00
In his first contribution to a regular column for CoStar News, Legal & General head of performance analysis and research Robin Martin asks whether the UK market is taking too much comfort from low interest rates, particularly given the lessons of 1994.
On 22nd February 1994, Alan Greenspan, then the chairman of the US Federal Reserve, told Congress that the Fed was ready to take action to keep inflation under control. Over the course of that year, the Fed nearly doubled short-term interest rates to prevent the economy from overheating.
This sent bond yields around the world sharply higher.
In the UK, 10-year gilt yields rose from 6.1% to 8.7% over the course of 1994. This was enough to choke off a recovery in property values from their post-crash levels, despite the fact that rents, as they have today, had largely stabilised.
What is the chance that we will see a repeat in the next one to two years?
Focusing on bond yields, the economists at Legal & General Investment Management (LGIM) have a high conviction view that US bond yields are headed higher in the medium-term. While the UK is making a more serious attempt to tackle its budget deficit, there will still be a large supply of gilts which should require higher yields to entice buyers.
Acting against that is the fact that continuing instability in global financial markets is pushing investors into safe-havens – 10-year gilt yields are currently back around 3.2-3.3%, exceptionally low on almost any measure.
The team would happily admit that whatever the fundamentals driving higher bond yields, calling the timing is more likely to be a case of good luck rather than good judgement. To mangle Keynes, the market can stay irrational longer than you expect.
But even if we reassure ourselves that higher bond yields may be some way off, the flipside is the fragile state of the economy. UK GDP has moved sideways over the past two quarters. Deleveraging and austerity are weighing on consumers and the government and there is little sign yet that businesses have the confidence to invest.
Most business surveys have stabilised or turned down over the past several months. In a ‘normal’ recovery, we would expect rapid growth at this point, as resources which fell out of use in the recession are put back to work. Instead, the annualised growth rate since the economy bottomed out in Q3 2009 has been just 1.6% per annum.
That compares to an average of 2.5% per annum in the decade leading up to 2007. Our economists see little let up in the short term - they are forecasting growth to average 1.4% per annum in 2011 and 2012. These are sobering statistics for an asset class that depends on growth to deliver the equity /bond hybrid that investors look for.
It is easy to overstate the bear case. Most of the value anchors for property are in ‘fair value’ territory and the bank deleveraging process has not flooded the market with stock. Overseas capital continues to seek a home in UK real estate and domestic investors are largely maintaining or modestly increasing their allocations. But there does seem to be at least the potential for a scare – and unlike the mid-90s, a reversal in the short term is more likely to centre on growth than interest rates. What might such a scenario look like?
- A reversal of the (albeit limited) recovery in risk appetite. Renewed preference for long, secure income streams. Minimal value placed on void / development potential.
- Talk of opportunities in good, or even poor, secondary markets would likely fall away once more, given the weaker prospects for occupier demand and rents in those assets
- A growth scare would usually be bad for Central London. At the risk of uttering the fateful words “this time it’s different”, we do see different drivers this time which should allow Central London to fare reasonably well, given the bias to global growth and investment.
Bottom line
With income returns running at respectable levels, investors may well look through the poor growth story in the short term and sit on yield in anticipation of rental recovery further down the line.
But with inflation running at high levels, there must be at least a risk that investors lose patience, a process that would punish certain parts of the market more than others.
In the more volatile environment that seems to have become the new normal, avoiding these trouble spots will limit downside risk in portfolios and could end up being a source of significant outperformance.