Inflation: what follows ultra-low interest rates?

COMMENT: Conventional economics looks at inflation as either a monetary phenomenon linked to theories about money supply or unemployment rates a la “the Phillips curve”, writes Paul Stewart, director, real estate research & strategy – Europe at Barings. Post-global financial crisis quantitative easing (QE) by the Bank of England has swelled its balance sheets and boosted broad money supply (M4). Meanwhile in the real economy, UK unemployment has fallen steadily from a peak of more than 8% in 2011, to its lowest level since 1975, at 4.3%. Add to the mix a post-Brexit sterling depreciation, which is still steadily filtering through to UK import prices, and it is understandable that some investors are nervous that rampant inflation could be lurking around the corner. Asset price implications The implication for all asset prices, not just real estate values, should be fairly self-evident. If the inflationary climate is about to ratchet upwards, then so too will risk-free rates, which is the theoretical yardstick by which all assets are judged. The cost of property debt financing will also rise, more directly affecting those looking at things from a more practical property perspective. Either way, higher inflation will push up minimum acceptable nominal hurdle returns and consequentially property yields and capitalisation rates will need to rise, thus resulting in falling prices. However, this view completely ignores some fundamental facts: First, falling unemployment and a grossly expanded monetary base have characterised the UK economy throughout the post-crash recovery, yet UK CPI has averaged just 2.2% pa over this period. So much for economic theory. Perhaps the answer to this conundrum resides with a much more prosaic realisation that QE wasn’t ever “helicopter money” and that despite near full employment in the UK, wage growth and thus demand-pull inflationary pressures remain very weak. Some now link this to the combination of globalisation (offshoring and immigration), reduced unionisation of the UK workforce (zero-hour contracts etc) and demographics (an older UK workforce are less likely to shift jobs and/or make aggressive wage demands). While Brexit may now alter the UK’s demographic profile by way of a reduction in immigration, these are longer-term drivers and it is difficult to imagine a sudden volte-face, given labour shortages particularly in many UK public services. Second, while property’s higher yields remain a key attraction, it is ultimately not a fixed-income investment. Rental growth prospects are just as important to investors, making them a vital determinant of property market price expectations. Inflation protection While rents might not be a hedge in the very purest academic sense, there is no doubt property is a real asset capable of offering inflation protection over the longer term, if not the 1-2-1 correlation that a technical hedge implies. This opens up an entire debate about rental growth prospects for the UK CRE sector. On the one hand, Brexit uncertainty might mean a sluggish economy and therefore slower momentum in our occupier markets, yet on the other, structural tailwinds such as technology and demographics are building. One such example is the IPD UK All-Industrial rents which are growing by more than 4% pa, powered by e-commerce, at a time when the UK GDP growth rate has effectively halved following last June’s EU referendum. Come and hear Paul Stewart and a panel of other influential speakers discussing this topic on Thursday, 19 October at MIPIM UK Click here to find about more about MIPIM UK and UK Cities