Inflation: The only way is up?
While we agree with the consensus view that inflation is set to peak in the first half of 2022, then recede in the second, we also believe the medium-term inflationary landscape has shifted. Our opinion is that the pre-pandemic situation of inflation typically between 1% and 2% will be replaced by a new norm of 2% to 3%. The property world is set to adapt accordingly, probably causing a search for higher returns. Nevertheless, this is not a big upwards shift in inflation, and we expect the property market to evolve successfully in 2022.
Revamping real estate
Inflation increased significantly in 2021 as the economy struggled to keep pace with the rebound in demand as pandemic restrictions were lifted. While central banks drew flak for describing the increase as ‘transitory’, that continues to be the general suggestion from most respected commentators’ forecasts. Oxford Economics are forecasting inflation to peak at 4.6% in Q2 2022, then fall to 2.1% in Q4, returning almost to target. The Bank of England are predicting 5% inflation in Spring 2022, which then falls back to 2% in late 2023.
The factors that drove inflation in 2021 – commodity prices, port congestion, and supply bottlenecks – are expected to ease gradually over the course of 2022, causing inflation to peak then moderate. The chart below shows that the effect of petrol and energy price increases ‘dropping out’ of the inflation figures at the one year mark will exert huge downwards pressure during late 2022 and 2023.
CONTRIBUTIONS TO CPI INFLATION
There are also some price increases that are in effect distortions created by supply chain shortages, which are unlikely to become ‘baked in’ and could quickly go into reverse. The obvious example being the sharp increase in prices for second-hand vehicles.
The fall in inflation will in part be facilitated by policy response, such as rising rates – we see the base rate finishing 2022 at 0.5% – and the end of Quantitative Easing in December 2021. However, we see the increase in rates as being partly one of message, signalling to markets that we are past the need for emergency measures and now on a gradual path towards normalisation of policy.
‘Part two’ inflation
However, a risk to the outlook is the possibility of ‘part two’ inflation, driven by wage growth which is arriving ahead of productivity gains. Although real wages growth did moderate between July and October, there is the risk that growing labour shortages might worsen next year as the economy pulls clear of the brake effect of Covid, leading to demand pull inflation. Other factors that could feed into this risk are the hike in the National Living Wage and the 7.7% increase in consumer spending predicted next year by Oxford Economics.
In this scenario, we believe there could be pressure from Downing Street on Threadneedle Street not to aggressively hike rates in response, as this will increase the cost of servicing the national debt. The government’s debt interest repayments are already forecast to jump by 36% in 2022 to a record high of £51.9 billion, and a rising base rate could lead to spending cuts and austerity. An inflationary environment will push up debt repayments on index-linked government bonds – about a quarter of the national debt – but would also erode the real value of the overall debt and the coupons on standard Gilts.
UK GOVERNMENT DEBT INTEREST PAYMENTS
Consequently, we see a scenario ahead where typical inflation levels shift from between 1% and 2% in pre-Covid years, to around 2% to 3% over the medium-term. This amounts to inflation that is higher than we are used to but not ‘high’ if we look at the last 50 years. However, this would occur to the backdrop of an interest rate that does not reach 1% until perhaps 2024.
After all, there are other factors that we see playing out in the coming years that could weigh on inflation without Bank of England intervention. For instance, a drive towards more workplace automation, driven by current labour shortages, would improve productivity. Also, the emergence of a ‘new China’, whether it be India, Indonesia or Vietnam (or all three) might rein back global inflation.
Implications for property
While UK property returns are not strongly correlated with inflation, there is a widespread perception that as a real asset, property is a good investment during inflationary periods. This suggests that evidence we are moving into an inflationary time might push more money in the direction of real estate, with a knock-on effect for capital values. Moreover, higher inflation erodes the debt burden in real terms, and an indexed rent would provide some inflation hedging (albeit only as high as the cap).
Also, if the current inflation is symptomatic of a recovering and expanding economy – which we expect - and not the stagflation of the 1970s, then a generally rising tide of business activity should buoy occupier demand. This ultimately could lead to rental growth and raise income returns. We see these potential upwards pressures on capital growth and income returns as being marginal compared to the future market dynamics of supply and demand for the various property sectors. Nevertheless, this could add some additional upside to property as we move into the new market cycle.
Flight to safety
Another implication for property is that inflation tends to create uncertainty on the business outlook. Also, the prospect of rising interest rates is adding to the likelihood that 2022 will see repossessions of assets and forced sales of properties.
Consequently, rising inflation might further encourage a flight to safety on the part of investors. The shopping centres market may find itself dogged by concerns over distressed sales, while conversely logistics property continues to gain from confidence that the rise of ecommerce will guarantee high occupier demand. Whether this is a positive or negative scenario will depend on what the investor is seeking to buy or sell.
Higher inflation will also shape the potential returns investors can expect, as well as the dynamics of pricing. A higher interest rate environment will erode the risk premium offered by property yields over government bonds. It will also increase the cost of new debt and push up the cost of development. As a result, investors are likely to seek higher returns, and pursue properties that have asset management potential, to lift the yield in a ‘good’ way. We may also see more landlords seeking indexed rents with an eye to the investment market.
Good or Bad?
An inflationary environment is not necessarily a good or bad thing for property, it is something that needs to be priced into the business plan for an investment or development decision. The current burst of inflation is looking at an advanced stage, and close to its peak. While we believe the typical band for inflation has taken a 100 bps step up into a new 2.0% to 3.0% environment; we also expect the vast majority of the real estate sector to successfully adapt to the new normal.