Cost of living crisis
The cost of living – struggling with high inflation
In 2022, inflation dominated global economic news, and prompted a cycle of interest rate increases that hit growth and caused financial market volatility. This has had major repercussions for the property sector. We are forecasting 2023 to be another year in which there is pressure on households’ finances, as high interest rates continue to dampen consumer spending power. Inflation is expected to ebb in 2023, but only gradually and to levels that are still high by historic standards. However, 2024 could mark a turning point for households, potentially leading to opportunities in consumer-facing real estate.
In most major economies, including the UK, inflation consistently came in ahead of expectations in 2022, and wrong-footed policymakers. In January 2022, the consensus forecast for UK CPI inflation for the year was 4.6%, yet by October it had hit 11.1%. Real terms pay growth went from 0.2% in January 2022 to -2.6% in September 2022. In nominal terms, workers were receiving average pay rises of 6.0%, but inflation was eroding the spending power of pay packets. As well as seeing their incomes shrink in real-terms, households were hit by high energy costs, rising food prices and increasing interest rates.
Central banks normally ‘look through’ surges in energy and food prices, but the extent and duration of the increases on this occasion led to concern that higher inflation would become baked-in. This risked a 1970s-style wage-price spiral, which is a concern at a time when we are seeing more strike action. Consequently, central banks have aimed to anchor inflation expectations at a lower level to show their determination to bring down price rises, even if that meant dampening growth. Since Summer 2022, the Bank of England has been simultaneously forecasting a recession for the UK while hiking interest rates.
“Consequently, we believe consumer-facing real estate will face a difficult market in 2023, but it could become an area of opportunity in 2024 and 2025. A consumer recovery will also bode well for distribution warehouses, due to the rise of e-commerce.”
Nick Axford, Principal, Chief Economist
UK CPI INFLATION
Source: Oxford Economics
Having seen one set of inflation forecasts after another torn-up and revised upwards, financial markets decided to get ahead of the game by pricing in much higher interest rates. This wrong-footed some financial institutions, as was the case with several UK pension funds that faced margin calls on leveraged positions in the Gilt market in September and October 2022. Debt became more expensive and less available than many had become accustomed to.
Heading into 2023, there is now even more reason to be cautious on the economic outlook, as many households and firms face big hikes in rates on debt when their existing fixed rate deals expire.
The good news is that UK inflation is now believed to have reached its peak, and is forecast to steadily fall over the course of 2023, although it will still be high by historic standards. Also, the consequences will be with us for some time to come.
As mentioned, the Bank of England is concerned that high and protracted inflation may have raised future inflation expectations among consumers and firms. Therefore, we do not expect the forecast fall in inflation to translate into interest rates quickly being cut. Oxford Economics are predicting the base rate to peak at 4.0% in Q1 2023 and stay at that level well into 2024, as the Bank of England ensures that inflation remains firmly in check. This will encourage firms and consumers to revise down their outlook for prices, thus anchoring inflation expectations at a lower level.
This should provide a firm base for a low inflation environment over the medium to long-term, but will result in difficult economic conditions in 2023, particularly the first half of the year. So, there is little near-term prospect of a let up in the squeeze on household incomes, and consumers will be making less of a contribution to GDP growth in 2023 than would be the case in a typical year.
Real estate implications
This suggests that consumer-facing commercial property sub-sectors, such as retail, leisure and hospitality, will face another difficult year. Many tenants in these industries faced tough trading conditions in 2020 and 2021 with the Covid lockdowns, and another difficult year so soon afterwards could prove too much for some. Therefore, landlords could be looking at tenant bankruptcies, resulting in voids that are difficult to fill. Further down the line, when the economy has returned to sustained growth, these property sub-sectors may be targeted by opportunist investors hoping to ride the future recovery.
Given the UK is experiencing a cost of living crisis, we could also see some households unable to meet their mortgage repayments, leading to home repossessions. Moreover, with consumers looking to paydown debt and economise on expenditure, there is good reason to suppose house prices in 2023 will come under pressure.
UK CONSUMER SPENDING GROWTH
Source: Oxford Economics
Forecasts from Oxford Economics point to UK inflation getting back closer to 2.0% in 2024, which is when they believe base rate cuts will begin. Oxford are predicting private consumption to shrink by -1.0% in 2023 then return to growth in 2024 (2.0%) and 2025 (3.4%). This should help consumer-facing property, like retail, hospitality and leisure to move into a new market cycle. Moreover, falling interest rates will be good for real estate across all the sectors, as it will lower debt costs and bring back to the market those buyers who make greater use of leverage.
Consequently, we believe consumer-facing real estate will face a difficult market in 2023, but it could become an area of opportunity in 2024 and 2025. A consumer recovery will also bode well for distribution warehouses, due to the rise of ecommerce. Stronger household finances will also clear a path to a new cycle for the housing market.