As global economies suffered from the consequences of the Covid-19 pandemic, central banks worldwide responded through quantitative easing policies by lowering interest rates to encourage lending and spending. For example, the US Federal Reserve dropped interest rates by 90%, from 2.5% to 0.25%, and the UK Central Bank decreased its interest rate from 0.75% to 0.1%. As a result, bank interest and mortgage rates dropped to historic lows. People were able to afford interest payments on more expensive homes. Additionally, demand for space had reached an all-time high as most people were bound to their homes during the Covid-19 lockdowns. These two factors combined resulted in a very rapid increase in the demand for housing, which resulted in extraordinary growth rates in prices over the past two years.
Public health policies have since relaxed and normal life has resumed. Economies have shown strong and rapid recovery, and consumer demand has returned. However, this recovery has been uneven, especially in Asian countries which seem to have fallen behind. China’s persisting zero-covid policy has disrupted global supply chains through production and distribution bottlenecks and the war in Ukraine and western sanctions on Russia have caused further supply chain disruptions, commodity shortages, and soaring energy prices. The first half of 2022 has therefore been characterised by a rapid resurgence in consumer demand, whereas the supply-side has fallen behind, causing consumer prices to skyrocket.
Consumer prices in the US rose 9.2% in June 2022 compared to the same month in 2021. In the EU, consumer prices rose 8.6%, and in the UK, 9.1%. These elevated levels are well above the 2% target rates across these regions. As low unemployment rates and 2% inflation are the main targets of central banks, these central banks have rushed to reduce inflation rates through a reduction in spending by raising their ultra-low interest rates again. The following table shows the current rates and forecasts.
Though demand for goods is showing signs of a slowdown, demand for services continues to boom as the world begins to operate freely post COVID-19. For example, summer travel demand is far outpacing the supply of flight seats which has been heavily constrained through understaffed airports due to lockdown lay-offs.
The most important supply constraints are still ongoing, with no near-term end in sight for the Chinese zero-covid policy and the war in Ukraine. The expectation is, therefore, that inflation levels will stay elevated throughout the year and well into 2023. Interest rates will continue to increase in attempts to dampen demand until a better balance is reached, whilst simultaneously being constrained to limit the negative indirect effects on economic growth and the labour market.
As we are now navigating a high-inflationary environment, investors have been quick to shift across different assets. Equity valuations have dropped as interest rates have increased, with the S&P 500 benchmark down 20% since the start of the year - its worst performance in 52 years. Cash is currently losing its value rapidly at the rate of inflation. So which asset classes should investors look at? Real assets have historically performed well in high inflationary periods. Most physical assets retain their value during inflation surges, and houses tend to perform better than other comparable assets within this category. Historically, real estate returns tend to move in line with inflation and therefore act as a strong hedge as seen below.
Economists at Oxford Economics forecast direct corporate real estate returns and REITs to average around 7.6% per year over the next 5 years. This is well above their forecasts for the wider equities market (1.7% pa) and 10-year US Treasuries (1.6% pa). Moreover, compared to other real estate returns, the apartment sector is best positioned to weather the inflation storm, according to historical US data. Most analysed US cities had apartment returns that were relatively well insulated in times of nationally high levels of inflation, making them an attractive investment in the current economy.
Mortgage rates are still relatively low compared to long-term averages. Let’s take the UK as an illustration of where rates lie. At the end of 2021, mortgage rates reached a low of 2% and have climbed up to 3% for a 5-year fixed rate -35% below the long-term average of 4.1%.
As real estate values move closely in line with inflation and property prices are still rising, a potential 9.1% growth in value (in line with inflation) could essentially be achieved borrowed at only 3%. This would provide the purchaser with a steep negative inflation-adjusted rate of interest (-6.1%) which only occurs when the rate of inflation is greater than the nominal rate of interest (essentially a negative real interest rate). Investors are therefore currently likely to make real returns on their mortgage loans until inflation cools down.
Finally, US Dollar and the Euro are currently at parity for the first time in 20 years, with the Euro down 16% since this time last year and the Pound down 14% against the US Dollar over the same period. The strong US Dollar owes to two main factors: the US interest rates are relatively higher, and investors have been buying up dollars as a safe-haven asset. For many foreign currency investors, this means that UK and Euro investments are currently at a steep relative discount, which can provide investors with great value investments and a potential capital appreciation from just the currency upside once the Euro and Pound appreciate and return to their long-term averages.
If you're interested in taking advantage of currency saving in Europe and the UK, request a free consultation with an IP Global Wealth Manager here.
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