The last time government bond yields were this low, the UK had just voted to leave the EU. Moorfield’s CIO considers what this means for UK real estate
Ten-year UK gilt yields are now around 0.5% in the UK (approximately 1.5% in the US, negative 0.7% in Germany and negative 0.3% in Japan). The key driver for global bond yields falling in recent months has been blamed on the trade war between the US and China and related fears of recession that in turn has prompted a shift back to base rate cuts and more quantitative easing (QE).
However, it is striking that the last time yields were at this level in the UK, US and Japan it was at the time of the Brexit referendum in the summer of 2016. Surely this can’t be a coincidence now that we are fast approaching another Brexit deadline? Is it really because of the fear of a no-deal ‘hard’ Brexit that global bond yields have plummetted?
German bond yields are even lower now than in 2016 as more QE has been launched by the European Central Bank and rates lowered yet again amid growing concerns of recession risk in Germany.
There are different forces at play now compared to the summer of 2016; Trump hadn’t even been elected and we had no idea of the tariff dispute to come. Perhaps investors are now equally worried about inflation/growth prospects, but for different reasons. Nevertheless, I find it hard to ignore the correlation between the key Brexit dates.
After the direction of Brexit has been settled we could see yields rise again, as they did in 2016, and one way or another the path ahead should be clearer. If we see some inflation emerging then this could happen quite quickly – indeed the latest release showed the employment rate at the highest level ever in the UK; unemployment is only 3.8% and annual wage growth is running at 4% versus inflation at 2%.
Low bond yields should be helpful to real estate valuations from a relative value perspective, but if the low yield levels reflect a fear of recession with lower corporate and consumer earnings, then rents are also going to come under pressure. Equity markets and real estate valuations don’t currently appear to be pricing in this risk and so who is right?
Should we assume that these very low levels of yields are here to stay? Perhaps the level of global savings looking for a home due to monetary measures, emerging markets’ economic growth and ageing populations will have a structural effect of keeping yields low – and at the same time, globalisation and technology will also keep inflation at bay. Certainly, very high levels of employment have not yet produced the wage inflation and resultant interest-rate rises normally associated.
I am reluctant to take too much comfort from a longer-term low-yield environment, as it implies that growth is expected to be constrained. Yields will also remain at risk of normalising and rising again; if global market expectations of rising yields can be reversed in the space of a few months then the same is true now the other way around.
It is also the case that, while wage inflation has been low, asset price inflation has been very high, boosted by low rates and QE. This has resulted in the wealth gap widening and made it harder for younger generations to access the housing market and save adequately. This inequality is becoming increasingly political and real estate will continue to be at risk of higher taxes and other initiatives such as rent controls that try to address the imbalances (even if they have the undesired effect of reducing supply and increasing house prices and rents).
The other important factor to take into account is how different subsectors are faring. Transaction volumes are down overall because of Brexit concerns, but real estate yields remain generally low overall – and assets with long-term leases with bond-like characteristics especially so. However, where there is any doubt about rental resilience, which is especially the case for the retail sector, yields have risen markedly and values have fallen substantially to the point where many retail assets are almost unsaleable in the current environment.
We see capital continuing to be allocated to the more defensive, demographically supported sectors such as residential for rent, student accommodation and senior living, alongside ongoing demand for logistics.
Charles Ferguson-Davie is CIO at Moorfield