Maskells Market Outlook

It is always difficult to return to the office in the New Year and contemplate what the market is going to do next. In this outlook we want to share some thoughts on pricing in Prime Central London (PCL) with a focus on inflation and economic growth. We agree with Dr Nick Axford and Dr Alexandra Krystalogianni at Avison Young, who have carried out some very good research, that income derived from housing is not a great hedge against inflation and that, while long-term buy and hold may offer protection, economic growth is the true driver of house prices.

Milton Friedman maintained that "inflation is caused by too much money chasing after too few goods". While some economists will argue that Friedman’s theories assume price changes are uniform (which they are not), we think we can agree for the purposes of this piece that the quote is not controversial. We currently have too much money in the system and not enough goods.

Global Covid lockdowns (which also led to a slow-down in spending) and continuing Covid measures in China have resulted in supply chain issues; Brexit has caused customs challenges, and the war in Ukraine is having widespread ramifications. Three years of sustained disruption has, unsurprisingly, impacted the production and availability of goods, both in the UK and worldwide – and we am sure you have noticed empty shelves and long delays in ordering items.

With this, there was and remains too much money in the system, evidenced by the large household saving ratio (the proportion of disposable income not spent on consumption). This peaked in 2020 Q2 at 26.8%, versus an historical average since the 1980s of around 10%. As at Q3 2022, even with a cost-of-living crisis, the ratio is 9% (Source: ONS). According to the Bank of England, the usual inflows into deposit accounts from Jan 2018 up to the start of the pandemic were around £5bn per month. During March and May 2020, that rose to approximately £20bn per month, and between December 2020 and March 2021, the figure was around £17bn.

So, while there is no doubt a cost-of-living crisis, there remains a great deal of money in deposit accounts available for people to spend. Add to that the lack of available goods and very quickly prices rise, as people that have the cash to do so are prepared to pay those higher prices.

The only real way to deal with inflation is by increasing interest rates, as we have written about previously.  In so doing, cash is removed from the system in the form of, for example, higher mortgage payments. As manufacturers’ costs fall and competition from globalisation rebounds, prices will then begin to fall.  We have seen this in the USA, where aggressive interest rate increases by the Federal Reserve have produced improved economic data, so much so that investment banks have started to change their forecasts for the year.

Rate rises in the UK have also taken effect and confidence has improved, with Panmure Gordon recently announcing, "UK inflation – like the inflation seen across all major economies – has now peaked". They are forecasting that inflation will drop from its current 10.5% to 3.5% by the end of the year and to 2.5% in 2024. Nevertheless, the Office of Budget Responsibility is seeking to reduce its forecast of GDP growth - currently at 1.4% for this year and 2.6% next year - by 0.2% and 0.5%, respectively.

So how does this relate to property? Well, for a long time, property has been viewed as a potential hedge against inflation, the argument being that property prices capture inflation - i.e. their market value rises in line with it. However, the case for property is more nuanced than that when you break down rental/lease income and rises in capital values, as established by Dr Nick Axford and Dr Alexandra Krystalogianni at Avison Young - and full credit to them for their work.

They express their findings in terms of correlation, which may require a brief explanation. In essence, correlation is a measure of the extent to which two variables change at a constant rate, expressed in a range of -1 to 1.  A value of -1 would be a perfect negative correlation, meaning the two variables act as opposites and a value of 1 would be positive, in so far as they act together. Zero would be weak or neutral.

In their research, Axford and Krystalogianni found that UK property total returns (net operating income and capital growth) on property investments have a negative correlation against annual CPI inflation of -0.23. However, against economic (GDP) growth, total returns have a much higher correlation of 0.57 - remembering that 1 is the highest measure. So, they suggest that real estate income alone is not an effective short-term hedge against inflation and maintain that "the key driver of property performance is occupier demand, which results from economic growth"

However, when it comes to capital value, the longer the asset is held, the greater the protection against inflation and therefore property is a key component to any investment portfolio. The research suggests that 5-year capital values have a correlation of 0.42 against 5-year CPI, which rises to 0.75 over 10 years and 0.92 over 17 years. Their conclusion is that real estate over the optimum period (per their calculation) of 17 years, "[does] seem to offer a more reliable and predictable level of capital value protection against inflation".

They go on to maintain that the UK residential property sector performance versus inflation over a 5 to 10-year period shows a 0% correlation - that is, 0% of holding periods with negative returns. This is something that buy-to-let landlords may want to consider. Zero means no loss, but it does not mean that property in an inflationary environment will produce a higher income than any other investment, and this is something to discuss with your financial advisors.

This research is online and we would invite you to read it; but, in short, it supports the view that the metric on which the decision to buy property should be based is economic growth, rather than inflation. So, although the OBR is suggesting long-term economic growth will be bleaker than expected, the fact remains that they are expecting growth and, if the above argument is accepted, that translates to a positive outlook for the real estate market.

In conclusion, property should continue to be of interest to buy-to-let investors, who may be able to hedge against inflation with long-term property holdings and potentially enjoy higher total returns as the economic situation improves. It should also be of interest to home buyers, who have an opportunity to purchase before prices increase due to economic growth – indeed, this may explain why our viewing requests have risen 400% this January, compared to last year. Finally, for vendors seeking to move up the ladder, the current price compression makes that transition into a different price bracket more financially viable.

Posted on Wednesday, February 15, 2023