Made in Britain: Inflation
Since the introduction of fiat money, much ink has been split on the vicissitudes of inflation. This note isn’t going to address that. Much ink has been split too on the interplay between real estate and inflation, as well as central banks responsibility to keep it in check, and we intend to add to this chorus. In Stephen King’s timely book, ‘We Need to Talk About Inflation: 14 Urgent Lessons from the Last 2,000 Years’, he argues that central banks’ bias against deflation during the past decade may have inadvertently created a bias in favour of inflation. By distorting the bond market, quantitative easing - buying bonds to push up their prices and bring down long-term interest rates - removed a key early warning indicator available to central banks to gauge inflationary risks. QE also obscured the relationship between finance ministries and central banks, heeding to populist ideas of economic growth and sucking central banks into the corrosive orbit of fiscal decision making. This was consequential and we are feeling the pinch today.
Inflation figures for the UK in May, published this week, were expectantly dire and sentimentally destructive. The headline figure remained constant at 8.7%, above economists’ expectations of a fall to 8.4%. More ominously however was core inflation – excluding food and energy – which jumped to 7.1% from 6.8% from the previous month. Excuses that it is as a result of war, choked supply chains, high global food prices, is misdirection. Inflation, unlike much else, is made in Britain. Britain is exposed to higher prices for natural gas, however it has become clear inflationary pressures are overwhelmingly the result of decisions taken at the national, not supranational level. The rate of services inflation, overwhelmingly a domestic factor, rose in May to an annual rate of 7.4% from 6.9%.
The chaotic economic events in Turkey is an unfair comparison to what could occur in the UK, but taken in extremis, the evidence of unchecked inflation is foreboding. In the last two years, the price of a square metre of real estate in Istanbul has shot up by over 480%, according to Endeksa, a consultancy and quoted in The Economist. Even after adjusting for inflation, which peaked at 86% year-on-year last autumn before slowing to a mere 40% in May, housing prices in Turkey as a whole increased by 51% last year, more than in any other major economy, according to a study by the Bank for International Settlements. The leading causes are reckless interest-rate cuts, imposed as a result of the misguided policies of Turkey’s president and a resulting surge in inflation. The combination of these developments has encouraged those Turks with access to sufficient credit to protect their wealth by investing in property, which is not too dissimilar to the UK story of artificially inflating house prices by providing easy access to credit.
Inflation is typically bad news for mainstream assets such as stocks and bonds, because it reduces the present value of future earnings and coupons. Yet this is where, after a decade of slow growth and sluggish inflation, investors have parked much of their trillions and a growing cohort is placing its faith in real assets. Are these a haven in times of rapid inflation? A report by BlackRock, suggested that the total returns of privately held property and infrastructure assets globally have beaten those of main stock and bond indices when inflation has exceeded 2.5%. But if inflation has risen to levels not seen since the 1980’s, what then?
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McKinsey, in a recent report, quantified this. In the seven inflationary periods from 1980 to 2022, CRE returns, at 11.7% annualized, have generally outperformed inflation, their own historical average, and other asset classes, including the S&P 500 and BBB corporate bonds. More specifically, CRE outperformed inflation in six of the seven inflationary periods and outperformed its own historical average in five of them. The asset class outperformed stocks in four of the seven periods, and bonds in six of them. Real estate broadly has been a useful hedge against inflation.
The principal reason CRE has served well as an inflation hedge is that in periods of higher inflation, cap rates - effectively, the net operating income yield investors are willing to accept - have tended to compress. While interest rates typically rise in periods of inflation, cap rate spreads often tighten. This counterintuitive finding is perhaps partly the result of widespread belief in real estate’s inflation-hedging properties: investors put money into asset classes they believe will protect real value. However, McKinsey’s analysis reveals that rent growth alone has not historically provided a full hedge against inflation. Although rents do tend to increase more quickly during inflationary periods, those increases “rarely match the pace of rising inflation point for point.” Annualized CRE rent growth averaged only about 3% during the seven inflationary periods studied, compared with average annualized inflation of almost 5 percent. Thus, real rents fell.
If rents typically fall behind inflation, then how can CRE deserve its inflation-hedging notoriety? The key factor is cap rate compression, which averaged roughly 20 basis points annually during the periods studied, contributing significantly to total returns. In an environment of cap rate expansion – it was reported the 20-storey tower at 529 Fifth Avenue sold for almost the plot of land adjacent to it (sold in 2015) – macroeconomic conditions might mean that its historicity is less relevant. As the rating agency Scope said, lenders' concerns are exacerbated for properties with little pricing power to pass inflation on (shopping centres, secondary office).
This has implications for the loans markets too, specifically those issued in an environment of historically low interest rates. As reported in the FT, analysts at rating agency Moody’s cautioned the $1.4tn private credit industry faces its “first serious challenge” as tens of billions of dollars of loans underwritten at the top of the market in 2021 are under strain by higher interest costs and a slowing economy. Ares and Owl Rock, two of the industry's biggest players, were singled out by Moody's. The majority of the loans were underwritten when interest rates were almost zero and the US economy was still growing; however, this world disappeared once the Federal Reserve started to aggressively raise interest rates in an effort to curb US inflation. According to Moody's, the interest coverage ratios for the loans held by the Ares and Owl Rock funds will eventually drop by around half. CRE debt is not immune. In a research briefing, Oxford Economics, which downgraded its outlook for UK real estate, said the following: “This meaningful increase in the cost of debt raises the risk of commercial real estate distress as interest coverage ratios fall further, particularly concerning for those with higher loan-to-value ratios and fixed-rate loans maturing this year and in 2024.”
It took 2.5 years for the annual rate of UK inflation to rise from 0.3% to 10%: yet, throughout that period, the Bank of England persistently forecast that inflation would return to the 2% target within two years. Perhaps central bankers spend too much time in the company of politicians: they don’t want to be blamed for higher unemployment. They are no longer the detached philosopher kings of legend, immune to the social consequences of their actions in the inexorable pursuit of low inflation. Perhaps the biggest danger, though, is that real assets fall victim to their success. Many investors already turned to them over the past decade as they hunted for stable yields and sought diversification. Between 2010 and 2020 private real assets under management more than doubled, to $1.8trn. In theory products like inflation linked bonds could offer more protection, although in practice there are not enough of them to go around. Inflation-linked Treasuries, for example, comprise just 8% of the total. Finding things to buy is getting harder.