Real estate, alternative real assets and other diversions

On risk, inflation and gilt yields Does recent movement in the 30 year gilt yields imply a knock-on effect in property?

Investor's Notebook

Close up of metal cogs

The UK stock market has recovered from its spring snooze and despite worries over the effects of Brexit on UK growth the indices are but a stone’s throw from their all time highs. But this hides frenetic activity under the surface with different sectors taking the lead, while some others with a more domestic UK bias such as retailers have fallen sharply.

We should not confuse the UK’s FTSE 100 index of the largest quoted companies with an investment exposure to the UK economy. The leaders in the recent rise have included the resources sectors – base metals in particular – which have reacted to better than expected economic growth numbers out of China and Europe in particular. Companies such as BHP, RTZ, Anglo American and Glencore have few if any activities within the UK. So the dominance of ‘overseas earners’ within our leading index insulates investors from many of the risks associated with Brexit. Actually the index is so dominated by a small number of giant companies, an investment in HSBC and Shell alone would do a decent job of replicating the index and if you add BP, Vodafone and Glaxo you have over 35% of the FTSE 100 represented by five shares!

But there is one area of the wider UK market which has been left behind, perhaps without justification. Sterling weakness has led to fears of imported inflation and the risk that UK interest rates will soon be on the way back up, and market considers financials, and banks in particular, to be beneficiaries of higher interest rates, while bonds and bond proxies such as utilities and PFI funds have not joined in the fun. These equity sectors now look interesting. The UK economy is slowing and so the pressure on inflation and interest rates has decreased. In any event many utilities and PFI investments have inflation increases built into their dividends and it therefore seems a tad unfair that the inflation outlook should have caused them to perform so badly relative to the wider stock market. So if you’re looking to de-risk your portfolios while maintaining a decent level of income you could do worse than consider stocks such as National Grid and HICL.

If we assume some long term correlation between gilt and property yields (although I accept not all analysts do), then the recent movement in the 30 year yield is of interest. There are contributors more qualified than me to comment on the outlook for commercial real estate rents, but given gilt yields initially hardened as a reaction to the inflation outlook, the yield on the 30 year’s return to below 2% seems to indicate that these concerns have eased and any upward pressure on commercial real estate yields likewise.

If short and long term rates rise due to ‘cost push’ (the inflationary effect of imported inflation) it would not be surprising if the MPC’s requirement to achieve a specific inflation target via higher interest rates had a knock on effect on property yields. ‘Demand pull’ is another matter entirely, and accounts for BNP’s conclusion that property and gilt yields need not be correlated. If rates rise because the economy is growing and inflation is therefore caused by capacity constraints, then the demand for property is likely to be buoyant, rents will rise and yields fall. This would represent a negative correlation between gilts and RE. However I fear that the UK faces the former scenario, and that bond and bond proxy yields will to an extent correlate with the yields available from bonds issued by the Treasury.

Investor's Notebook

About Jo Welman

Jo Welman

Jo Welman is an adviser to Epic Private Equity and the Non-Executive Director for ARK Syndicate Management Ltd, as well as advising several small companies and individuals on the structure and allocation of their investments. His previous roles have included managing balanced portfolios at Barings, Managing Director at Rea Brothers (Investment Management) Ltd, and Executive Chairman at Brit Insurance Holdings Plc. He has also set up a range of fund management operations and investment groups. He graduated from Exeter University with an honours degree in economics.

Articles by Jo Welman

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