FULL REPORT
2022 will be a year dominated by Central Bank action, tasked with keeping inflation expectations anchored whilst maintaining a supportive environment for growth.
The 25bps rise in interest rates at the 3 February MPC meeting was all but certain. In August, the MPC announced its intention to reduce the stock of purchased assets when the interest rate reached 0.5% and actively selling assets once rates reached 1%. The Bank of England (BoE) is therefore expected to start shrinking the balance sheet imminently, signalling a move from QE (quantitative easing) to QT (quantitative tightening). The BoE is ahead of the curve, with the Fed and ECB still deploying QE. The Fed is tapering the rate of these purchases with the intention to stop in March, while the ECB will 'look' to scale back QE.
Typically the shift to QT implies bond yields will go up. But this may not happen as to some extent QT has already been factored in. Looking back to 2018-19, QT was deployed during a very different backdrop. Central Banks' balance sheets as a proportion of GDP are much larger now. Demand for bonds is more dependent on economic prospects and other asset classes' relative valuations instead of supply. Furthermore bond yields are impacted by future policy rates, and the real neutral rate (full employment and inflation at target), which has been falling, suggesting that bond investors should not be fearing a rise in interest rates.
When the BoE begins QT, we anticipate some short-term volatility, thereafter if future actions are clearly communicated minimal impact on bond yields is anticipated. Gilts are expected to hit the 1.0-1.5% range, but may begin to fall again as we move towards year-end as wider structural drivers that have caused the downward trend in gilts continue to take hold.
Inflation once again surprised to the upside, but how many surprises can we expect this year? Producer price indices (PPI) may provide some respite, with PPI edging downwards towards the end of 2021, suggesting producer price pressures may have peaked. The impact of the slowdown in PPI to CPI will take approximately six months, therefore sustaining inflationary pressures in H1 22 at least. In addition with increases in utility prices of c. 50% expected in April, inflation is likely to get closer to the 7% mark. There is speculation surrounding some government intervention to mitigate the price increases, but what form this intervention looks like is unclear. Inflation is expected to ease after its April peak, remaining above target (3.5%) by the end of 2022. If however, higher inflation were to persist, Central Banks will struggle to fight off the threat of a new recession. The big dilemma of tightening too soon and too much could in fact push Central banks to intervene again.
The UK investment market demonstrated extraordinary resilience in 2021. MSCI's UK index shows an all-property total return of 19.9% in 2021, outperforming UK equities and bonds and that direct property remains the best performing asset class over five years with a 7.7% annualised total return. In contrast, the FTSE's 5-15-year Index-Linked Gilt index has returned 3.9%.
Investment volume rebounded strongly to surpass pre-pandemic levels. The c. £60bn invested in 2021 represents a 28% y/y increase, a 12% rise on 2019 and a 10% premium on the ten-year average. Central London offices, after a slow start to the year, finished at £12.5bn – 31% up on 2020. Although still below the ten-year average, early data suggests a busy 2022, with c. £3.0bn currently under offer in the City market alone and some eye-catching deals already transacting.
Logistics was the clear stand-out sector, with c. £16.5bn invested - a record annual total and almost 30% of overall UK volume (in 2011 it was just 10%). Much of the sector's meteoric rise is down to persistently-fierce competition from US-based investors. Capital flows from the US reached £13.3bn last year, the highest annual total on record and almost double the ten-year average (+90%). Approximately 50% of this was invested in logistics assets.
Also encouraging was retail investment volume's 26% y/y increase, the first uptick after seven consecutive years of decline. Most of this was driven by retail warehousing, which enjoyed its strongest year since 2015 with c. 3.3bn invested. Significant challenges remain, but with Shopping Centre capital values now 50% below where they were at the end of 2016, the sector is starting to attract opportunistic capital.
These trends will continue to sustain real estate investment this year. Reduced travel restrictions will fuel cross-border capital flows, particularly from Middle Eastern and Asia-Pacific investors, who were relatively quiet last year. Moreover, with inflation elevated and monetary policy tightening, there will be a material shift away from growth-focused equities and bonds towards alternative sources of high-quality, stable income that are resilient to inflationary pressures.
UK investment volume is likely to reach c. £66bn this year, the highest annual total since 2017. Geopolitical and inflationary pressures are causing considerable volatility, and rising interest rates will push up investors' financing costs, but markets have already priced in multiple rate rises this year. Gilts, with central banks poised to begin tapering, are unlikely to perform well this year, and index-linked products remain expensive. That said, yields are not forecast to rise to levels that will adversely affect Property's attractive risk premium.