FULL REPORT
At the latest Bank of England ("BoE") meeting, the Monetary Policy Committee voted to keep rates on hold at 0.10%, with no change to quantitative easing at GBP895bn. The minutes of the meeting reveal the BoE stand firm on their previous guidance and do not intend to make any changes until they see strong evidence that “significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably". No change to monetary policy also shows the Bank is not concerned about the recent rise in UK bond yields. Despite the rise raising some concerns for investors, the Bank has not seen any change to financing conditions and are content that the recent rise in yields have been driven by positive news on economic growth and the vaccine rollout.
Monetary policy plays a part in bond yields as interest rates essentially impact the risk-free rate of return. Although yields are still low by historical standards, investors are worried about a rapid rise in yields. The recent rise in bond yields have been driven largely by an improvement in risk appetite, as more investors now feel confident to move away from purchasing bonds towards riskier assets.
Furthermore, inflation expectations have been rising, which have also contributed in lowering bond prices. BoE’s latest quarterly survey of public attitudes to inflation reveal the median expectations of the rate of inflation over the coming year were 2.7%, with expectations in the longer term of 2.9% unchanged from November.
However, the current rate of inflation fell in February to 0.4% from 0.7% in January, with large downward contributions from clothing, toys and second-hand cars. Despite the unexpected decline, the factors contributing to the fall are not expected to last. The rate of inflation is expected to pick up as we emerge from lockdown and consumers begin spending the £150bn of accumulated savings. Additionally, the rise in energy prices will effect the headline rate of inflation in April. It is worth noting that the shift in consumer spending habits because of COVID-19 have made it difficult to accurately measure, as lockdown restrictions have prevented people from spending on their 'usual' goods and services. The ONS have adapted the 'basket of goods' and weights to reflect the changes, but as we emerge from lockdown spending patterns will change once again and the ONS do not plan to review the weights anytime this year.
Looking ahead, the BoE expect the rate of inflation to return and stay close to the 2% target in the spring. Despite the recent rise in energy prices, short-term inflation expectations remain unchanged, therefore no change to monetary policy.
The investment market continues to be relatively quiet. Preliminary transaction volume data for Q1 suggests a 66% year-on-year decline, with offices down 77% due to a continuing stock shortage in Central London. The industrial sector, with £1.7bn of investment volume recorded so far this quarter, is the only sector to outperform year-on-year.
Even so, there is evidence of improving investor confidence and weight of capital, particularly for long income. In an indication of current core pricing, high-end jeweller Wempe’s flagship store in Bond Street is for sale for £60m a 2.8% yield. In the alternatives space, recent strong bidding on a 30-year index-linked lease to an NHS Trust drove the yield below 3.0%, while a student accommodation asset in the East Midlands with a 28-year unexpired term and annual RPI uplifts has just gone under offer at c. 3.25%.
This suggests that, while landlords may be waiting to see how the economy emerges from lockdown before fully committing to disposals, investor sentiment for core real estate has improved enough to begin to affect pricing. With economic growth forecasts being revised upwards, and property’s risk premium relative to bonds still high, capital allocations to income-producing real assets have continued to increase. At the same time, the supply of core assets to the market has remained low.
As a result, there is room for UK prime yields to compress further. An analysis of the UK property risk premium over time suggests that the Financial Crisis brought about a sudden change in attitude to risk, and property yields didn’t keep pace with the general decline in fixed-income yields. In the UK this was exacerbated further by Brexit uncertainty, and then again by the pandemic. However it also shows that the risk premium compresses during times of economic recovery and improving rental growth.
There are of course downside risks. Runaway inflation and bond yield increases could push yields higher, but measured increases are also products of economic growth, which will result in improved investor sentiment. The debate over office and retail obsolescence risk following the pandemic is by no means over, but we are confident that pent-up economic will usher in a strong recovery in investment activity this year.