Quo vadis mundus?
The title is a bit excessive (even megalomaniac), I agree. But the topic addressed here deserves it: where is the world economy heading to? What are the consequences for European real estate?
Macroeconomists (and I am not one of them) have an extremely difficult job. They are expected to understand all the economic forces going on around the world, their interactions, their relative strength and, furthermore, transform them into a forecast figure. Some of these people are geniuses, but the vast majority are not, so they fulfil their duties by ‘inventing' plausible and internally consistent stories that take into account the recent past and some other ‘major' forces.
I am certainly in the latter group, so my purpose here is to entertain the reader with a ‘plausible' story about the world today. We are currently experiencing a period akin to the industrial revolution. Both the emergence of China and India into the world economy and the information and communication technology (ICT) revolution are probably the two features that will shape the future.
The short-term effect of these two phenomena on European economies has been enormous. In the mid-1990s they created a gradual deflationary threat in both labour intensive and technology products. They also created a massive world demand for commodities and energy from countries where energy efficiency is certainly not at the top of the agenda.
Deflationary threats pushed central banks to maintain low interest rates for a long time. Low rates meant cheap borrowing for both businesses and households, which triggered housing booms throughout Europe and the US, together with strong business borrowing. The result was a period of low inflation and high growth.
Easy money and a massive growth in labour supply in the world economy increased the price of capital relative to the price of labour. That is, they triggered a massive increase in asset prices across the globe.
The emergence of China and India and the ICT revolution are both structural trends - they boost long term growth yet are not exempt from busts, collapses etc. Remember that the industrial revolution boosted world output over a number of decades, yet recessions - and depressions - did indeed happen. The ICT boom and bust of the late nineties should thus be seen in this context.
What is the situation right now? The world is facing massive financial imbalances. The US, with enormous deficits and close to the end of a consumption boom led by cheap money, is heading towards an economic slowdown. China and the Asian tigers, with massive surpluses and over appreciated currencies may, as a consequence, face a slowdown in export demand, especially from the US.
The Euro-zone also suffers from imbalances, but they are mostly internal (a consuming and borrowing south and an exporting north). Furthermore, most of its trade is also internal, so a slowdown in consumption in the US will not hamper growth significantly.
What about the asset price boom? To what extent are assets currently overvalued? Has the era of cheap money come to an end? My humble opinion is that the inflationary pressures from commodity prices are finally feeding into consumer prices, and central banks are now adapting their monetary policy to tackle this. Therefore, money will not be so cheap going forward. If interest rates rise, excess liquidity should ease, which will probably have a negative impact on asset prices.
But that is enough about macroeconomics. What are the consequences of all this for European real estate? The historic high returns that we have enjoyed in recent years can partly be explained by the asset price boom referred to earlier. This is, however, a partial explanation. Real estate also enjoyed a structural change in terms of investors' perceptions of its benefits as an asset class. This triggered a repricing of property relative to other assets - and probably a reconsideration of its risk premium.
In order to understand this, I invite you to think as a physicist for a second: Take any asset class you want and apply to it two positive shocks. Assume also that both shocks are structural and long lasting. The first consequence of your experiment is that both forces trigger positive demand shifts and price increases; but they also boost expectations and tend to attract bullish investors (or bullies in transaction departments) with a lot of boldness and little sense. What is the result? That's right: An overreaction. It happened in the ICT boom - a structural, long lasting, change which overreacted and thus triggered a bust - and it will probably happen in real estate, albeit not as strongly.
There are a number of indicators that suggest that property is overpriced, while there are others that suggest that it is not quite there yet. Some forecasters are bold enough to predict strong negative returns in 2008, whilst others just call for a soft landing.
The UK is probably most advanced in this process. Indeed, I could compare property yields with gilts and say that if property were fairly priced, the long-term risk return profile should be identical, which is not the case at the moment. I could also compare property yields with swap rates and say that, over the long term, property income yields should be higher than swaps, which is not quite the case at the moment. It would be even possible for me to show that property company dividend yields are currently one percentage point below the average FTSE all share dividend yield and that this difference has grown from zero over the last few years.
But if I say all that, someone will try to silence me by quoting the famous recovery in occupier markets. Indeed, rental growth is clearly apparent - and is expected to continue - in many office markets across continental Europe, which is putting further downward pressure on yields. Do not get carried away by this. Occupier markets are cyclical; what we have seen in investor markets is the aftermath of a structural shift. The recovery in occupational markets is just another ‘positive' force that may both delay and make the landing harder.
There may be a price correction, but not an enormous one; real estate is a now a serious asset class and we should congratulate ourselves for that.