Global Real Estate – Has the tide begun to recede?

Global Real Estate – Has the tide begun to recede?

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Macro Letter – No 113 – 19-04-2019

Global Real Estate – Has the tide begun to recede?

  • Despite the fourth quarter shakeout in stocks, real estate values keep rising
  • Financial conditions remain key, especially in a low rate environment
  • Isolated instances of weakness have yet to breed contagion
  • The reversal of central bank tightening has averted a more widespread correction

I last wrote about the prospects for global real estate back in February 2018 in Macro Letter – No 90 – A warning knell from the housing market – inciting a riot? I concluded: –

The residential real estate market often reacts to a fall in the stock market with a lag. As commentators put it, ‘Main Street plays catch up with Wall Street.’ The Central Bank experiment with QE, however, makes housing more susceptible to, even, a small rise in interest rates. The price of Australian residential real estate is weakening but its commodity rich cousin, Canada, saw major cities price increases of 9.69% y/y in Q3 2017. The US market also remains buoyant, the S&P/Case-Shiller seasonally-adjusted national home price index rose by 3.83% over the same period: no sign of a Federal Reserve policy mistake so far.

As I said at the beginning of this article, all property investment is ‘local’, nonetheless, Australia, which has not suffered a recession for 26 years, might be a leading indicator. Contagion might seem unlikely, but it could incite a riot of risk-off sentiment to ripple around the globe.

More than a year later, central bank interest rates seem to have peaked (if indeed they increased at all) bond yields in most developed countries are falling again and, another round of QE is hotly anticipated, at the first hint of a global, or even regional, slowdown in growth.

In the midst of this sea-change from tightening to easing, an article from the IMF – Assessing the Risk of the Next Housing Bust – appeared earlier this month, in which the authors remind us that housing construction and related spending account for one sixth of US and European GDP. A boom and subsequent bust in house prices has been responsible for two thirds of recessions during the past few decades, nonetheless, they find that: –

…in most advanced economies in our sample, weighted by GDP, the odds of a big drop in inflation-adjusted house prices were lower at the end of 2017 than 10 years earlier but remained above the historical average. In emerging markets, by contrast, riskiness was higher in 2017 than on the eve of the global financial crisis. Nonetheless, downside risks to house prices remain elevated in more than 25 percent of these advanced economies and reached nearly 40 percent in emerging markets in our study.

The authors see a particular risk emanating from China’s Eastern provinces but overall they expect conditions to remain reasonably benign in the short-term. The January 2019 IMF – Global Housing Watch – presents the situation as at Q2 and Q3 2018: –

housepricesaroundtheworld IMF, BIS, ECB,Federal Reserve, Savills, Sinyl Real Estate

Source: IMF, BIS, Federal Reserve, ECB, Savills, Sinyl, National Data

Hong Kong continues to boom and Ireland to rebound.

They go on to analyse real credit growth: –

creditgrowth IMF, Haver Analytics

Source: IMF, Haver Analytics

Interestingly, for several European countries (including Ireland) credit conditions have been tightening, whilst Hong Kong’s price rises seem to be underpinned by credit growth.

Then the IMF compare house prices to average income: –

pricetoincome IMF, OECD

Source: IMF, OECD

Canada comes to the fore-front but Ireland is close second with New Zealand and Portugal not far behind.

Finally the authors assess House price/Rent ratios: –

pricetorent IMF, OECD

Source: IMF, OECD

Both Canada, Portugal and New Zealand are prominent as is Ireland.

This one year snap-shot disguises some lower term trends. The following chart from the September 2018 – UBS Global Real Estate Bubble Index puts the housing market into long-run perspective.

ubs-bubbles-index

Source: UBS

UBS go on to rank most expensive cities for residential real estate, pointing out that top end housing prices declined in half of the list:-

real-estate-bubbles list UBS

Source: UBS

Over the 12 months to September 2018 UBS note that house prices declined in Milan, Toronto, Zurich, New York, Geneva, London, Sydney and Stockholm. The chart below shows the one year change (light grey bar) and the five year change (dark grey line): –

housing-bubbles-growth-rates 1yr - 5yr change UBS

Source: UBS

Is a global correction coming or is property, as always, local? The answer? Local, but with several local markets still at risk.

The US market is generally robust. According to Peter Coy of Bloomberg – America Isn’t Building Enough New Housing – the effect of the housing collapse during the financial crisis still lingers, added to which zoning rules are exacerbating an already small pool of construction-ready lots. Non-credit factors are also corroborated by a recent Fannie Mae survey of housing lenders which found only 1% blaming tight credit, whilst 48% pointed to lack of supply.

North of the border, in Canada, the outlook has become less favourable, partly due to official intervention which began in 2017. Since 2012, house price increases in Toronto accelerated away from other cities, Vancouver followed with a late rush after 2015 and price increases only stalled in the last year.

In their February 2019 report Moody Analytics – 2019 Canada Housing Market Outlook: Slower, Steadier – identify the risks as follows: –

Interventions by the BoC, OSFI, and the British Columbia and Ontario governments were by no means a capricious attempt to deflate a house price bubble for the mere sake of deflation. Financial and macroeconomic aggregates point to the possibility that the mortgage credit needed to sustain house price appreciation may be unsustainable. Since 2002, the ratio of mortgage debt service payments to disposable income has gone from a historical low point of little more than 5% in 2003 to almost 6.6% by the end of last year…

The authors go on to highlight the danger of the overall debt burden, should interest rates rise, or should the Canadian economy slow, as it is expected to do next year. They expect the ratio of household interest payments to disposable income to rise and the percentage of mortgage arrears to follow a similar trajectory. In reality the rate of arrears is still forecast to reach only 0.3%, significantly below its historical average.

External factors could create the conditions for a protracted slump in Canadian real estate. Moody’s point to a Chinese real estate crash, a no-deal Brexit, renewed austerity in Europe and a continuation of the US/China trade dispute as potential catalysts. In this scenario 4% of mortgages would be in arrears. For the present, however, Canadian housing prices remain robust.

Switching to China, the CBRE – Greater China Real Estate Market Outlook 2019 – paints a mixed picture of commercial real estate in the year ahead: –

Office: U.S.–China trade conflict and the ensuing economic uncertainty are set to dent office demand in mainland China and Hong Kong. Leasing momentum in Taiwan will be less affected. Office rents will likely soften in oversupplied and trade and manufacturing-driven cities in 2019.

Retail: The amalgamation of online and offline will continue to drive the evolution of retail demand on the mainland. Retailers in Hong Kong and Taiwan will adopt a conservative approach towards expansion due to the diminishing wealth effect. Retail rents are projected to stay flat or grow slightly in most markets across Greater China.

Logistics: Tight land and warehouse supply will translate into steady logistics rental growth in the Greater Bay Area, Yangtze River Delta and Pan-Beijing area. Risks include potential weaker leasing demand stemming from the U.S.-China trade conflict and the gradual migration to self-built warehouses by major e-commerce companies.

The Chinese housing market, by contrast, has suffered from speculative over-supply. Estimates last year suggested that 22% of homes, amounting to around 50 million dwellings, are unoccupied. Government intervention has been evident for several years in an attempt to moderate price fluctuations. Earlier this month the National Development and Reform Commission (NDRC) said it aims to increase China’s urbanization rate by at least 1% with the aim of tackling the surfeit of supply. This is part of a longer-term goal to bring 100 million people into the cities over the five years to 2020. As of last year, 59.6% of China’s population lived in urban areas. According to World Bank data high middle income countries average 65% rising to 82% for high income countries. For China to reach the average high middle income average, another 70mln people need to move from rural to urban regions.

The new NDRC strategy will include the scrapping of restrictions on household registration permits for non-residents in cities of one to three million. For cities of three to five million, restrictions will be “comprehensively relaxed,” although the NDRC did not specify the particulars. Banks will be incentivised to provide credit and the agency also stated that it will support the establishing of real estate investment trusts (REITs) in order to promote a deepening of the residential rental market.

The NDRC action might seem unnecessary, average prices of new homes in the 70 largest Chinese cities rose 10.4% in February, up from 10.0% the previous month. This is the 46th straight monthly price increase and the strongest annual gain since May 2017. Critics point to cheap credit as the principal driver of this trend, they highlight the danger to domestic prices should the government decide to constrain credit growth. The key to maintaining prices is to open the market to foreign capital, this month’s NDRC policy announcement is a gradual step in that direction. It is estimated that at least $50bln of foreign capital will flow China over the next five years.

Despite the booming residential property market, the Chinese government has been tightening credit conditions and cracking down on illegal financial outflows. This has had impacted Australia in particular, investment fell more than 36% to $.8.2bln last year, down from $13bln in 2017. Mining investment fell 90%, while commercial real estate investment declined by 32%, to $3bln from $4.4bln the previous year. Investment in the US and Canada fell even more, declining by 83% and 47% respectively. Globally, however, Chinese investment has continued to grow, rising 4.2%.

Australian residential housing prices, especially in the major cities, have suffered from this downdraft. According to a report, released earlier this month by Core Logic – Falling Property Values Drags Household Wealth Lower – the decline in prices, the worst in more than two decades, is beginning to bite: –

According to the ABS (Australian Bureau of Statistics), total household assets were recorded at a value of $12.6 trillion at the end of 2018. Total household assets have fallen in value over both the September and December 2018 quarters taking household wealth -1.6% lower relative to June 2018. While the value of household assets have fallen by -1.6% over the past two quarters, liabilities have increased by 1.5% over the same period to reach $2.4 trillion. As a result of falling assets and rising liabilities, household net worth was recorded at $10.2 trillion, the lowest it has been since September 2017…

As at December 2018, household debt was 189.6% of disposable income, a record high and up from 188.7% the previous quarter. Housing debt was also a record high 140.2% of disposable income and had risen from 139.5% the previous quarter.

In 2018 the Australian Residential Property Price Index fell 5.1%, worst hit was Sydney, down 7.8% followed by Melbourne, off 6.4%, Darwin, down 3.5% and Perth, which has been in decline since 2015, which shed a further 2.5%. The ABS cited tightening credit conditions and reduced demand from investors and owner occupiers.

According to many commentators, Australian property has been ready to crash since the bursting of the tech bubble but, as this chart shows, prices are rich but not excessive: –

AMP Capital - Australian housing since 1926

Source: AMP Capital

Conclusions and Investment Opportunities

The entire second chapter of the IMF – Global Financial Stability Report – published on 10th April, focusses on housing: –

Large house price declines can adversely affect macroeconomic performance and financial stability, as seen during the global financial crisis of 2008 and other historical episodes. These macro-financial links arise from the many roles housing plays for households, small firms, and financial intermediaries, as a consumption good, long-term investment, store of wealth, and collateral for lending, among others. In this context, the rapid increase in house prices in many countries in recent years has raised some concerns about the possibility of a decline and its potential consequences…

Capital inflows seem to be associated with higher house prices in the short term and more downside risks to house prices in the medium term in advanced economies, which might justify capital flow management measures under some conditions. The aggregate analysis finds that a surge in capital inflows tends to increase downside risks to house prices in advanced economies, but the effects depend on the types of flows and may also be region- or city-specific. At the city level, case studies for Canada, China, and the United States find that flows of foreign direct investment are generally associated with lower future risks, whereas other capital inflows (largely corresponding to banking flows) or portfolio flows amplify downside risks to house prices in several cities or regions. Altogether, when nonresident buyers are a key risk for house prices, contributing to a systemic overvaluation that may subsequently result in higher downside risk, capital flow measures might help when other policy options are limited or timing is crucial. As in the case of macroprudential policies, these measures would not amount to targeting house prices but, instead, would be consistent with a risk management approach to policy. In any case, these conditions need to be assessed on a case-by-case basis, and any reduction in downside risks must be weighed against the direct and indirect benefits of free and unrestricted capital flows, including better smoothing of consumption, diversification of financial risks, and the development of the financial sector.

Aside from some corrections in certain cities (notably Vancouver, Toronto, Sydney and Melboune) prices continue to rise in most regions of the world, spurred on by historically low interest rates and generally benign credit conditions. As I said in last month’s Macro Letter – China in transition – From manufacturer to consumer – China will need to open its borders to foreign investment as its current account switches from surplus to deficit. Foreign capital will flow into Chinese property and, when domestic savings are permitted to exit the country, Chinese capital will support real estate elsewhere. The greatest macroeconomic risk to global housing markets stems from a tightening of financial conditions. Central banks appear determined to lean against the headwinds of a recession. In the long run they may fail but in the near-term the global housing market still looks unlikely to implode.

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European Bonds – warning knell or cause for celebration?

European Bonds – warning knell or cause for celebration?

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Macro Letter – No 85 – 13-10-2017

European Bonds – warning knell or cause for celebration?

  • Greek bonds have been the best performer in the Eurozone year to date
  • IMF austerity is still in place but there are hopes they will relent
  • Portuguese bonds have also rallied since March whilst Spanish Bonos declined
  • German Bund yields are up 28bps since January heralding an end to ECB QE

Writing, as government bond yields for peripheral European markets peaked in Macro Letter – No 73 – 24-03-2017 – Can a multi-speed European Union evolve? I felt that another Eurozone crisis could not be ruled out:-

The ECB would almost certainly like to taper its quantitative easing, especially in light of the current tightening by the US. It reduced its monthly purchases from Eur 80bln per month to Eur 60bln in December but financial markets only permitted Mr Draghi to escape unscathed because he extended the duration of the programme from March to December 2017. Further reductions in purchases may cause European government bond spreads to diverge dramatically. Since the beginning of the year 10yr BTPs have moved from 166bp over 10yr German Bunds to 2.11% – this spread has more than doubled since January 2016.

Was I simply wrong or just horribly premature, only time will tell? The December end of the asset purchase programme is growing inexorably closer. So far, however, despite a rise in the popularity of AfD in Germany, the Eurozone seems to have maintained its equanimity. The Euro has not weakened but strengthened, European growth has improved (to +2.3% in Q2) and European stock markets have risen. But, perhaps, the most interesting development has occurred in European bond markets. Even as the Federal Reserve has raised short term interest rates, announcing the beginning of balance sheet reduction, and the ECB has continued to prepare the markets for an end to QE, peripheral bonds in Europe have seen a substantial decline in yields: and their respective spreads against the core German Bund have narrowed even further. Is this a sign of a more cohesive Europe and can the trend continue?

To begin here is a chart of the Greek 10yr and the German 10yr since January, the Bund yield is on the Left Hand Scale and the Greek 10yr Bond on the Right:-

Greece vs Germany 10yr yield 2017

Source: Trading Economics

The table below looks at a selection of peripheral European markets together with the major international bond markets. Switzerland, which has the lowest 10yr yield of all, has been included for good measure. The table is arranged by change in yield:-

Bond_yields_Jan_vs_October_2017 (1)

Source: Investing.com

This year’s clear winners are Greece and Portugal – the latter was upgraded to ‘investment grade’ by S&P in September. It is interesting to note that despite its low absolute yield Irish Gilts have continued to converge towards Bunds, whilst BTPs and Bonos, which yield considerably more, have been tentatively unnerved by the prospect of an end to ECB largesse.

As an aside, the reluctance of the Bonos to narrow versus BTPs (it closed to 41bp on 4th October) even in the face of calls for Catalonian independence, appears to indicate a united Spain for some while yet. Don’t shoot the messenger I’m only telling you what the markets are saying; in matters of politics they can be as wrong as anyone.

Where now for European bonds?

A good place to start when attempted to divine where the European bond markets may be heading is by considering the outcome of the German election. Wolfgang Bauer of M&G Bond Vigilantes – Angela Merkel’s Pyrrhic victory – writing at the end of last month, prior to the Catalan vote, takes up the story:-

Populism is back with a vengeance

One of the most striking election results is certainly the strong performance of the right-wing nationalist AfD (12.6%). Not only is the party entering the German Bundestag for the first time but the AfD is going to become the third largest faction in parliament. If the grand coalition is continued – which can’t be ruled out entirely at this point – the AfD would de facto become the opposition leader. While this is certainly noteworthy, to say the least, the direct political implications are likely to be minimal. None of the other parties is going to form a coalition with them and AfD members of parliament are likely to be treated as political pariahs. We have seen this happening in German state parliaments many times before.

However, I think there might be two important indirect consequences of the AfD’s electoral success. First, within Germany the pressure on Merkel, not least from her own party, with regards to policy changes is going to build up. For obvious reasons, preventing the rise of a right-wing nationalist movement has been a central dogma in German politics. That’s out of the window now after the AfD’s double digits score last night – on Merkel’s watch. In the past, she has been willing to revise long-held positions (on nuclear power, the minimum wage, same sex marriage etc.) when she felt that sentiment amongst voters was shifting. In order to prise back votes from the AfD she might change tack again, possibly turning more conservative, with a stricter stance on migration, EU centralisation and so on.

Secondly, the success of the AfD at the ballot box might challenge the prevailing narrative, particularly since the Dutch and French elections, that anti-EU populism is on the decline. This could have implications for markets, which arguably have become somewhat complacent in this regard. The Euro, which has been going from strength to strength in recent months, might get under pressure. Compressed peripheral risk premiums for government and corporate bonds might widen again, considering that there are more political events on the horizon, namely the Catalan independence referendum as well as elections in Austria and Italy.

This sounds remarkably like my letter from March. Was it simply that I got my timing wrong or are we both out of kilter with the markets?

The chart below shows the steady decline in unemployment across Europe:-

European Unemployment - BNP Paribas

Source: BNP Paribas Asset Management, Datastream

The rate of economic expansion in European is increasing and measures of the popularity of the Eurozone look robust. Nathalie Benatia of BNP Paribas – Yes, Europe is indeed back puts it like this:-

…take some time to look at this chart from the European Commission’s latest ‘Standard Eurobarometer’, which was released in July 2017 and is based on field surveys done two months earlier, just after the French presidential election, an event that shook the world (or, at least, the French government bond market). Suffice it to say that citizens of eurozone countries have never been so fond of the single currency.

EZ survey July 2017

Source: European Commission, Eurobarometer Spring 2017, Public Opinion in the European Union, BNP Paribas Asset Management

The political headwinds, which I clearly misjudged in March, are in favour of a continued convergence of Eurozone bonds. Italy and Spain offer some yield enhancement but Portugal and Greece, despite a spectacular performance year to date, still offer more value. The table below shows the yield for each market at the end of November 2009 (when European yield convergence was at its recent zenith) and the situation today. The final column shows the differential between the spreads:-

Euro_Bond_spreads_2009_versus_2017

Source: Investing.com

Only Irish Gilts look overpriced on this metric. Personally I do not believe the yield differentials exhibited in 2009 were justified: but the market has been proving me wrong since long before the introduction of the Euro in 1999. Some of you may remember my 1996 article on the difference between US municipal bond yields and pre-Euro government bond yields of those nations joining the Euro. I feared for the German tax payer then – I still do now.

I expect the yield on Bunds to slowly rise as the ECB follows the lead of the Federal Reserve, but this does not mean that higher yielding European bond markets will necessarily follow suit. I continue to look for opportunities to buy Bonos versus BTPs if the approach parity but I feel I have missed the best of the Greek convergence trade for this year. Hopes that the IMF will desist in their demands for continued austerity has buoyed Greek bonds for some while. The majority of this anticipated good news is probably already in the price. If you are long Greek bonds then Irish Gilts might offer a potential hedge against the return of a Eurozone crisis, although the differential in volatility between the two markets will make this an uncomfortable trade in the meanwhile.

Back in March I expected European bond yields to rise and spreads between the periphery and the core to widen, I certainly got that wrong. Now convergence is back in fashion, at least for the smaller markets, but Europe’s political will remains fragile. The party’s in full swing, but don’t be the last to leave.