Er centralbankernes pengepolitik forsvarlig?

Are central banks pursuing sound monetary policy?
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Current and planned monetary measures by central banks may give rise to concerns about investments in real estate. In this article, we provide our take on how upcoming monetary policy changes may impact the market.

By Christopher Elgaard Jensen, Manager, Sadolin & Albæk Research & Valuation

 

Opposing views on the course of monetary policy
One of the most topical issues currently debated by economists in the world’s leading economies is whether central banks are pursuing a sound monetary policy. Monetary policy, which e.g. controls the key policy rate, may be used to influence several key macroeconomic indicators of a country’s economy. Central banks directly control short-term interest rates, whereas they can buy or sell government bonds (quantitative easing or tightening) to influence long-term interest rates directly, in addition to the implicit adjustment that follows from market expectations, also affected by short-term rates.

The below figure illustrates how monetary policy may impact the economy. Please note that the figure shows the theoretical effect. In practice, the effect is not always clear-cut. The figure lists selected factors that are, in theory, affected over time by monetary regulation.

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Are rate hikes imminent?
In the USA, the Federal Reserve is gradually raising interest rates after a seemingly persistent economic recovery with growth in consumer spending and downtrending unemployment rates. Several of the most recent key US economic indicators, however, suggest that the impact on US wage growth has been limited, with inflation staying below the target. For the same reason, the Federal Reserve has proclaimed that it will exercise restraint in terms of the originally scheduled rate hikes if inflationary expectations are not supported by solid key indicators. Indeed, the latest Federal Reserve policy meeting (FOMC) did not prompt further rate hikes, but instead raised expectations of an upcoming sale of the vast bond portfolio of some USD 4,500bn, purchased by the Fed by means of quantitative easing measures in the aftermath of the financial crisis.

In Europe, the situation is different. Several EU economies continue to struggle to maintain a stable growth momentum and lower unemployment. In addition, the full implications of Great Britain’s Brexit have probably yet to materialise. We therefore expect European interest rates to remain low, although the European Central Bank, the ECB, has hinted at upcoming monetary policy contractions, provided European economies show clearer signs of recovery. Signs of recovery are already seen in the economies of northern Europe, whereas the economies of southern and eastern Europe find it difficult to kick-start growth. The ECB is currently buying government bonds at a monthly rate of EUR 60bn. US rate hikes have been one of the factors causing long-term eurozone rates to edge up slightly, but strong demand for Danish government bonds, thanks to Denmark’s ”safe haven” status, has helped to keep Danish interest rates low.

The present historically low interest rates date back to the aftermath of the financial crisis and the credit crunch, when central banks carried out substantial rate cuts and started to buy bonds to provide liquidity to banks and other businesses as an economic stimulus to accelerate growth. However, the effect on economic growth has been limited in many European countries. Low interest rates, on the other hand, have boosted the pricing of investment assets, including investment property and stocks, partly because the yield on government bonds is less attractive in a low interest rate setting, and partly because financing is cheap. Recent increases in house prices are also largely attributable to low interest rates, allowing for more favourable terms on new mortgage loans.

There is hardly any definite answer to the question of whether the central banks are pursuing the right monetary policy. Instead, as is often the case with economic issues, it is possible to list advantages and disadvantages. The disadvantage of rate hikes is that they inflict higher loan costs on businesses and homeowners, who may be in dire straits if their budgets do not allow for a higher cost level. Rate hikes may cause corrections in the financial markets and in the property market. At the same time, rate hikes may depress favourable housing market trends as the financing of home purchases becomes costlier. In the past, we have seen that rate hikes as a response to rising inflation have resulted both in dramatic corrections in the pricing of investment assets and economic recession. But then again, rate hikes may limit possible bubbles in the financial and housing markets and give central banks greater leeway to cut rates when the next recession sets in. The advantage of keeping interest rates low is that money remains inexpensive, which may potentially have a substantial effect on the personal finances of Danish homeowners.  

Limited effect?
In brief, the pursuit of expansionary monetary policy has given banks more money at their disposal so that they have sufficient capital to grant the loans required. At the same time, banks are faced with stricter demands in terms of liquidity reserves and lending, e.g. via the Basel regulations, which is putting a dampener on banks’ lending activities. In fact, the lending volumes of domestic banks have been shrinking since the financial crisis, whereas mortgage lending volumes have been growing. In particular the combination of increased mortgage lending and record-low interest rates has driven the surge in demand for real property. 

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The fact that the expansionary monetary policy has had limited effect on real-economic growth in practice is probably due to a combination of factors. One essential factor is that domestic households have greatly increased their savings and bank deposits instead of raising their debt. This may be due to stricter financial regulation and uncertainty about the economic outlook. Low interest rates have served to provide many homeowners with higher disposable incomes and increasing equity, seemingly affecting savings more than spending, at least until 2015. In terms of economic growth, the effect has been limited. In addition, higher savings ratios serve to increase the placement requirements of institutional investors. Similarly, the effect of monetary policy is limited when demographics indicate fewer young consumers and more senior citizens with a preference for saving. This is especially the case when the latter demographic group stands to benefit from expansionary monetary policy, as this policy to a certain degree is expected to have increased the equity of established homeowners. This matters in a country like Denmark, where an increasing proportion of the population is aged 50+.

The business sector has only on a moderate scale increased its debt in order to invest in their own operations. The increase in commercial lending is apparently driven by mortgage loans, mainly via direct bond issues. This suggests that investments are placed in fixed assets and not in core business operations (except for property companies). However, since 2015, banks have seen a slight but upward trend in commercial lending activities.

Moreover, because of the low interest rates, the yield on government bonds in particular has plummeted to an unprecedented low. This has made investors zoom in on asset classes other than bonds, as clearly reflected in the overall deposit statistics of domestic investment funds.

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It is becoming obvious that low bond returns have sent investors in pursuit of higher returns. Investors have therefore turned to stocks and real property instead. Properties with great cash-flow security may act as an alternative to bonds, offering a similar low-risk profile. Among other things, this has caused a surge in investment property transaction volumes since 2011. In this context, it deserves mention that prime (first-class) properties offering great cash-flow security account for the majority of traded properties. The strong demand for such properties has driven down yield requirements, in the process driving up the pricing of this type of property, in theory equivalent to the price increases in the bond markets when interest rates are downtrending.

Will the pricing of investment property be affected?
In light of the fact that transaction volume and property pricing are gradually nearing pre-crisis levels or perhaps even higher levels, many investors may well be concerned that the market has in fact already peaked or is about to. Bearing in mind the effect of the low interest rate level, it is only natural to fear that the favourable trend in pricing and transaction activity will not continue in the prime property segment.

Although the low interest rate levels in Denmark and the rest of Europe are expected to be maintained for some time yet, it is extremely difficult to predict when Danmarks Nationalbank is expected to start hiking rates, and not least at what pace. Of course, much will depend on the ECB’s monetary policy as well as the future key indicators of economic momentum in Denmark and the rest of Europe. Provided interest rate levels remain low, we expect investors to continue to allocate an increasing share of their capital to assets other than bonds. The spread between the yield on a 10-year government bond and the net initial yield on prime residential rental properties, assets with a history of comparable risk profiles, is currently just in excess of 300 bps.

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Adjusted for inflation, the bond return becomes more directly comparable to the net initial yield on prime residential property. The fact that the net initial yield on prime property exceeds the inflation-adjusted bond return makes good sense as the spread denotes the illiquidity premium achievable when investing in real property.

In the years preceding the onset of the financial crisis, the spread between the inflation-adjusted bond yield and the net initial yield on residential property fluctuated between 0.91% and 2.30%. In 2002-2007, the spread averaged 1.68%. Today, the spread is as wide as 4.08%. The wider spread is mainly due to higher capital and liquidity requirements imposed on banks.

Even if rate hikes will make it possible to achieve higher bond returns, making this asset class more attractive in relative terms, such rate hikes may well coincide with rising inflation. As a result, the above-mentioned spread is not likely to change much. Theoretically, we believe that the current spread between the yield on bonds vs. properties with a comparable risk profile is still sufficiently wide for the current property returns to tolerate an increase of 125 bps in 10-year bond rates before the net initial yield on prime property is driven up.

For this precise reason, investment property is still to be considered a highly attractive asset class in terms of risk-adjusted returns – also when factoring in the illiquid nature of property assets. Although we do not expect the yield requirements on prime property to continue downtrending at the same rapid pace as we have seen in the past three years, we still maintain that there is room for further – albeit marginal – reductions in yield requirements, provided the low interest rate level is maintained, in light of the historically wide inflation-adjusted yield spread vis-à-vis bonds.

In addition, we do not consider a gradual and moderate escalation of interest rates a major short-term threat to the prevailing pricing mechanism in the investment property market. The greatest threat in this market is no doubt a renewed financial crisis in tandem with economic recession, which could limit monetary policy manoeuvrability as well as impact the occupational market. All other things being equal, however, that is the (probably greatest) fear of any investor, no matter which asset class the investor is exposed to.