The Bank of England on Thursday raised the base rate by 0.5% to 5%, the highest level since 2008. The move came a day after the Consumer Prices Index for May showed core inflation had accelerated again, reaching the highest level since 1992. Debt markets have repriced sharply and the UK's economic outlook is now acutely uncertain. What does this mean for investors? Here are our top five themes to consider as you position your portfolio for the future:
- The economy is yet to feel the full impact of higher interest rates
The stronger-than-expected inflation data for May prompted the Bank of England to raise Bank Rate from 4.50% to 5.00% in its June meeting. The surprise 50bp rate hike sent a clear message that the Bank is trying to get back on the front foot in tackling the UK’s persistent inflation problem.
With a tight labour market contributing to stubbornly high core inflation, the Bank will need to increase interest rates further to stamp out inflation. As a result, markets are pricing in a peak in Bank Rate of 6.25%, which would likely send the economy into a recession.
- Risk-free rates to stay higher for longer
The recent run of stronger-than-expected macroeconomic data has led to a wholesale re-appraisal of the path for Bank Rate. This has had a significant impact on long-term debt costs. 10-year gilt yields rose from just over 3% in March to near 4.5% at the end of June, which is in line with the mini-Budget peak seen last Autumn.
We anticipate inflation will be sticky and remain above its 2% target throughout 2024. This means the Bank will need to keep interest rates higher for longer, which points to 10-year Gilt yields holding close to their current levels for the remainder of the year.
- Loans to remain more expensive than the income to cover them
Three months ago, we had hoped that we were starting to see signs of the fall in capital values bottoming out. In light of the surprise upside to inflation and further acceleration in increases in interest rates and debt cost, the market is now likely to take longer than initially thought to reach the bottom.
The 5-year SONIA Swap Rate – a crucial metric for pricing loans - has reached as high as 4.8%. This has pushed all-in debt costs for prime office assets to over 6.5%. For leveraged investors the current prime yields remain unattractive, since these are below debt cost even at a reasonable LTV level. As such, we believe the market is poised for further outward yield shift.
- Pricing uncertainty is likely to be widespread for longer, but with that comes greater arbitrage opportunities
The property market has switched from the sellers’ market of the last ten years to a buyers’ market. That dynamic is likely to shape market outcomes in the immediate future. Investment into commercial real estate remains relatively low this year. The brief rebound in Q1, following an unprecedentedly quiet Q4 in 2022, lacked sustained momentum. Provisional H1 data reveals volumes are around c.49% of the 10-year H1 average.
There remains a gap between what some sellers want and what some prospective buyers are willing to pay. Sellers will move first driven by the reality of the market. This standoff could begin to ease as sellers read the writing on the wall and start bringing more stock to the market. The nature of this uneven approach to repricing by sellers means that active investors will find there are attractive deals before competition picks up significantly, though it’s worth noting buyers will be slow to return to the market in meaningful numbers until there is more certainty over when monetary policy will pivot.
- New investment parameters - this time it really is different
It’s tempting to draw comparisons between this period and 2008, but there are three critical differences:
- The current correction in the market is being driven by cost of finance and not lack of debt/liquidity as was the case in 2008. This means that the market today can reactivate quickly once rates stabilise.
- Due to relatively low LTVs in the market, we are not seeing the market flooded with assets, therefore generating over supply in the market, as in 2008. Today, it is the high cost of finance that the tilting the demand/supply balance.
- Occupier demand for the very best modern buildings remains competitive because oversupply does not exist. Excess construction in the run up to 2008 was central to the following market correction, and the market saw landlords entering into incentive bidding wars to secure leases. Whereas today, the market is coming off a 10-year cycle of low supply, and so occupiers face comparatively less choice.
