Peter Verwer |
Monday, 2 May 2011 1:25 PM |
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In this year of disasters we’ve been shocked by black swans – disruptive forces such as earthquakes, floods and tsunamis that trash fiscal and monetary policy tweakings, as well as exquisitely calibrated asset allocations models.
However, inflation is more your common or garden (or lake) white swan. We can see it gracefully gliding toward us, but fail to register that this time it’s equipped with knuckle dusters and a taser.
After spending the past few days in China, it’s clear the mega threat to world economies is a new era of inflation, similar to the contagion that erupted after the two major oil shocks of the 1970s.
Some notable economists believe the post oil shock era is the best guide to the investment performance prospects of property assets.
Let’s start with China.
During this last cycle of global economic growth up to the GFC, China exported disinflation. It helped meet the West’s exuberant demand for commodities at a far cheaper cost of production than high wage, high taxing developed nations.
However, in the words of one Communist Party official who spoke to a captive property audience at the recent APREA conference in Beijing, “China is big, but not strong”.
The thrust of China’s 12th five-year plan focuses on domestic demand, rather than export-driven growth.
The snag is that prices are already rising in China, due mainly to its burgeoning middle classes and the wage growth demanded by a newly urbanised workforce.
It was fascinating to hear Communist Party bigwigs directly referring to human rights in the context of wages policy. While there was lots of speechifying about a “harmonious and inclusive future”, it was easy to read between the lines.
China’s solution to the political disruptions of the Middle East is to pay its workers more and encourage them to stimulate their home-grown markets by purchasing local goods and services. But that makes China more expensive and reduces its competitive advantage over the West.
China’s official response is price controls, regulation (of residential real estate, in particular), higher capital reserve ratios for its banks and some currency flexibility.
However, that doesn’t make food cheaper or decrease the price of oil. It doesn’t deal with tens of millions of unemployed and under-employed Chinese workers.
While last months’ startling headline inflation figure for China was 5.4 percent, the cost of food and staples rose by more than 11 percent.
In short, China (and many other Asian countries) face a classic wage-price spiral.
We also need to consider the massive debt the West has racked up in response to the GFC.
Politically, it’s nigh on impossible for governments to tighten their belts by the required notches. It’s also politically ‘courageous’ to persuade citizens to accept higher taxes to write more bail-out cheques.
In this light, inflation is an attractive temptress for governments because it eats into the mountains of public debt and helps them juggle their books.
This may be one reason why official inflation statistics generally underestimate real price cost increases.
The United States doesn’t even include food or energy costs in its consumer price index.
The upshot is twin inflation drivers: a wage-price vortex and weak governments that fail to encourage productivity improvement, labour market flexibility, liberalised trading markets and spending discipline.
What does this disturbing new age of inflation mean for the real estate industry? Basically, there’s good news and bad news from the growing literature on this topic.
An inflation hedge will outpace both increases in prices and inflation-linked Treasury bonds.
Many think a true hedge will also move in lock-step with inflation – CPI goes up, investment performance rises in sync.
Finally, an inflation hedge should continue to provide steady income streams. In technical terms, that means a low Sharpe Ratio (excess returns divided by volatility).
On the plus side, property prices tend to strongly correlate with economic growth (unlike equities). Lease covenants often contain inflation protection clauses that build on CPI.
A recent NAREIT study of property returns showed that REITS easily outperformed inflation and other asset classes over the medium to long term.
On the flip side, another recent study by the Investment Property Forum in the UK says property returns might outperform inflation increases, but don’t hedge them – that is, returns don’t move up at the same time as inflation.
In addition, highly leveraged property is easily bruised and bloodied by the interest rate stick that governments brandish to fight off inflation.
A new study into the relationship between inflation in property investment performance in eight major Asian property markets released at the APREA conference raises perverse conclusions.
There is no short-term correlation between property performance and inflation, and thus no hedge.
However, property is co-integrated over the long term (10 years) – that is, property return and inflation indexes share common long term fluctuation profiles.
The APREA study also concluded that the extent of hedging depends on the economic and market dynamics of individual cities.
Maybe this is another argument for investors to take a longer-term perspective and give greater attention to research into stock/asset selection in specific markets.
Peter Verwer |
Monday, 2 May 2011 1:25 PM |
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