“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.” Warren Buffett
Gravity is back. This quarter we discuss how the markets are awakening to the new reality of significant increases in the cost of capital and inflation eroding purchasing power. Ten years of yield suppressing quantitative easing is coming to an end as central banks wrestle to tame inflation. Even Westminster couldn’t escape the forces of gravity as the weight of public discontent forced Boris Johnson to accept reality and resign.
Within the quarter, we witnessed the manifestation of the risks we have been discussing over the past six months. As we wrote in January, increasing interest rates has led to a sell-off in risky assets. In April, we discussed the impact of the energy crisis on the global economy and the unfortunate predictions that the alternative energy transition is not yet able to cushion the impact of the disruption caused by the Ukraine conflict. Both trends will continue throughout the year, raising the possibility of a recession in most developed economies. Looking forward, central bankers now have to pick their poison as they attempt to tame supply led inflation with demand tapering monetary policy. With a generation of consumers only knowing low rates and the average global debt to GDP ratio at 256%, it is a very different world to when Paul Volker addressed US inflation in the 1980s.
In the real estate markets, we focus on the Residential sector, noting its defensive capabilities, developing UK market and pricing pressure on mortgage costs. Looking at retail, we discuss how the cost of living and fears of recession will impede its recovery however its recent rebasing should limit further downward pressure on valuations. The office market continued its recovery for most of the quarter, despite the likelihood for an increased demand for hybrid working. However, in June, activity reduced in line with the deterioration of the wider macro environment. Our view on the industrial market has only been emboldened by recent market activity. Fears over demand reduction and a rising yield environment will place significant pressure on logistics assets. Notwithstanding the challenging macro environment, active management strategies should thrive as fear and emotion detaches prices from true value.
In summary, this report reflects the deteriorating position of the global economy and the stark realisation that markets will not sustain their pricing as the cost of capital increases. The optimists view would include a resolution to the conflict in Ukraine, a reduction in political disruption across the world and reduced supply chain pressures. However, the accumulation of negative factors weighing on the world economy forces us to give a strong health warning for most investment markets.
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