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Twist again

MONTHLY INVESTMENT BRIEF

April 2021

 

Laurent Denize

Laurent Denize,
GLOBAL CIO

The central question now remains to know when the FED will decide to intervene, either through rhetoric or action

In recent weeks, bond investors have suffered slight capital losses and are wondering about a more significant rise in long-term rates which would have a more significant impact on portfolios. This question is particularly legitimate since a sustainable rise in rates would not only affect the equity markets but also the real estate market.

How big is the global real estate market?

The $90 trillion global stock market is significant. However, this figure remains more than three times smaller than the $300 trillion global real estate market. Real estate valuations may seem stretched relative to other assets and relative to historical data. But, clearly, the continued high valuations of global real estate have been driven (at least in part) by the continued low level of bond yields. If higher bond yields were to lead to even a 10% decline in property values, this would represent a $30 trillion drop in global wealth. Such a deflationary impulse, equal to one third of global GDP, would totally wipe out the temporary inflationary shock we are about to experience.

So should we be worried about an inflationary shock, when the consequences of a rate hike on the world economy would lead us fairly quickly into a much greater deflationary spiral?

The true risk is real estate

Over the past decade, global property rents have broadly followed nominal GDP, as expected. But property prices have far outpaced the rate of increase in rents. In fact, the price paid for these rents has jumped by 35%. This multiple expansion of real estate, which has added $80 trillion to global wealth - equivalent to the world's GDP - is mainly due to falling bond yields

In the global real estate market, the residential segment accounts for 80% of the value. Commercial real estate (offices included) accounts for just over 10% and agricultural and forestry real estate makes up the rest.

The real estate boom has mainly been the housing boom. Since most housing is owner-occupied (except for Germany), the boom in property prices has increased the wealth of the ordinary global citizen far more than the rise in share prices.

Moreover, the housing boom of the 2010s was unprecedented in its regional penetration and scope, simultaneously encompassing cities, suburbs and rural areas in North America, Europe and Asia. Even Germany and Japan participated, making it the largest real estate boom in economic history. The key question is where the turning point lies.

What 30-year interest rate in the United States or China could lead to a reversal of the trend?

Hard to say, but Freddie Mac recently reported that the average rate for a 30-year fixed rate mortgage has risen to 3.02%. After several consecutive weeks of increases, this is the first time that the rate on America's most popular mortgage has exceeded 3% since July.

The FED cannot remain insensitive to this phenomenon of long-term rate tension that could derail the recovery. Under the code name "operation twist", it has the means to intervene on the yield curve by buying long-maturity bonds rather than short ones. The central question now remains to know when the FED will decide to intervene, either through rhetoric or action. At the speed at which rates are rising, this moment may not be far away...

 

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