CIO Viewpoint

In October, core inflation in the Eurozone slowed to a five year low of 0.4%, remaining consistently below the European Central Bank’s target of 2%. This is perilously close to zero and raises the fear of deflation. Not surprisingly, the ECB has acted by cutting the main lending rate from 0.15% to 0.05%. At the same time, it has also increased the negative deposit rate to -0.2% p.a., the interest (or cost in this case) which banks have to pay for depositing money with the Central Bank. The whole idea is to provide a monetary stimulus to ward off deflation and boost growth. But if deflation does come about, holding cash could be seen as attractive given that its purchasing power improves over time as prices fall.

There are good things and bad things about deflation when it comes to property investments. Persistent deflation is bad. You just need to look to Japan where property prices are still below their 1989 peak by some 32% while both rental and land values are around 50% of those 1989 levels. Although there were cycles in between where real estate outperformed the other asset classes, over the whole period property did worse than bonds but better than equities. The clear message from this is that growth orientated priced stock will underperform compared to the bond biased equivalent. Real estate, which itself is a hybrid of the two, can have counterbalancing qualities but it would best to bias yourself towards the bond characteristics, particularly where the threat of deflation is the greatest. Prime property in core locations, by nature, fits this bill. Despite the keen pricing, there may be some merit in still holding core real estate rather than chasing the value-add and/or opportunistic investment where future growth is required to justify today’s pricing. In the main economies of western Europe, Italy and Spain are the countries which are already exhibiting deflation. Other countries where the rate of inflation is dropping fast include Sweden, France and Belgium. In the case of Sweden, its central bank only last week cut interest rates to zero to try to curb the threat of deflation.

The problem with Europe is that it is still saddled with weak economics such as high unemployment, relatively weaker consumption and muted investment. Although a generalisation, there are very few countries to choose from where this is not the case. Deflation in this environment, where economic growth is constrained, requires a boost of quantitative easing of some sorts. This may be forthcoming via a declining currency and the ECB’s target to leverage its own balance sheet (again) but this will take time and therefore prime property with bond type characteristics is seen as the safer, more prudent option.

But there is also good deflation such as some of the things we are encountering in the UK for example falling transport costs, food prices and the prices across a range of recreational goods, including laptop and tablet computers. And although UK inflation is low (1.2% in September) and trending downwards of late, it has been in an environment where the economics are not poor. On the contrary, unemployment is low at 6%, retail sales are running at just under 3% and the Purchasing Managers’ Index is one of the highest in Europe, thus giving credence to continued GDP growth. Rather than chasing prime property in the UK, the case for value add and opportunistic investing may be more compelling where the likelihood of (rental) growth is that much greater.