12 minute read
No light in the tunnel yet
“Supply restraints and sanctions are hurting the economies in Europe” No light in the tunnel yet
Covid, inflation, rate hikes, war, market blowout. Recent years have seen huge economic shocks. Property markets all over the world have been hammered, also in the Nordic region. The question is whether we are close to the trough or whether the beating will continue for yet some time. Unfortunately, the risks are skewed to the downside. Real demand is falling while rates are rising. They will stay elevated also during 2023, which will slow down the eventual property rebound.
Klas Eklund, Senior Economist, Mannheimer Swartling
At the time of writing the Newsec Property Outlook for Spring 2022, inflation was rising and central banks were turning hawkish after many years of under-estimating inflation. Property markets had started to turn down. I warned that a period of uncertainty and market turbulence was likely before a new property market equilibrium could be found. But events unfolded worse than that. Just as the report was sent to the printer, Russian troops massed at the Ukrainian border. When the report was published, the invasion had already begun. As a result, oil and gas prices rose, as did the price of grain and other foodstuffs. Real income and production in Europe was hurt. Stagflation came knocking on the door. Central banks set inflation-bashing as their core priority. Now, the war has already been ongoing for half a year. Supply restraints and sanctions are hurting the economies in Europe. Key rates and short term market rates are rising, which is hurting property
markets. High inflation is undermining real income, which hits private consumption and GDP as a whole. Looking ahead, these three uncertainties – inflation, rates and real contraction – will decide the development of property.
High inflation, risk of recession
Inflation has in most Western countries reached levels not seen for 30-40 years. The inflationary impulse has come both from supply (bottlenecks) and demand (fiscal stimulus). Originally concentrated in commodity markets, inflation is now wide-spread. There are signs that some of the bottlenecks from the pandemic are easing, lowering that inflationary pressure. However, as gas deliveries from Russia to Europe are being cut off, gas prices are rising – and as a result electricity prices follow suit. Term contracts are sky-rocketing, indicating a winter with inadequate access to electricity and falling real income.
This will not have a great impact in the US, where inflation probably has peaked, but it will push up inflation in Europe further. It is probable that inflation will reach 9–10 per cent for the Euro area as a whole; in the UK it will rise to some 13–14 per cent or even more.
It is obvious that central banks have made severe policy mistakes, underestimating inflation, claiming it would be low and transitory. Now they have to make up lost ground and regain trust, which means hiking rates quickly and high. The Fed has hiked in big steps, and the ECB is following. In summer, the ECB hiked its key rate for the first time in 11 years – and for the first time ever by 50 bps. More big steps will follow.
We are now in uncharted territory. However, it is possible now the Fed hiking cycle will reach its peak as early as this winter, as the American economy slows down and hovers on the brink of recession. In summer, bond markets rallied on that hope, but the Fed has quenched that optimism and stated it will pursue its hawkish stance. Negative yield curves indicate that markets are pessimistic about future growth. It is yet, however, an open question how much unemployment must rise to defeat inflation.
• The US economy is in better shape than Europe’s, but several independent economists are still pessimistic that considerably tighter policy and an ensuing recession will be necessary. An inflation rate this high has never been defeated without a recession.
• Europe shows slower productivity growth, worse employment numbers – and is much more vulnerable to the Russian gas weapon. High inflation will cut into real income and cause private consumption to fall. The UK is in a particularly bad spot, due to slow productivity growth and negative Brexit effects. Euro zone GDP growth will probably come in at just a crawl during the winter and spring of 2023. Some quarters will show negative growth. An outright recession is likely in Germany and some Eastern European countries.
Fiscal policy might help alleviate the pain, e.g through direct subsidies to households, to compensate for high electricity prices. However, such benefits come at a cost – not only supporting Russian exports during the war but also hurting government finances. Government debt will rise, and the ECB will need to support countries where the bond yield spreads rise – and create future problems.
Market developments
In spring, bond yields rose sharply, anticipating key rate hikes. The blow-out in international bond markets was the worst for several decades. But in summer, yields actually fell back. The reason was central banks taking a tougher anti-inflationary stance, giving some hope that inflation will fall back next year and short-term rates may peak early. The other reason is the risk of recession, which clearly has increased. However, markets were too quick; central banks still need to continue tightening policy. After some hawkish speeches from the Fed and the ECB, yields moved up again. The volatile path is typical of a market still shrouded in deep uncertainty – and will remain there until more clarity has been won over the development of inflation, rates and real growth. Even though both short-term and long-term yields may peak during winter, they will only slowly fall back. Stock markets fell in spring but rebounded in summer, partly courtesy of good quarterly reports from many companies, but also for reasons given above: hopes that the period of rate increases will soon be over. Once again, I would like to warn of too strong rebound hopes. High inflation and key rate hikes normally hurt stock markets. As bond yields move up, stocks will show continued vulnerability. In this environment, property has suffered, just about everywhere. Increasing rates and rising costs have hurt both construction and prices. In most European countries, we have seen a slowdown, after several years of rapid rises. Still, property as an asset class has fared better than both bonds and stocks – which is what we should expect as real yields (which have fallen) are more important. But in e.g Sweden prices of houses and flats are actually falling. The reason is that property markets
were more vulnerable in Sweden than in most countries, given high household debt. Given the scenario pictured above, it would be surprising if the trough is reached soon.
The Nordics
The Nordic region showed great resilience during the pandemic. Throughout the initial phase of the Ukrainian war, the Nordics also did well. But inflation is high in all countries. It will fall back in 2023, more markedly in Norway and Finland, more slowly in Sweden and Denmark. The real economies will slow, and the region as a whole will suffer a rather mild recession. Denmark and Sweden will show the weakest real development, because of the need to cool off an overheated economy. Norway will – as always – be the strongest performer, courtesy of oil and gas revenues. Monetary policy will differ between countries, as monetary regimes differ – Finland is a member of the Euro zone, Demark has a fixed exchange rate to the Euro, Sweden is an EU member but with a floating currency, while Norway is outside the EU. Housing markets will decline for some time yet. Sweden For a long time, Sweden‘s monetary policy was an outlier, the Riksbank pursuing negative rates and massive QE at the same time. The wake-up call has been brutal, with the Riksbank having to make up lost time by delivering big hikes, fast and high. This in a situation when growth is slowing and GDP forecasts point to more or less zero GDP growth in 2023. High inflation and stagnant real growth means that disposable income falls dramatically. Higher rates and falling real income means high-debt households will suffer. Add to that rising construction costs and sharply higher electricity bills, and of course the housing market will fall. In summer, house prices and flats fell by almost 10 per cent. Given the macro backdrop, housing prices will fall further.
Commercial property is not as vulnerable since companies can compensate and react to problems more actively than households. But more expensive funding will hurt profitability. Real estate companies have been hit hard on the stock market. Yields will rise for the first time since the Great Financial Crisis in 2008–09, mirroring rising interest rates. Consolidation of the sector will continue, as weaker companies are bought by stronger ones. Denmark Denmark experienced the strongest bounce-back in the Nordic region after the pandemic. GDP growth has been strong and inflation is high – it may actually peak at an even higher level than in Sweden. Consumer confidence has collapsed, which will have negative consequences for consumption. Construction has been an important growth engine, increasing its share of GDP. This rapid rise, however, means that the fall – which has now started – can become unpleasant. Denmark’s central bank will continue to shadow the ECB in order to keep the currency stable. Rising rates and falling real income will lead to a cooling-off of the economy. Tight fiscal policy
will exacerbate the effects. The over-heated labour market will weaken and see rising unemployment. Negative GDP growth in 2023 is a clear risk.The property market was strong in the first half of 2022, with a high level of transactions, largely driven by foreign investors. The worsening macro environment and rising interest rates have recently made investors more cautious, but growth has held up well so far. Norway Norway has been on the verge of over-heating, with a strong property market, fuelled by oil and gas revenue. Inflation is high, but not as high as in Sweden or Denmark. One reason is that the Norwegian krone has performed better than the Swedish, meaning Norway does not import as much inflation. Wage increases have been rapid, the labour market is tight. All this has caused Norges Bank to hike earlier and faster than her neighbours. No surprise, since Norway has a tradition of higher rates, caused by the perennial inflation risk emanating from the oil sector and an overheating property market. Also during this cycle, the key rate will be lifted higher than in Sweden – and much higher than in Finland and Denmark, where the ECB sets the pace. Mortgage rates will, consequently, rise more than in the other Nordic countries.
The Norwegian property market has been exceptionally strong in recent years, also during H1 of 2022. Housing prices continued to rally. But tighter monetary policy and a slow down of the economy will have negative effects on real estate. The transaction market is thus now weakening. Prices will cool, but not fall as deeply as in Sweden or Denmark. Finland Finland started 2022 on a strong note. The economy has shown surprising resilience to both covid and the invasion of Ukraine – so far. But harder times are now arriving. As the war in Ukraine drags on, this will cause increasing problems in Finland, who has been more dependent on Russian gas and trade than the other Nordic countries. Supply bottlenecks are pushing up inflation, and – as in the other Nordic countries – household confidence is hurting. This will lower consumption growth. Also in Finland, monetary policy will cool off the economy, but as Finland is a member of the Euro zone, and the ECB sets the key rate, the hikes will be smaller than in Norway and Sweden. But recession is looming for 2023 and construction will slow. The property sector performed well in H1 2022, despite the war. Transaction volumes saw record highs propelled by megadeals. However, the environment is getting more challenging and yields will probably rise. Construction in the property sector is falling.
The Baltics The three Baltic economies have gone through wild gyrations in recent years. They were hard hit by Covid, then made an impressive comeback, entering 2022 with strong growth, in particular in Estonia. Labour markets are strong in the region, resulting in rapid wage hikes. But now they are all suffering from the Russian invasion of Ukraine, as well as from Western sanctions. Russia has traditionally been an important trading partner, but now trade with the big Eastern neighbour is falling sharply. GDP growth will fall sharply in all three countries this year, and in 2023 it will hover around zero in both Lithuania and Estonia. Latvia may fare better in 2023 – at the cost of higher inflation. Supply disturbances and rapid wage increases are pushing up inflation to extreme levels – some 17–18 per cent this year in all three countries. Monetary policy will tighten, but since the ECB sets its rates based on the economy of the Euro zone as a whole, the expected hikes will not be sufficient to stop inflation. Also next year, inflation in the Baltics will be much higher than in the rest of Europe – probably some 6-8 per cent, even higher in Latvia. So stagflation will characterise all three countries.
Conclusion
In the spring Newsec Property Outlook, the forecast rested on the assumption that monetary tightening would be gradual and that housing markets would cool, but in a measured way. Those assumptions have proved to be wrong. The war hit, inflation rose further – and central banks abandoned the gradual approach in favour of swifter tightening. We are now back in a scenario where inflation-bashing likely will lead to recessions in many countries, including the Nordics and Baltics. As a result, housing markets have fallen.
The long-term question is when – or rather whether – inflation and interest rates will fall back to the low levels of recent years. Here, the jury is still out, but the tendency is that forecasters have become more pessimistic. Inflation has become increasingly entrenched and it will take some time to stamp it out – and only at a higher cost. Global savings will probably remain high, which speaks in favour of low real rates. But supply disturbances because of war, protectionism, “decoupling” and sanctions will linger for some time. Thus, we probably should assume that inflation will stay above central bank targets for at least another two years. As a result, key rates will need to stay above neutral levels for some time. This would mean that the rebound of property markets will be slower than during the covid years.
