14 minute read
From pandemic storm to inflationary headwinds
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Klas Eklund, Senior Economist, Mannheimer Swartling
After two years of wild swings, in 2022 the global economy was supposed to return to normalcy. However, we now face a new uncertainty: the return of inflation. Will price increases fall back or will they prove to be more persistent? The answer decides central bank actions and how much interest rates will climb. A gradual move in step with somewhat higher inflation is not problematic; it can be seen as a much-needed normalization, still from an historically low level. But a more abrupt move would cause turbulence in financial markets – and in the property sector.
My view is that rates will indeed climb and create headwinds. Still, real rates will continue to stay low, since long term factors like global savings and demography will stay in place . From a fundamental perspective, property still looks like a good long-term investment, although not as spectacular as during recent years. But market uncertainty and turbulence are likely on the path to a new equilibrium.
In the Nordic region, economies are strong. All Nordic countries emerged from the pandemic with rather small economic injuries and with strong property sectors. The stage is set for a year of good growth as economies open up. Also the Baltics are now recovering quickly. But also in the Nordic/Baltic region inflation and interest rates will constitute headwinds before a new equilibrium is reached.
A strong recovery
Despite Delta and Omicron the economic recovery was strong in 2021. China led the way with 8 per cent GDP growth, US growth was not far behind with 6 per cent. Even the stodgy Eurozone grew by 5 per cent. The main reasons were rebounds after the horrible year 2020, and the roll-out of vaccine.
Trade met disturbances as supply chains were hurt by lockdowns and lack of shipping containers. In certain sectors, e.g semiconductors, shortages caused ripple effects along several industries. Nonetheless, world trade →
did rebound strongly, and the global economy showed resilience.
The main problems have instead come from energy supply and energy prices. A perfect storm emerged with simultaneously rising prices for oil, gas and electricity. This pushed up consumer prices in all countries and real income took an unexpected hit.
In the autumn edition of Newsec Property Outlook I wrote that most of the uptick in prices was caused by transitory factors and that inflation would fall back in 2022. However, I also added that the major risk to this benign picture was the risk that inflation would stay elevated for a longer time, and that central banks would react by hiking key rates more rapidly, with the ensuing risk that markets – including property – would be rocked. I now must admit that what I saw as the main risk scenario has become the main scenario. Inflation has spiked, central banks are being forced to react and the future has become more uncertain again.
Inflation is back!
In all regions, inflation has returned with a vengeance. In the US, it is over 7 per cent, in the Eurozone around 6, in the Nordic countries 4–6 per cent and in the Baltics even higher. These are the highest inflation numbers for decades.
Supply disturbances have been a driving force. We have also seen strong increases of energy prices across the board. Energy price increases have been particularly strong in the Euro zone. Most central banks initially claimed that the inflation uptick is temporary and will fade as energy prices first stabilise and then fall, while supply disruptions after the pandemic gradually heal.
But the situation has become more troublesome. In the UK, labour market disturbances have been exacerbated by Brexit. In the US a strong demand impulse was injected by the generous fiscal stimulus last year, contributing to a shrinking of labour supply as many workers left the labour force. At the same time the Fed sent out signals that the central bank would welcome inflation above target and a “red-hot” labour market.
As labour supply fell and inflation rapidly rose, they got what they asked for and then some. Cost pressures now are pushing up wage compensation claims, and inflation expectations are
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rising. As a result the Fed by year-end scrapped all talk about inflation being “transitory” and in a swift U-turn returned to traditional inflation-bashing rhetoric.
Both the Fed and the Bank of England (BoE) have now set out on paths with quantitative tightening (selling securities) and rate hikes. The ECB has sent out signals that it, also, is about to embark on a more rapid pace of tightening, tapering its asset portfolio and then hiking the refi rate, maybe already this year.
Market nervousness
This has troubled financial markets during the start of of 2022. Bond yields have risen and stock markets wobbled as investors try to adapt to a new reality, with higher inflation and higher rates. Valuations have to be re-calibrated.
This process will take some time, simply because it will take time before we know the trajectory of inflation and central bank reactions. What is clear is that the inflation peaks of this winter automatically will pull up inflation numbers also for the whole year of 2022 because of base effects. Furthermore: the longer inflation stays elevated, the higher the risk of contagion to other sectors, such as food and wage costs. High inflation means real wages suffer and consequently compensation wage claims may rise, not only in the US but also in continental Europe and the Nordics.
Central banks are turning hawkish
Consequently, more central banks will switch to tightening mode. From a fundamental point of view, this should not really be much of a problem. For too many a year our countries have lived in fear of deflation, with historically low interest rates, both real and nominal – causing asset markets to rise to unprecedented heights. As both inflation and interest rates rise, this may be regarded as a start of normalisation back to an economy on a more sounder footing.
But markets rarely adjust gradually. More often, they react in spats and jerks, driven by fear and greed. So market rates jump – often too much – and force monetary tightening to move ahead faster than was priced in at the beginning of this year. This is happening now in several countries. Consequently, there will be continued volatility and financial headwinds before markets settle down in a new equilibrium.
Longer term, the main forecast is still that inflation gradually falls back – albeit from a higher level and more slowly than would be optimal. The new equilibrium will be characterized by low real rates. The global forces which have pushed neutral real rates to historical lows are still in force, not least ageing populations and high savings rates.
What we see today is therefore probably not the start of a new 1970:s period of stagflation with high inflation and high rates. But even so, we may be in for a period of adjustment, which may become painful to some investors.
Property markets
In this situation, also property markets will meet headwinds in the short term. But they will be weaker than for stock markets. Margin calls and derivatives do not play the same destabilizing roles as for stocks. For housing, rising mortgage yields probably will hurt some households who cannot compensate increasing nominal costs with increasing income. But this change is starting from a very low trough and most households will not feel the pinch that strongly. Longer term, the neutral real rate is more important than short-term nominal fluctuations.
Commercial property generally is in a more benign situation, as real yields are more important than nominal ones – and real yields will stay historically low as both nominal yields and inflation rise. Liquidity will continue to be strong and the volume of transactions are likely to stay elevated, but perhaps not breaking new all-time highs.
Different segments of the property markets will face very different conditions. Retail is squeezed, and the pandemic has speeded up the transition to e-commerce. Logistics, on the other hand, is gaining from the same transition. The office market is subject to divergent forces, where some employers will want to downsize, while others need to upscale their premises. Rental will stay more stable as the revenue flows change only gradually.
The Nordics
The Nordic region’s economic performance during the pandemic was outstanding. After the initial dip in 2020, all the Nordic countries have outperformed the Eurozone and the UK – an interesting and unexpected common result, since health strategies and stringency measures varied →
between countries (where a high death toll stood out in Sweden). GDP surpassed the pre-pandemic level early in the year, government finances have been robust and labour markets are strong.
One reason may be that the Nordics are not as dependent on tourism as Southern Europe. Another can be that health care is universal and of high quality, and that vaccine was rolled out swiftly. Now that economies are opening up again, recovery in the service sector will support a year of good growth, albeit not as spectacular as in 2021. Growth rates will be above potential, but gradually taper off during the course of the year.
The challenge of inflation and the risk of over-heating labour markets is common for all countries in the region. But it will be met differently, not least because of different currency regimes and monetary policy strategies.
Norway As usual, Norway leads the way towards higher inflation and higher rates. This is what we would expect, since Norway traditionally shows higher price pressures from her large off-shore sector and, consequently, tighter monetary policy. Norges Bank is both formally and practically independent from ECB and is now using that independence to push up its key rate faster than her neighbours. A shift of governor by year-end is not expected to change monetary strategy.
Hiking has already started and will continue throughout this year and next. One reason is the risk of over-heating, both of labour and property. Unemployment has fallen from 10 per cent to just 2 per cent, and high oil prices assure a massive inflow of purchasing power. As result, the scramble for labour is intense, and labour unions are pushing for wage increases.
These factors speak in favour of higher house prices, but tightening from the central bank aims to stifle such increases. Despite strong macro fundamentals, the housing market will therefore cool during 2022.
Denmark Also the Danish labour market is tight, on the verge of over-heating. Unemployment is only 3 per cent. Recruiting people with the right skills is increasingly difficult. As resource utilization is strained, strong real growth and bottle-necks in the labour market tend to push up both wages and the general price level. Construction has been strong with a rapid increase of housing starts.
As the economy opens up after restrictions, Denmark will show good growth and inflation will stay above the target. The Danish krone is, however, pegged to the euro, which means that the central bank – contrary to the Norwegian – will not run away on its own but will shadow the ECB. Only minor deviations of key rates are possible, to ensure currency stability.
Sweden The Swedish export sector has performed well during the pandemic. As the economy now opens up, services will bounce back and help propel both employment and income growth. Private consumption will be boosted as the high household savings ratio probably will fall somewhat. The Swedish labour market is different from the other Nordics in the sense that it is clearly divided. A large portion of the labour force has difficulties being integrated into the regular labour market, and almost half of the unemployed are structurally, long-term unemployed. On the other hand, the regular labour market is over-heating and vacancies are reaching record numbers. Demands for higher wages in manufacturing are starting to emerge as a result of over-heating and as compensation for high inflation cutting into real wages.
Inflation is high, but the Riksbank claims it is temporary, driven by energy prices which will fall back. The bank has vowed to keep the repo rate at zero for two more years. Markets, however, expect that the bank will have to change course and tighten earlier. Soft monetary policy will support the property sector a while yet, but over the year as a whole headwinds from inflation and future rate increases will make the property sector somewhat cooler than last year.
Finland Also Finland is in the midst of an upswing, driven by manufacturing and construction. Parts of the service sector are lagging, but are expected to catch up as the economy opens up again. Here, the scope for growth is high, as the room for pick-up in services is large.
The upturn of the economy has brought the same side-effects as in the other Nordic countries: inflation and labour shortages. The housing market has been thriving, in particular larger houses and apartments have gained from pandemic-induced demand.
As Finland is a member of the Eurozone, monetary policy is set by the ECB. The ECB will start its tightening process earlier than previously said, next year for sure, possibly even this year. The housing market will cool somewhat.
The Baltics
The Baltic region was hit by a severe wave of the Covid Delta virus. Nonetheless, economic recovery has been swift, in particular in Estonia. Inflation has risen sharply, and by the beginning of this year was close to the 10 per cent mark in all three countries. The reasons were the same as in their Nordic neighbours, i.e primarily rising energy costs. Wages have followed suit, driven by compensation claims and bottlenecks in the labour markets. Monetary policy is set by the ECB, meaning a tightening could start this year.
The Baltic countries should also be noted for the geopolitical risks. With Russia massing troops along the Ukraine border and hurling threats against NATO, the Baltic states – all three of which are NATO members – have been caught in the crossfire. The economic effects will be negative, due to more expensive gas imports and sanctions imposed by the US. At this stage, however, it is impossible to quantify the outfall since the geopolitical and military outfalls are unknown.
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Conclusion
The Nordic and Baltic countries have weathered the pandemic storm better than feared. This holds also for property markets, who have boomed. Looking ahead, the challenges will be to weather the inflationary storm. Inflation will fall back gradually, but probably more slowly and from a higher level than central banks have expected.
In all countries the central banks will gradually tighten monetary policy, most rapidly in Norway. In the other countries monetary policy will be set by the ECB, or in the case of Denmark and Sweden by central banks who normally follow the ECB closely. The Swedish Riksbank will be the laggard.
This means that tightening will be gradual, not in itself causing havoc. Fundamentals speak in favour of a gradual cooling of a hot property market. Commercial property is not as vulnerable as the housing market, since real rates will still be negative for some time yet. In general, the Nordic property market also will be supported by capital inflows from other countries and non-Nordic investors.
What if?
Just as this report is sent to the printer for hard copies, Russian troops are massed at the Ukrainian border and preparations are made for an invasion. The analysis in this chapter, however, does not include any serious effects of a hot war.
But military action will cause severe disruptions in Europe. For one, commodities prices will rise further. Oil, gas and grain prices will move up. The result will be higher prices on electricity and food in most of Europe. At the same time, trade restrictions will cause a setback of production and income in several countries, not least Finland and the Baltic states. This puts economic policy in a difficult situation, where stagflationary forces pull policy in different directions. Higher inflation calls for tighter policy, but blows to production and income calls for support. The path chosen will depend on the severity and length of the war.
Stock markets will fall, most dramatically in Russia and Ukraine. Property markets will be less affected since the investment horizon is longer and they are more dependent on real rates. Cyber attacks may wreak havoc in important sectors, sanctions such as blocking Russian banks from the international payments system would hurt not only Russia but also her trading partners. At this stage, however, it is not possible to formulate any quantitative assessments of these shocks.
