Irrespective of whether the yield curve can forecast recession, for investors in real estate and other assets, it is wise to constantly consider the impact of different future economic scenarios on their portfolio.
The inverted bond yield curve may or not be useful for predicting the likelihood of recession, but it is worth noting that the last time the curve was inverted, in 2007, a significant economic downturn followed in 2008/2009. This suggests to me that we should consider what could happen if the theory does have some value in predicting future events. Economists and their forecasts have historically had a thin time when it comes to accuracy. But the real value of forecasts is to provide investors with scenarios of what might happen and how one might indeed prepare if an event such as recession starts to materialise.
Global real estate has just enjoyed one of its best ever starts to a calendar year, surprising even the most optimistic of its investors. The rally followed the significant reversal of real estate along with broader equity markets in the fourth quarter of 2018. There are numerous reasons for the recovery, but the loosening of monetary policy was probably the principal factor that supported risk assets, removing market fears of recession that built up as 2018 ended.
Yield curve inversion raises recession speculation
But as the equity rally progressed in the first quarter of 2019, long bond yields dropped in the US and Europe, while short-term rates remained largely steady. US 10-year yields fell below three-month Treasury yields, marking the inversion of the yield curve and sparking a flurry of speculation that recession was imminent as well as considerable commentary about the usefulness of the curve as a tool for predicting the course of the economy.
So what might happen to real estate markets if there is a risk of recession? After all, markets are pricing in a 25% chance of a US recession in the next year, at the time of writing, and as high as 40% in Japan. The global economy has been expanding for a decade, so might it be time for a downturn? In the interest of being prepared, let’s consider what may lie ahead.
A game of two halves?
The last six months has seen two contrasting quarters for capital markets. The market sold off heavily in Q4 2018 amid fears that US Federal Reserve policy tightening would induce recession. Financial conditions tightened worldwide. Moreover, investors were wary of the ECB’s determination to normalise monetary policy and eventually raise interest rates despite weak inflationary pressures and few compelling signs of growth.
Global real estate fell by 4% in euro terms in Q4 2018, slipping alongside global equities, which fell by 13%. Markets in Europe were the most heavily sold. The recovery that followed in the first quarter of this year was impressive: global real estate returned 17%, led by Hong Kong and North American companies.
Exhibit 1: Real estate returns in Q4 2018 and Q1 2019 in developed markets
In EUR. Source: Bloomberg, FTSE EPRA Nareit, 31/3/2019. The value of investments may fluctuate. Past performance is no guarantee of future returns.
The Fed’s volte-face in the face of weaker domestic data and disgruntled US politicians had the desired effect in the capital markets. Likewise, the ECB acknowledged that weak inflationary pressures in the eurozone would delay any additional tightening of monetary conditions. Then the yield curve inverted.
Exhibit 2: Inverted curve - US 10-year Treasury yield minus 3-month Treasury bill yield
In %. Source: Bloomberg, 31/3/2019. The above-mentioned securities are for illustrative purpose only, are not intended as solicitation of the purchase of such securities, and this does not constitute any investment advice or recommendation. The value of investments may fluctuate. Past performance is no guarantee of future returns.
Beware false prophets
The yield curve has been valued as signalling turning points in the business cycle, with curve inversion typically claimed to be useful in predicting US recessions. The chief worry is that banks will stop lending if it is no longer profitable to borrow short and lend long. If credit dries up, the argument goes, recessions will follow.
Whether an inverted curve has successfully predicted recessions or not, it pays to consider what happens to real estate markets in a recession. Markets across the world have seen a number of recessions since 1990: three in the US and four in the eurozone.
Equity and real estate market performance during downturns has varied. While property stocks in the UK and Japan have on average sold off, markets in the US and the eurozone have delivered double-digit returns in the year of a contraction in GDP. Equity markets as a whole have also tended to do well in the US and the eurozone when GDP has fallen.
However, investors typically anticipate developments in the real economy and performance in the year preceding recession presents a different picture. In all four markets (see Exhibit 3), in the year prior to a contraction in GDP, the average return of listed real estate was negative, with general equities also selling off.
Exhibit 3: Average returns of listed real estate during a year of negative GDP growth
(period 1990 to 2018. Returns are annual and in local currencies; GDP growth is year on year)
Source: Bloomberg, FTSE EPRA Nareit, 31/3/2019. The value of your investments may fluctuate. Past performance is no guarantee of future returns.
A modest proposal
Whatever the merits of the yield curve as a forecaster of future economic health, it is clearly advisable to constantly consider the impact of different future economic scenarios on a portfolio, including recessions.
Ten years into the current business cycle, the volatility of the past six months and the focus on the yield curve caused by recent central bank policy U-turns are helpful reminders to investors that economies as well as markets do experience downturns. Moreover, our look at recent history suggests that the behaviour of real estate stocks in a downturn is nuanced and not entirely predictable.
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