The German mainstream media are all running scare stories about how inflation is on its way back, and prices across the country are galloping upwards. The Bundesbank boss Jens Weidmann issued a statement a few weeks ago that with the upward pressure on prices the central bank might have to tighten the money supply and shift the direction of monetary policy. Inflation in Germany is expected to hit 3% this year, possibly even 3.5%, albeit in what is likely to be a temporary distortion, fuelled by COVID.
Still, it's all led to more scare stories; tied in with stock markets coming off their recent peaks, Germany has joined the rest of the world in pushing up government bond yields over the past month, and although they've pulled back a little bit, they (along with Italian bond yields) are up about 20bps since the start of the year. Italian bond yields are up 10bps. Other alternative assets, such as corporate bonds and equity dividends, have also seen upwards shifts in yields.
Over at Capital Economics, the smart analysts issued a note recently which crossed our desk saying that they still hold to their view that yields on office and industrial property will continue to edge downwards over the next couple of years, with no broad-based upward pressure on property yields until 2023 at the earliest. In other words, they believe that property yields will be largely unaffected by the rise in government and corporate bond yields in Europe.
Their argument is that the recent rises in bond yields are expected to be temporary, and have been driven by these well-touted fears of rising inflation, rather than really expecting a more hawkish ECB approach. And since recent increases in inflation have been driven by temporary factors, while economic activity remains weak, this shift is not expected to be permanent, they say. Added to this, ECB policymakers have expressed concerns about the recent rise in bond yields and would likely step up their asset purchases if the sell-off in bond markets were to resume.
In any event, they add, bond yields remain low by historic standards, so that property remains attractive to investors. Indeed, even with the rise in bond yields, they say valuations continue to suggest that most office markets are still fairly or undervalued, with some exceptions in Europe such as Prague, Athens, Oslo and Zurich.
Of these, Oslo and Prague are markets where they think the respective central banks will start tightening interest rates in the second half of this year, keeping upward pressure on bond and property yields, and therefore property valuations are unlikely to improve.
Although they concede that bond yields may now start trending up sustainably from next year, earlier than they'd projected in a recent note, The Capital Economics researchers say their prime office yield model does not suggest that any significant changes are needed to their forecasts as a result. They're sticking their neck out and saying that the rise in bond yields will come alongside an improvement in economic activity and expected rental growth, which should provide offsetting support to property yields.
In fact, they say, model estimates would be consistent with only small upwards moves in offices yields of around 5-10bps, but not until later in their forecast horizon. So, office and industrial yields will continue downwards in a small way this year and next, before stabilising and gradually edging back up after 2023. So, now you know.
