Where to next for rates, currency and listed property?
Morningstar expects short-term rates to remain steady into 2019 at least, bond yields to move higher and property ex-retail to remain strong.
Morningstar expects short-term rates to remain steady into 2019 at least, bond yields to move higher and property ex-retail to remain strong.
Australian cash and fixed interest
While 90-day bank bill yields are up a bit year to date, from 2.07 per cent at present, this has reflected higher funding costs for banks rather than any formal tightening of monetary policy, which is still keeping down the general level of short-term rates.
The Reserve Bank of Australia (RBA) maintained the cash rate at 1.5 per cent at its latest monetary policy decision on 5 June. It has been held steady since May 2016. Bond yields have been more volatile, and not as closely linked as usual to US bond yields.
On occasions, the local 10-year Commonwealth bond yield has yielded less than its US equivalent, as is the case currently, with the local 2.71 per cent below the US 2.92 per cent. The Australian dollar is weaker year to date, and is down 3.9 per cent in overall trade-weighted value. Some of its weakness is down to depreciation against the Japanese yen and Chinese renminbi, down 5.9 per cent and 5.8 per cent, respectively. But in recent months, the key moving part has been the impact of a globally stronger US dollar.
Rates likely to stay put
Short-term interest rates are very likely to remain around current levels over the next year. The RBA has said the next move is more likely up than down, but has given no signals about when it might start raising rates.
Forecasters typically expect it will not be for some time with a general expectation of a 0.25 per cent increase sometime in the second half of next year, though it could be later again.
For example, Westpac thinks there will be no change before March 2020. Low rates on cash in the bank will be a feature of the local investing landscape for some time yet.
Bond yields look likely to head higher. Inflation is likely to be a little higher over the next year, with forecasters typically seeing it around 2 to 2.5 per cent, which means bond yields will have to rise to maintain the same real – or after inflation – return. And while the relationship has not held exactly this year, there is also likely to be some impact from higher US bond yields. Forecasters on average see the local bond yield around 3.5 per cent in a year's time.
Currencies reflect a wide range of factors which often point in different directions, but at the moment, there is one factor, a particularly obvious divergence between the likely path of US and domestic monetary policies, which is likely to dominate.
The US policy rate is already above the local rate, with the target US federal-funds rate at a range of 1.75 to 2 per cent, compared with the RBA's cash rate of 1.5 per cent, and the gap is likely to widen further as the Fed raises rates again later this year while the RBA holds rates steady.
While other factors could intervene – there could be a pickup in overseas portfolio investment into the equity or property markets, which would tend to support the Australian dollar; and the Commonwealth Bank, for example, sees the US exchange rate rising to US 80 cents in a year's time – at the moment, the forecasters picking a lower Australian dollar look to be taking the more realistic view.
The ANZ Bank and Westpac, for example, see the dollar down in a year's time from its current 74.3 US cents, with ANZ picking 70 US cents and Westpac 72 US cents.
Australian and international property
The A-REITs have struggled to recover the ground lost at the start of the year, when the sector (like its counterparts overseas) was hit by concerns over the potential impact of rising interest rates.
Currently however, the REITs have just managed to creep into the black for the year, possibly helped by reinvestment of cash from holders of Westfield with $7 billion of cash paid out on 7 June as part of the Unibail takeover, and this may have supported the remaining names in the sector.
North America is largely to blame for poor results in overseas listed property
The S&P/ASX 200 A-REITs index is now marginally ahead (0.1 per cent) in capital value for the year and has delivered a total return of 1.1 per cent, a little behind the 2.4 per cent return from the wider share market.
Overseas, listed property has also underperformed, with the FTSE EPRA/NAREIT Global index showing a small 0.4 per cent loss in terms of net return in US dollars, compared with the 2.5 per cent net return from the MSCI World index.
The underperformance is largely down to ongoing poor results in North America – down 1.8 per cent – and to a lesser extent, a sharp setback to emerging market REITs – down almost 10 per cent, although they have only a small weight in the index.
Losses in the US and the developing world outweighed a 2 per cent gain in Asia. Japan was up 8.8 per cent and in parts of the eurozone, where listed German property returned 3.5 per cent (all regional results in US dollars).
Solid operating outlook
The operating outlook for property (ex-retail) is solid, particularly in Sydney and Melbourne. In the office sector, for example, there are tight supply/demand conditions in the central business districts of both cities, which are having knock-on benefits for the wider metropolitan office markets.
As Colliers' first half of the year review of metropolitan offices found: "Some metro markets, such as Parramatta and the Melbourne City Fringe, are even more tightly occupied than the Sydney and Melbourne CBDs, and we expect them to stay this way until new supply starts completing around 2019/20."
Industrial property is also performing strongly with high demand but limited supply, largely but not exclusively driven by online shopping logistics. Colliers' half-year review said: "Although investment choices in logistic-type assets will remain dominant, particularly as e-commerce continues its exponential growth path, other industrial sectors have experienced positive employment growth over the past five years."
Retail is the laggard, although the high end of the market, for example, large "destination" malls, appears to have better prospects against the online challenge than lower-tier shopping outlets.
A good operating outlook, improved by recent evidence that the pace of the economy has kicked on a gear, has not, however, appeared to offer a compelling proposition to investors who have been getting better capital gains from the wider market, and without sacrificing much yield. The A-REITs offer 4.6 per cent compared with the overall market's 4.2 per cent (on Standard & Poor's calculations). The prospect of rising bond yields is also an ongoing challenge. Further underperformance looks the most likely prospect.
Overseas, the key market is the US, which accounts for 45 per cent of the benchmark FTSE/NAREIT index. On the plus side, the US economy has been performing strongly, and while retail remains under the global shadow of ecommerce – US retail-focused REITs are down 4.8 per cent year to date, with shopping centres down 7.5 per cent – other sectors have been doing well, particularly industrial (up 3.8 per cent).
Colliers' latest report on the industrial sector said: "The national industrial vacancy rate remained at an all-time low of 5.1 per cent for the second consecutive quarter despite nearly 53 million square feet of new supply completing in the first quarter of 2018"; rents have risen by 5 per cent to a new record high; and "growth in investor demand for industrial properties continues to surpass all other property types."
On the down side, however, the US market is also the market most exposed to higher bond yields as American monetary policy tightens faster than in other major regions. So far, the contest between improving rental income and the prospect of lower capital values as interest rates rise has not worked out well for investors, and although there are some very strong property markets outside the US, overall listed property outcomes are likely to remain on the disappointing side until US bond yields peak.
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Peter Gee is a manager research analyst, Morningstar Australia.
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