European real estate and capital markets update Q3 2021
Managing Partner, Board Member
Head of EMEA
Real Estate | London
It’s back-to-school month for most children, and back to the office for an increasing number of workers too. What better time to host our semiannual market update webinar for real estate? On 15 September, participants listened to our experts, Adrian Ng and Jamie Macdonald, provide an overview of the economic outlook, the market environment for interest rates and hedging, and an update on the IBOR transition.
This short summary encapsulates the key themes and conclusions as well as the outcome of the polling questions.
The GDP bounce back is evident across the U.S., Europe, and the UK as pent-up demand was unleashed. Consumers shopped and enjoyed the leisure activities that they were denied, all with a bit more cash in their pockets from their lockdown savings. Economies are close to their pre-pandemic size, with the impact of COVID-19 all but wiped out. As summer winds down, the upward revisions in GDP are also coming to an end and the activity surveys (PMIs) look to have peaked. Slightly slower growth is therefore expected through Q4 and into 2022. The key question is what will a “normalised” growth rate for the economy look like? Neither 2021 or 2022 are representative. The downturn and recovery have changed the overall shape of the economy, making forecasting even more challenging. Global growth forecasts for 2022 are around 4.5%–4.8%, but revisions skew to the downside. Our audience’s mood reflected the headline good economic news and general consumer confidence: the majority of respondents noted they were optimistic for the next 12 months, and a significant proportion remain optimistic on a five-year outlook.
Our webinar featured inflation as the cornerstone economic topic. Global goods shortages, increasing component prices, and supply chain bottlenecks are widely reported. These short-term impacts, combined with the statistical impact of the “base effect” has led economists to conclude that inflation will be transitory. The Bank of England (BoE) has already announced that they expect inflation to rise further this year, to 4%, but then for a return to 2.5% in 2022. The transitory arguments don’t account for the second-round effects which bake higher inflation into wages and other contracts. Christine Lagarde has commented that the European Central Bank will be paying close attention to autumn wage negotiations in Germany’s industrial sector. So far, the market remains sanguine about this risk.
Rising interest rates do not yet reflect concerns about non-transitory inflation. The market, via the forward curve, is firmly in the low interest rate expectations camp, with no increases expected until into 2022; and even then, these will be minimal. Talks of tapering QE or quantitative easing (reducing the bond-buying programme) have also been shrugged off by the interest rate markets. The BoE has signaled that it will end the reinvestment of its pool of Government bonds in 2023 — the first stage of quantitative tightening. This is expected to be coincidental with a second interest rate rise. The forward curve is rarely ever correct in its predictions, and this could be the time when it underestimates the risk of rate rises, both in timing and magnitude.
One poll question focused on the 10-year U.S. Treasury yield (as a bellwether for global interest rates) — with the most popular forecast choice among our audience being 1.25–1.50% by the end of this year. This is within its current range, having come off a low of 0.6495% in September 2020. Like the inflation story, it feels the risk to this estimate is to the upside. This will be driven by concerns of more persistent inflation and any signals from the Federal Reserve on accelerated QE tapering.
In light of this, we are hearing from more clients who are considering pre-hedging both for new transactions in 2022 or refinancings currently planned for 2023/2024. There are a few instruments which can be deployed to meet this objective, with a swaption (option to enter a swap) providing the most flexibility. It is worthwhile considering how to take advantage of current rates and secure the cost of financing into the future.
At Chatham, we see a myriad of different approaches to hedging FX risk. A growing number of investors are asking funds what their strategy and approach is to mitigate exposure to this risk. There can be a tendency to conclude that FX hedging is costly, and this has certainly been the case for EUR-denominated funds looking to hedge their GBP exposure. However, the interest rate changes in the last year have very significantly reduced this cost from an annual 140 bps drag (on a rolling forward strategy) to only 80 bps.
The conclusion is that the ever-changing market in FX means that investors should regularly reassess any risk management decision. Opportunities arise when markets move in unexpected ways.
The final topic of the webinar was IBOR transition. We focused predominantly on GBP since it is furthest along in preparing for cessation and replacement with SONIA. The calculation methodology in the loan market is now agreed and set, and the choice of credit adjustment spread (CAS) is also becoming more uniform. There are still a few wrinkles around the definition of interest rate floors (whether daily floor or period floor) but nothing which is insurmountable. Our clients' outstanding concerns are more on the administrative aspects — who will pay the legal bill? And will we be ready by 31 December? We see good market practice being that each side pays their own legal fees, but there are some lenders who are passing all legal costs to their borrowers. While the 31 December deadline is crucial, there will still be a (final) LIBOR fixing on that date. If you are running out of time to complete by then, there might be some breathing space so long as you execute your transition documentation before the first interest payment date of 2022. We are not suggesting that borrowers run it to the wire, but we need to accept the reality of the situation; that there is still a mountain of transitions to be documented. Fortunately, our audience appears well prepared with the majority of the respondents to the poll indicating they have an inventory of IBOR exposures and have assessed the accounting and tax impact.
- The economic rebound has been strong and has led to supply shortages. Inflation risk is high, and the conclusion from policymakers that they are transitory might be tested into early 2022.
- The forward curve is sanguine about interest rates rising. While the BoE might not make an active policy change, if inflation expectations start to embed into the market, the forward curve reflects that which means hedging (swap) rates increase. Investors are considering pre-hedging as they look to take advantage of the current market.
- FX rates have been volatile, and the “cost” of hedging with certain currency pairs has changed quite considerably over the last year. It’s time to reassess decisions on FX hedging strategies.
- LIBOR transition for GBP is well progressed, but there is a mountain of restatements and amendments to complete before 31 December 2021. We expect a very busy Q4 trying to get these over the line.
If you would like to hear more detail on any of these topics please reach out to your Chatham representative.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0251
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