Yield Curves, Spreads and implications
The Australian economy continues to produce mixed economic results with news last week of slower economic growth and worsening business confidence followed this week by a record low unemployment rate of 4.9%. The markets reacted positively overall pushing the Australian dollar to a 3 week high of US71.6c on Thursday.
The improving AUD and recent comments from the Federal Reserve have placed downward pressure on Australian bond yields which fell below 1.9 per cent this week, almost reaching the lowest-ever level of 1.82 per cent in August 2016.
What is more surprising is that the the Australian 10 year bond rate is now 60 basis points lower than the US 10 year bond rate which currently trades at 2.52% as shown in the chart above.
US Bond Yields are reacting strongly to the US Federal Reserve and European markets and for the first time since 2007, the treasury bond yield curves for both the US and Australia have inverted which typically implies the the markets expect a recession is looming within the next 18 months.
The 10-year bond rate is now trading marginally above the current RBA official cash rate of 1.50%, suggesting that the market expects the RBA to lower the cash rate in months to come.
The potential of a recession and the implications of lower bond yields will result in a further search by global investors for higher yielding real assets. Australia will remain firmly on the agenda for global investors.
Core property investments tend to trade between a 200Bps and 400Bps premium to 10 year bonds however with the recent drop in bond rates, the yield spread has pushed above the historical norm, suggesting that yields, particularly for commercial and industrial assets, could sharpen by 50bps and still remain in the historical range.
The chart below shows the movement in the yield spread to 10 year bonds from 2016 based on the transaction evidence in the market gathered by ReSourceData.
So what are the implications for property across the sectors ?
The commercial sector will be the significant beneficiary of further global investment with core property assets trading well. The disposal of the ex Investa assets by Oxford and other commercial offerings will likely achieve strong results in the coming months.
The risk premium for retail assets may have changed permanently as the structural changes in the sector continue to influence pricing of assets. Some counter cyclical investors see retail as a miss-priced sector and will be on the hunt for good assets. Our view is that the retail sector requires a deep understanding of the demographic and psychographic factors that will influence retail expenditure in any given area and that a capability (&capital) is required to create an environment for retailers to thrive. The key to this however will be in sifting the wheat from the chaff and actively managing the assets where mistakes could be costly.
Likewise some investors believe the industrial market to be over-priced with little regard for the risk that single tenant exposures have on what can be an obsolete structure. Our view is that the industrial sector requires scale, a land bank and a development capacity to mitigate the risks in the sector.
The next big risk to the property market will follow a global sell off in equities and the potential re-weighting of investments that will follow. Investors, (globally and locally) will need to sell property all at the same time in order to re-adjust their investment holdings and as this usually coincides with tightening credit policies, the outcomes aren't often pleasant.