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Interest rates to fall

There is one thing the markets and investment community agree about which should come true in 2024. The main central banks of the advanced world are likely to lower interest rates as the year advances.

| 12 min read

There are disagreements about how far they will be able to lower them and when they might do so. The bond markets have been telling us about falling rates for some time, with good rallies in bond prices in the closing weeks of 2023. Inflation is coming down on both sides of the Atlantic and should fall further as the monetary squeeze of last year has its full impact, as long as world trade disruptions are contained. China, Brazil, Chile, and some eastern European countries have already started cutting their official interest rates.

There are important elections in 2024, led by the US presidential election at the end of the year and the European elections in the summer. A UK election is also expected. This will mean pressure to offer the prospect of more growth to come and some further easing of the cost-of-living squeezes which characterised 2023. The US Federal Reserve has a remit to consider both inflation and employment to provide a more balanced policy whilst the European Central Bank will not wish to prolong the downturn longer than necessary given the fragile finances of some states and companies within its jurisdiction.

By the end of 2024 it is very likely the emphasis will be on policies which stimulate economic growth.

If growth slows too much or if GDP starts to fall in some places, then public finances deteriorate further, and government choices between taxes and spending become less palatable. Governments are highly geared to growth, gaining more revenue for each additional unit of output or income given progressive rates of taxation on incomes and profits. Public spending tends to rise more in a downturn given the costs of unemployment and other benefits.

Limited scope for more fiscal stimulus

It is true the US has administered a very large fiscal stimulus in the year to September 2023 and will not be able to repeat this. Republicans are keen to slow or end the growth in public spending and borrowing and now have some power to influence outcomes through their narrow majority in the House of Representatives.

In the EU the partial reintroduction of some financial discipline to member states’ governments will not have much impact. Individual countries will be given permission to exceed the underlying debt and deficit targets or will simply fail to comply with budget rules. The EU itself will borrow more and increase its own spending in pursuit of its recovery and green transition agenda. The largest country in the EU, Germany, is having to retrench after losing a court case over its borrowing levels.

Nonetheless, the permissions embedded in the US Inflation Reduction Act and the EU’s Green transition investment plans give some continuing assistance from a fiscal stance.

Sector rotation?

Last year saw substantial outperformance by technology oriented shares, favouring the US which has such a strong position in digital technology and the magic star dust of artificial intelligence (AI) which burst upon the scene last year, The companies that will dominate this area deserve a premium rating as long as they deliver the profits, but the market last year left other sectors and companies that can also do well languishing on much lower ratings. It is in these areas we would expect more equity buyers to be looking this year, seeking the value and the opportunity for recovery that some of the neglected sectors and shares now offer.

Sectors that are sensitive to changing interest rates are an obvious place to start when looking for companies and sectors that might do better in these new conditions. Commercial property and infrastructure are two traditional beneficiaries. Property performed very badly in 2022/23 until the last couple of months. Higher interest rates meant higher yields being demanded by people buying property, so lower property prices. Past returns have been depressed by a period of declines in property valuations and in the share prices of property REITs.

Office properties

The return to work after COVID-19 lockdowns revealed that many more people will be working from home in future as more and more office-based service providers accept their employees can do a good job for part of the week from a home base. Many of the larger service sector office users have been keeping on their existing offices until there is a break clause in the contract. It is at this point they look at reducing the floor print they need, with more hot desking and staggered use of the offices by their hybrid-working staff. Older accommodation and some more marginal locations are under pressure from this process.

It is not all bad news for property owners. Those downsizing and relocating often want better quality space.

Good green credentials are high up the agenda as companies come under more pressure to show good ratings for their carbon footprint.

They often also want more collaboration space and a better quality of employee services and support as companies compete to recruit and retain best talent and seek to encourage more people to want to spend more of their working time in the office. There are good examples of firms paying higher rentals for the quality and location they want against a background of more wishing to downsize.

Industrial, technology and distribution property

COVID-19 lockdowns and ultra-low interest rates led to a boom in the valuations of industrial properties. The digital revolution was boosted by lockdowns. People needed to buy more things online strengthening demand for warehouse space to fulfil computer-based orders. Cloud computing capacity was needed on a much increased scale as more companies and individuals wanted to store and process more data, video and messaging. This led to further demand for large modern sheds capable of containing the servers and data stores. Rentals rose under pressure of demand and capital values rose thanks to lower interest rates and higher rents.

The period 2022/23 saw a selloff in these assets after a long period of good performance. Higher interest rates hit capital values, whilst the growth rate in extra cloud capacity and more warehousing slowed on the larger base established during lockdowns. The outlook remains reasonable for this type of space. The advent of AI as an additional feature of digital service means continued growth in cloud computing and other digital service requirements. Online shopping and other services continue to expand, if at a slower rate.

Retail, hospitality, and entertainment property

There has been a contraction in the number of shops and the floorspace they need as online has increased. Various older shopping centres and some high streets have fallen out of fashion. Property owners in these locations have seen substantial drops in value and some are having to look to repurpose their shops given the absence of tenants capable of paying a good rent. In some locations it is possible to find service-oriented tenants for former shops, as there is better demand for cafes, personal services, entertainment venues and the like. In others, landlords are applying for changes of use to residential or are looking at other redevelopment opportunities.

Since the ending of COVID-19 restrictions some popular high streets and prime retail locations have come back to life and can attract good tenants. They usually have a relatively high ratio of restaurant and café space to retail space and are event or visitor destinations in their own right. Good retail requires successful promotion of the location as well as of the individual shop brands. Good access, free or realistic car parking arrangements, a range of public transport options and the care taken with presentation of the shopping area environment are all important features of successful retail centres.

Other specialist property

Some investors like student accommodation, a residential variant with the advantage of guaranteed turnover in the tenant population as courses end, making it less likely a landlord gets stuck with bad tenants for too long. Rents can be adjusted every time there is a new letting period. It also means, however, the need for marketing every year to try to ensure good occupancy levels. There is an element of protected market as universities usually keep an eye on how much student accommodation near their campus their students are likely to want.

Some investors favour speciality storage companies offering facilities for companies and families that cannot accommodate all their possessions in their own properties. Some are keen on hotel, holiday and hospitality properties. Some invest in care homes where there is a high element of expensive service provision in the business side of the relationship with tenants.

Ways of investing in property

Many people invest directly in property for their own homes and businesses. Some add a property or two which they rent out to others. The problems with directly owning rental property include the difficulty and costs of sale should you need to raise money. In a weak market it can take a long time and require offering a large discount to its former value. Most people and many investment funds do not have enough money to be able to afford a suitable spread of different types of property and different locations.

If you end up buying just one office or shop you can lose out if the location or nature of the building fall out of favour. The management of buildings can be expensive with the need to update, repair and keep main services in good order. You may need an agent who charges fees to handle tenant issues and any necessary re lettings. You can get a bad tenant which can lead to non payment of rents or expensive legal disputes.

Some funds and investors choose to invest in property funds. These funds take on the task of managing the properties and collecting the rents. They also can have enough money to provide a better spread of assets within their chosen theme or area. Management costs can still be high but they may be better spread and therefore lower per building than managing a building or two for yourself. However, it can be difficult to cash in your units in these funds during a downturn in property prices. The funds may well have powers to make you keep your money invested until markets improve or may charge you a large discount to get out.

You can invest directly in quoted real estate investment trusts (REITS).

There are companies with shares you can buy and sell all the time the relevant share market is open. If conditions in the underlying property market are poor, you may have to sell your shares at a discount to the stated asset value of the company you are invested in. All the management costs are a legitimate charge on the profits of the trust.

There are exchange traded funds (ETFs) which invest in portfolios of REITs. These offer you a spread of property portfolios and usually a greater ability to buy and sell the shares. You will still, however, suffer from falls in underlying property values and experience widening discounts to asset values in the share prices of the underlying REITs when property is out of favour.

Conclusion

Much of the downgrading of asset values has now taken place to reflect higher interest rates and less rental growth. As more transactions take place in the property market we will see more clearly how many properties can now be sold at or above the downgraded asset value. With many of the good commercial properties that are well located and meet modern environmental and tenant standards there are investment opportunities. As always it is wise to have a spread of assets and to take advice on how best to manage new commitments.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Interest rates to fall

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