While most practitioners may believe that inflation is good for property returns, most analysts know that it is economic growth that fundamentally produces the performance. It is easy to confuse the two, as strong economic growth in the UK is typically accompanied by high levels of inflation. Nevertheless, the distinction helps in identifying the prospects for property performance.
The best overall measure of the state of the domestic economy is, gross domestic product, which has shown positive growth over the last three years. The rate of growth peaked in the second quarter of 1994 and although GDP is still growing at above the long-term rate, the economy is now clearly slowing. It is, however, very unlikely that we will move to recession in the next couple of years. The Government has the ability to provide stimulus either by tax cuts (admittedly constrained), or by interest rate cuts. Although the Chancellor continues to pursue his objective of low inflation, political expediency will also ensure that the rate of economic growth will not be allowed to fall too much.
In particular, the Chancellor will be looking towards improving the lot of the personal sector and this is likely to result in a reduction in direct taxation in the November budget. The benefits of tax cuts would be expected to flow through to consumer spending and there are some obvious positive implications for the retail sector. Of course, not all personal sector expenditure results in improved retail sales. Indeed, over the twelve months to the second quarter of this year, consumer expenditure rose by 2.3%, while retail sales volumes have only risen by 0.4%, and this disparity appears to be increasing.
This is a reflection of the ability of consumers to more readily reduce retail spending compared with expenditure on personal services. It also demonstrates, however how the reverse might easily apply. As consumer confidence returns, the growth in retail sales is likely to out-strip consumer expenditure growth and the particular beneficiaries would be comparative goods, such as durables and luxury items. If tax cuts are sufficient to engender strong sales at Christmas, in contrast to the previous two years, the retail sector wants be an obvious beneficiary.
It will nevertheless take some time before retail property becomes the recipient of these benefits, and it is likely that the effect of improved spending would be spread over a period of one or two years. The short-term boost to the sector will nevertheless be most welcome in view of its poor rental value growth over the past couple of years. In the medium term, though we remain concerned about the sector.
Although economic growth could provide general benefits for property, interest rate cuts would be even better news. Not only would they provide further stimulus to economic growth, but bond yields would normally be expected to fall in response and this would leave property looking relatively cheap. Furthermore, the inherent gearing in property companies means that income-producing mid-to-high yielding investments become more attractive.
It is likely that we are at a turning point in the interest rate cycle. Arguably, interest rates may stay static for some time, but we believe that we will see the first marginal fall (a quarter of a percentage point) in the first quarter of 1996, followed by a further marginal fall later in the year. The Governor of the Bank of England may not fully approve, but the realities of politics will be a major force in the decision process.
Overall, we are optimistic about property's potential over the next few years. What it most needs is continuing GDP growth, and political considerations should ensure that this is what it is most likely to get.
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