Intelligent Investment

Inflation: Sources, Solutions and Consequences

11 Aug 2022 13 Minute Read

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Inflation caught us all by surprise!

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The near vertical rise in inflation in the U.S., Europe and to a lesser extent Asia Pacific caught economists, central banks and policymakers by surprise. Previous periods of high inflation such, as in the 1970s, emerged only after building up a head of steam over three to four years.

Figure 1: We Haven’t Seen this Since the 1970s

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Source: BLS, Eurostat, ONS (RPI), CBRE Research, Q3 2022.

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Inflation is now front of mind and is one of the main factors driving down consumer confidence to recession-era levels. While many consumers have not significantly cut back on spending, sentiment is increasingly fragile.

Figure 2: Driving Confidence to Recession Levels

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Source: University of Michigan, ECFIN, CBRE Research Q3 2022.

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Why did it happen?

High inflation has its origins in the response to the COVID-19 pandemic, when governments restricted social contact through lockdowns. This was accompanied by huge fiscal and monetary stimulus to support the economy, leading to a surge in money supply.

Figure 3: Money Supply (M2), Billions in USD, GBP and EUR

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Source: Macrobond, CBRE Research Q2 2022.

With the public receiving stimulus money but forced to stay home, consumption was channeled away from services, such as food and beverage, entertainment and travel, and to the goods sector.

Figure 4: The Pandemic Focused Demand in the Goods Sector

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Source: Macrobond, CBRE Research Q2 2022.

This phenomenon occurred at a time when the pandemic significantly disrupted global supply chains. Excess demand for goods at a time of restricted supply inevitably drove up prices.

Stimulus money and record low mortgage rates also led to a housing boom with residential prices in the U.S. rising by up to 50% in some markets since the beginning of 2019.

Other factors underpinning inflation include a spike in oil prices resulting from major producers keeping production low despite a strong rebound in demand after economies re-opened.

Figure 5: Then the Oil Price Spiked

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Source: "US Online Grocery Snapshot: Q4 2021", Forrester, February 3, 2022.

Russia’s invasion of Ukraine added further impetus to inflation. Supply constraints and sanctions pushed up natural gas prices in Europe, exacerbating the demand/supply imbalance in the global economy. Both countries are also major commodities producers, so the supply and cost of raw materials such as wheat has also been impacted.

Figure 6: Total Stock Levels of Primary Food Commodities, Rolling 4-Quarter Average

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Source: BEA, CBRE Research Q2 2022.

Figure 7: Then it Hit the Labor Market

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Source: Eurostat, ONS, BLS, CBRE Research, Q3 2022.

These factors have created an environment in which highly stimulated demand has converged with highly disrupted and restricted supply, driving up inflation.

Solutions

Interest rate hikes are an inexact science, with the lag and intensity at which they impact the economy varying substantially. Central banks have nevertheless chosen to tackle inflation by taking demand out of the economy by raising rates. The hope is that while this may cause a mild recession, such an outcome would be more desirable than a potentially more severe economic contraction occurring later.

This approach has led to the sharpest increase in U.S. interest rates since 1994, with short-term rates likely to peak at around 3.75% and the fed funds rate set to go as high as 4.0%. The Eurozone has witnessed its first rate hikes since 2011 while rates in the UK are also heading up.

Figure 8: Interest Rates Have to Go Up

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Source : Federal Reserve, ECB, CBRE Research, Q2 2022.

Figure 9: Interest Rates Have to Go Up

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Source : Federal Reserve, ECB, CBRE Research, Q2 2022.

Higher rates have created some turbulence in the currency market, with US dollar strength and Euro weakness among the most prominent consequences. As the US dollar strengthens, the cost of imports and oil declines in the U.S., but the reverse is true for Europe.

Is there another way of looking at this? Did the pandemic turbo charge the end of the cycle that began in 2010?

G7 unemployment data show that geopolitics typically does not derail the economy. There have been four distinct cycles since 1980 followed by an abrupt, pandemic-related surge in unemployment in early 2020.

Figure 10: Geopolitics Does Not Typically Derail The Economy

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Source: Eurostat, Wikipedia, CBRE Research, Q2 2022.

The subsequent sharp employment rebound has left the unemployment rate at the low level it was at prior to the onset of the pandemic, when the global economy was appearing likely to head into a recession.

The normal pattern of economic cycles is for interest rates to rise when unemployment gets low, triggering a recession.

The Economic Cycle and the Real Estate Cycle

There is a strong link between the economic and real estate cycles, with data showing a close correlation between unemployment and weighted average vacancy across sectors in the U.S. When unemployment rises, so does vacancy, with the same being true in Europe.

Figure 11: Unemployment and Vacancy Cycles in the U.S.

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*Source: CBRE Research Q2 2022.

Figure 12: Unemployment and Vacancy Cycles in the U.S.

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*Includes Germany, France, Italy, Spain and the Netherlands – weighted by GDP
Source: CBRE Research Q2 2022.

CBRE has also identified a clear relationship between office rental growth and employment, both in the U.S. and Europe.

Figure 13: The Cycle is the Primary Driver of Office Rents

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Source: FRED, CBRE Research Q2 2022.

Figure 14: The Cycle also Drives Rents in Europe

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Source: Eurostat, ONS, BLS, CBRE Research, Q3 2022.

The obvious conclusion is that if the economic cycle has come to an end and unemployment is about to increase, vacancy will rise and rents will fall.

Asia Pacific

Inflation in the region remains more moderate compared with the U.S. and Europe. The latest data indicate a decline in the rate of inflation across most Asia Pacific markets in June after a period of sustained increases.

Although China is the only major global economy that has not yet seen a spike in inflation, it is grappling with other challenges, most notably a housing market slowdown resulting from previous attempts to wean the economy away from real estate.

Figure 15: China Housing Market Sales are Falling

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Source : Federal Reserve, ECB, CBRE Research, Q2 2022.

China’s GDP grew 0.4% y-o-y but shrank 2.6% q-o-q in Q2 2022, signaling a recession, which is one factor why there is less inflation.

Economic weakness in China will gradually feed through to other economies in Asia in the coming months, easing inflationary impulses. Interest rates will also go up across the region to counter inflation.

Inflation and Building Management Costs

The cost of building services such as facilities management, engineering and maintenance has risen dramatically since the beginning of 2021, with sharp increases observed in both the CBRE Facilities Management Cost Index and costs for nonresidential maintenance and repair.

CBRE has also identified a clear relationship between office rental growth and employment, both in the U.S. and Europe.

Figure 16: Facilities Management Will be Badly Hit

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Source: FRED, CBRE Research Q3 2022.

While inflation in this sector will fall back when the global economy cools, this will take some time. Companies contemplating major office renovation or fit-outs or other significant CapEx are advised to delay plans until 2023 when building contractor prices should decline from current highs.

Consequences

A global recession is most likely on its way. There are reasons to think it will be a moderate recession – not as bad as the Global Financial Crisis:

  1. Corporate and consumer balance sheets are in reasonable shape, making severe cutbacks in employment or spending less likely. Corporations have had a hard time attracting and retaining talent after the pandemic and they are likely to hold on to skilled professionals as much as possible. Consumers still have cash accumulated during the pandemic lockdowns when it was difficult to spend.
  2. Northern European countries have very low levels of public debt. Governments have already started to spend to offset the negative effects of high energy prices.
  3. China has relatively low inflation and is ramping up its fiscal and monetary support for its economy.

On the other hand:

  1. Inflation is running hot, and central banks have vowed to bring it down. After more than ten years of near zero interest rates, it is not easy for central banks to calibrate interest rates in a way that gently brings down inflation. Central banks could tighten monetary too much, triggering a deeper downturn.
  2. Apart from higher borrowing costs, consumers are being squeezed by elevated energy and food prices. Even after inflation is under control, energy and food prices may not revert to prepandemic levels.

Recessions always impact real estate markets. They choke off occupier demand and release excess space onto the market, increasing vacancy and lowering rents. The digital economy and medical progress have created secular tailwinds that will mute the recession’s effect in sectors such as data centers, life sciences and industrial and logistics. Multifamily may benefit from reduced single-family home demand caused by higher mortgage rates. However, multifamily cannot avoid the effects of rising unemployment. Most of the rise in office vacancy has already taken place, and while the recession will delay full recovery, a shortage of Class A space is clearly emerging. Retail will feel the effects as consumers retrench, but the lack of new construction over the last ten years means that vacancy is unlikely to surge.

In capital markets, the cost of debt has risen by around 200 basis point in Europe and the US. This has already pushed cap rates out by 50 to 75 basis points, and more decompression is possible. However, inflation is expected to peak in the near term and rates will start to fall back in the middle of 2023. The opportunity to buy quality assets at ‘discounted’ values will not last long.

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