As the world enters a phase of post-covid economic recovery, we have seen sharp inflationary pressures throughout the global economy. Terms such as “OCR (official cash rate)” and “inflation” have become everyday language for many Kiwis as we try to understand why our lives have become so expensive. While each of us wrestle with what this financial rollercoaster means in an everyday sense, at Mackersy Property, we’re taking the current and future implications of these economic shifts very seriously.
To give you an understanding of how he thinks, Mick Pannett, Mackersy Property’s Finance & Treasury Manager explains what he’s seeing and Mackersy’s strategy to weather the short-term storm for the longer-term gain.
When we first saw the early signs of inflation emerging globally, economists and central banks saw this as being transitionary and short-lived. Their commentary was around international supply constraints causing inflation due to supply not keeping up with demand for goods and services as economies grappled with the ongoing health, isolation and lockdown effects associated with Covid-19. These supply issues have been exacerbated by quantitative easing (printing money and the increase in the supply of money) by many central banks internationally and most recently, the ongoing conflict in Eastern Europe having upward pressure on oil and energy prices.
At this point in the inflationary cycle, we saw an increase in wholesale 1-5 year interest rates as financial markets anticipated the OCR rising to combat this increase in inflation while supply caught up to demand. These increases in 1-5 year wholesale interest rates had a direct impact on Mackersy Property’s ability to fix debt as the market had anticipated an increase to the OCR, making fixing debt between 1.75-2.00% higher than the 90-day resetting (‘floating’) levels. At this point, Mackersy Property engaged with several economists and financial market dealers for their views on interest rates. Their feedback was similar, and they shared the market consensus view that this was a transitionary period and the consolidation of interest rates. The view was that fixed interest rates already looked to have factored in (if not over-factored in) an increasing OCR and we should look to stay on a 90-day resetting facility (floating) until the rates caught up. Fixing immediately would have meant paying for these increases before we needed to.
Since the emergence of the conflict in Eastern Europe, we have seen inflationary pressures escalate rapidly. Wholesale energy and food prices increased at a dramatic pace as global financial markets reacted to the potential supply implications of the conflict. Financial markets reacted to these inflationary pressures by pushing wholesale 1-5 year interest rates up again as they held the view that the OCR would have to be lifted more aggressively to combat this additional inflationary pressure. We saw wholesale rates increase at levels we had not seen since before the GFC, with financial markets factoring in the OCR peaking at 4.30%. Mackersy Property again conferred with trusted economists and financial markets specialists who held the same view that wholesale rates had increased too fast too quickly. At this point in the cycle, we saw fixed interest rate offerings well into the 7% range, 2.50-3.00% higher than floating levels. Our view was unchanged that fixing rates at this level was not justified. At fixed interest rates in the 7% range, if we saw a forecasted easing in inflationary pressures and subsequent softening of the OCR we could see wholesale rates decrease, making the 7% rate expensive.
Reduced economic activity has seen fears of a recession creep into the global economy over the last month, and we have seen 1-5 year wholesale interest rates reduce, signalling that the market’s expectations of the OCR peaking at over 4% were overstated. This pull-back across 1-3 year wholesale rates has held however and they are still at a level that matches or exceeds forecasted OCR numbers. When comparing where wholesale interest rates currently trade versus economists’ forecasts, fixing any debt still looks expensive compared to a 90-day resetting facility (floating). We have now seen a change in 5-year wholesale rates which are trading slightly lower than 3-year rates, a strong indication that financial markets are picking a peak to OCR in 2-3 years with a lowering to follow. Two of New Zealand’s leading economists have recently shared their forecasting and thoughts on wholesale rates and OCR projections, and they hold the same view that this spike in inflation and the subsequent spike in the OCR may need to be reversed just as quickly. We also hold the same view, that we will see additional increases in funding costs into the end of the year with some potential pullback into 2023.
The positive impact to syndicates of current inflationary pressures in the economy is significant rental growth across the industry which will flow into higher gross income for our syndicates where these can be captured (CPI increase, market reviews). Over time, income growth should catch up and exceed unrecoverable expense growth (i.e. the cost of debt) – this widely accepted principle is why commercial property investment is so important in high inflation environments as it provides an income and capital hedge against cash or bond style investments which can be reducing in net present value.
The latest CPI inflation data published (18 July 2022) saw a 7.3% rise in inflation for the June quarter, which is well outside the 1-3% band that the Reserve Bank is mandated to operate in. Economic commentary points to an easing in these numbers by year-end as supply and demand balance towards neutrality. Over the June period, we saw prices at the petrol pump increase by 32%, yet if the same metric is calculated today, this sits at 16% which is positive for inflation.
It is impossible to predict where interest rates will trade in the future which makes it difficult to make any hedging decisions that de-risk interest rate risk entirely. If we look back 12-14 months, we were in a very low inflationary time with market commentary indicating that the OCR may trade at a negative interest rate or hold at historically low levels for an undefined period. This shows how rapidly economic conditions are changing and how difficult it is to complete any meaningful interest rate hedging.
We have benefited from historically low interest rate levels since the emergency cut to the OCR in March 2020 when we first went into lockdown. We saw 90-day resetting facilities benefit with interest rates in the 2.00-2.75% all-up interest rate range. These rates were significantly lower than forecasted interest rates in our syndicate cashflows and we reaped the rewards of having 90-day resetting facilities, seeing cash balances grow across the entities we manage. We are now in an environment where the OCR will more than likely trade higher than the current 2.50% rate, however, financial markets are ahead of this and have already factored these increases into wholesale rates negating the benefits of fixing. Retaining a 90-day resetting facility and eventually paying for any potential increases to the OCR (if they eventuate) seems to be the best current strategy.
Mackersy Property, in conjunction with the accountants of each investment group, has reviewed and updated each entity’s cashflow forecasts due to the rapidly changing economic conditions and subsequent interest rate environments. Cashflow forecasting has been analysed at an increased interest rate level of 6.50% by December 2022 and maintained at this level through to 2025. The forecasted cashflow positions and applied interest rates will be monitored by both Mackersy Property and the accountants of each investment entity and adjustments made to forecasted interest rate levels if required. A small handful of investments will require a reduction in future returns to maintain positive cashflows by 2025. Mackersy Property will be communicating with those investment groups over the coming months. If you do not hear from us, your returns can be sustained at current levels based on interest rates increasing to a 6.50% level.
If you have any questions about this article or your investment, we’d love to hear from you.