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The economy is weakening as we go into 2023, and we expect a moderate recession throughout the year. The economic backdrop presents both challenges and opportunities for real estate.

Key Takeaways

  1. The economic downturn evident in the latter half of 2022 will continue into the new year, and we expect a moderate recession in 2023. This has in part been driven by the inflationary backdrop and the policies in place to bring inflation back to its target level.
  2. Throughout 2023, we expect unemployment to rise from its current historically low level. In tandem, job vacancies will decrease. Wage growth will not be able to keep up with inflation until late 2023, eroding consumer purchasing power.
  3. Inflation in the UK has reached levels last seen in the 1980s. This has been driven by a post-COVID surge in consumer demand and global supply chain issues, as well as rising energy and other commodity prices, due to the war in Ukraine. We expect inflation to peak at the start of 2023, and then slowly reduce. This reflects a reconfiguration of supply chains, falls in commodity prices, and weaker consumer demand.
  4. During 2023, the Bank of England will continue to rise interest rates, which are likely to peak at around 4.5%. As inflation begins to cool, rates will begin to decrease, declining gradually to a ‘new normal’ of around 2% from 2026 onwards.
  5. Long-term interest rates will peak at 3.9% in early 2023, and slowly reduce to 3% by the end of 2025. This decline partly reflects the movement expect for base rates, as well as by lower public spending and higher taxes, as outlined in the 2022 Autumn Statement. It will also follow the trajectory we expect in global long-term rates.

Recession and recovery in 2023

After a strong post-COVID rebound, the UK economy is now more challenging. Output has started to decline, inflation remains elevated, and the labour market is showing signs of weakening. We expect a moderate recession throughout 2023, with GDP falling by 0.9%. In 2024 the economy will recover, growing by 1.7%.

The key economic challenge is inflation, which has been at double digits for most of the second half of 2022, and hitting levels not seen since the 1980s. To contain inflation, the Bank of England has increased interest rates, with the base rate up 270bp since the start of 2022.

Faced with spiralling prices and higher interest rates on loans, businesses and consumers are limiting spending. Consumer confidence has been hit, and retail sales will continue to decline until inflation moderates and consumers restore their purchasing power. Businesses will have to cut costs to preserve margins in a high-inflation environment. This will lead to some job losses and higher unemployment in the first half of 2023.

However, we expect that economic growth will return by early 2024. We project inflation to peak at the end of 2022, or early 2023. It will then come down gradually, due to lower wholesale import prices and higher interest rates, as well as cooling domestic demand. The economy appears sufficiently healthy to avoid long-term scarring, such as reduced business investment, high long-run unemployment, and permanent decline in key sectors.

As inflation reduces and the Bank decreases interest rates, consumers’ incomes will restore their purchasing power. Spending will increase, ushering growth in output in early 2024, with strong recovery underway by the second half of 2024.

Figure 1: Falling inflation and fiscal support will help GDP recovery by Q4 2023

Source: ONS via Macrobond, CBRE Research

Inflation has risen sharply in 2022

CPI inflation rose by 11.1% in the year to October, up from 10.1% in September. Core inflation, which strips away volatile food and fuel prices, has remained broadly flat at around 6% throughout 2022, suggesting domestic inflationary pressures are not the decisive factor behind the spike to double-digit inflation.

Inflation has been rising relentlessly over the past 18 months and is at its highest for 40 years. Inflation has been driven by a post-COVID surge in demand, which could not be met due to supply bottlenecks. Russia’s war in Ukraine has exacerbated supply shortages, pushing energy, food, and other commodity prices even higher. Policy choices, such as China’s zero-COVID policy, are slowing down the recovery of supply chains, and raising the costs of imported durable goods. In the UK, inflation has been exacerbated by a weak pound, which has made imports more expensive to the UK consumer.

High inflation has not been just a UK phenomenon. It has affected most countries in the world, with developing countries experiencing higher inflation, on average. October CPI inflation in the Euro Area and the USA, was 10.7% and 7.7% respectively. Despite structural differences, high energy and durable goods prices, alongside broader global supply chain disruptions, are the common underlying cause. In the UK, the Euro Area and the US, very low unemployment has contributed to a tight labour market, further pushing inflation upwards.

Why will inflation fall in 2023?

We expect the underlying drivers of current inflation to be resolved slowly during 2023. After a year in which their levels were dictated by geopolitical events, commodity prices have begun to fall. A sharp global growth slowdown is weighing on commodity prices. The World Bank projects that energy prices will fall by 11% in 2023, agricultural prices by 5%, and metal prices by 15%, compared to their 2022 averages. It usually takes some time for these price movements to be passed on to consumers, but we believe this transition will be eased by the Energy Price Cap.

However, there are risks that supply chain disruption might persist. Russia’s war in Ukraine creates geopolitical risk that threatens to put upward pressure on energy and food prices, if the conflict escalates and current arrangements on food passage are not renewed. Meanwhile, the possibility of wage inflation will wane, as businesses and consumers are squeezed by higher costs. Signs of softening in the labour market, and increased business insolvencies, suggest that the risk of a wage-price spiral is currently low.

On balance, our view is that CPI inflation will peak at around 11% in Q4 2022 and then moderate to around 4.4% by Q4 2023. This forecast is subject to geopolitical and supply chain normalisation, as well as the avoidance of policy errors from both fiscal and monetary authorities.

Interest rates approaching the peak

The Bank of England has reacted to the steep rise in inflation by tightening interest rates; rates have increased by 270bp over 2022. In addition, the Bank has had to blunt the fallout from the September mini-budget, which caused a spike in market interest rates, by buying bonds to stabilise markets.

The Bank is likely to tighten further, reaching a peak of 4.5% in Q3 2023. While market expectations of the peak rate have been volatile, the alignment of fiscal and monetary policy that comes with the 2022 Autumn Statement, would make it possible for a lower peak Bank Rate to bring down inflation.

Long-term interest rates have closely followed the Bank Rate, but will peak in early 2023. We expect that ten-year Government gilts will peak at 3.9% in Q1 2023, and then decline to 3.5% by Q4 2023. After this, the yield will continue along a gradual decline path, reaching 3% by Q4 2025.

Once inflation comes under control, and interest rates start to fall, yields will shift downwards too, opening up new opportunities for investors and occupiers. The return to growth in Q1 2024 will boost occupier demand for offices, retail, and industrial space. Our models show that for every 1% point increase in GDP, total returns increase by 0.7%.

The risks to this forecast are both external and internal to the UK. A prolonged war in Ukraine might slow the downward adjustment of energy, food, and other commodity prices, keeping consumer prices higher for longer. Internally, the Bank of England might overtighten, causing a more painful landing than is necessary to bring down inflation. Substantial future cuts to Government spending may also adversely impact output, but the lower spending and higher taxes of the 2022 Autumn Statement are in line with our forecast.

Figure 2: UK CPI inflation and interest rates

Source: Oxford Economics, Macrobond, CBRE Research

Inflation and rising interest rates have brought about an increase in property yields. What's next?

  1. The ongoing yield shift has hit values and returns for past investors. As the cost of capital, closely related to the interest rates of central banks and therefore to inflation, have risen, valuations have changed.
  2. However, if we are right about inflation peaking in Q1 2023, and then reducing throughout 2023, prospects are rapidly improving for new investment in the UK property market.
  3. As interest rates and debt come down, we see the possibility of 13% returns over five years for levered investment made around end 2024, even with a low LTV financing.
  4. The time to reaching peak returns depends on how quickly yields correct after inflation and interest rates fall, as well as on when the interest rate loosening begins.

Generally, periods of high inflation have been associated with lower real returns, and low inflation with higher real returns. As inflation abates and growth returns, the opportunities for attractive return on investment will follow closely.

Figure 3: UK all property total returns for a 5-year investment (illustrative)*

Source: CBRE Research
*Returns are pre-tax and are based on the CBRE macroeconomic House View.

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