First of all, market expectations of the first base rate rise have drifted out until May next year even though the Bank's economic growth forecasts have been upgraded for both this year (from 2.5 per cent to 2.8 per cent) and next (by 10 basis points to 2.6 per cent). This reflects higher consumption growth expectations - the Bank is assuming growth of 3.25 per cent in both 2015 and 2016, up 50 and 25 basis points, respectively, on prior estimates; and much higher business investment - this is now expected to increase by 4.75 per cent in 2015, rather than the previous estimate of 2.5 per cent.
Forecasts for housing investment have been raised, too, which is hardly surprising given that the improved stability in the market resulting from a new Conservative administration, combined with the impact of significant real wage growth and record low interest rates, are creating a strong tailwind for an industry that is struggling to meet the increasing demand for new housing from a growing population.
In fact, the Bank also upgraded its projections for average weekly wage growth by a half a percentage point to 3 per cent for 2015, and now expects labour cost inflation to accelerate to 3.75 per cent in 2016. According to the latest data, real wages rose 3.2 per cent between February and May this year, the fastest increase in over five years. So, with UK employment at record levels, the UK unemployment rate of 5.6 per cent at its lowest reading since before the 2008 financial crisis, and closing in on the Bank's best estimate of the long-term sustainable rate of 5 per cent, then tightness in the labour market is forcing employers to pay more to their staff. The Bank expects wage growth to peak out around 4 per cent in 2017, rather good news if you work in the private sector.
Balancing act
Ordinarily, this raft of upbeat economic news would be raising concerns of wage growth spiralling upwards and leading to inflationary problems down the line. But this isn't what is being forecast by the Bank's economists. That's because they believe that the higher wage growth which would normally feed into higher unit labour costs will be offset by an improvement in productivity. Indeed, the Bank now expects productivity growth of 1 per cent in 2015, or four times higher than in its May projection. You may be paid more, but your employer will want more from you too. You have been warned!
The other reason for the Bank's sanguine approach to the inflationary outlook results from sterling's strength: the currency has appreciated by 3.5 per cent since the May Inflation Report. In turn, this is subduing import prices and to some extent counterbalancing the upswing in domestic cost pressure. The Bank also feels - rightly or wrongly - that progress towards its 5 per cent unemployment target will be slower than the rapid declines we have witnessed in the jobless rate over the past few years.
And, of course, with consumer price inflation (CPI) close to zero, reflecting the sharp falls in food and energy prices we have seen in the past 12 months or so, then CPI is miles off the Bank's 2 per cent target rate. Even after stripping out these two deflationary constituents of the index, core CPI is still only 0.8 per cent. The Bank now expects headline CPI to hit 1 per cent in the first quarter of 2016, or 40 basis points less than its previous forecast. The 30 per cent decline in the oil price since the end of June, falling to its lowest level since March this year, is one reason for the sharp downgrade. In the circumstances, it's hardly a surprise that only one member of the MPC, Ian McCafferty, voted for a rise in interest rates at last week's meeting.
It's also fair to say that the Bank of England will be waiting for the US central bank's Federal Open Market Committee (FOMC) to lead the way before it starts tightening monetary policy. All eyes will be on the Federal Reserve's next meeting on 16 to 17 September for guidance there.
Bottom line
The bottom line is that for the next six months at least, and possibly longer, the smart money is betting on record low interest rates being maintained in the UK. Of course, if the domestic data strengthens again, unemployment improves faster than anticipated, and wage growth accelerates, then the seven wise men and two wise women - Dame Nemat Talaat Shafik and Kristin Forbes - of the MPC will have to rethink their projections. But that's not worth betting on now.
Indeed, I still feel that the equity sector roadmap to play the first base rate move, as I outlined a couple of months ago, still holds ('Financial Market Watch', 9 Jun 2015). To recap, according to strategists at US investment bank JPMorgan, the best of the equity gains in the 12-month period ahead of the first base rate rise came from the following UK-listed sectors: construction and materials (30 per cent positive return relative to the MSCI UK index); housebuilding (26 per cent return); automobiles (24 per cent); leisure, restaurants and hotel (19 per cent); media (15 per cent); and consumer durables (12 per cent). And with the market backdrop still benign, selective stock picking in the small-cap arena, a strategy is showing very prosperous returns in the year to date, makes sense, too.
Equally interesting is the projection of economists at Swiss investment bank UBS who feel that the yield on the 10-year UK gilt will rise from 1.85 per cent currently to 2.35 per cent by the end of the year and to 2.5 per cent at the end of 2016. They predict that the move will be led by short maturities, resulting in a flattening of the curve. If they are right, and it's only sensible for the fixed income market to start to factor in a tightening cycle in UK interest rates before the first rate rise in the first half of next year, then this points to further sterling strength against the euro as the yield differential widens against sovereign European bonds. Potential sterling strength against the US dollar will be determined by the actions of the US Federal Reserve.
Hot property
Assuming my interpretation of the macroeconomic backdrop plays out, I feel that the capital flows into commercial property, and retail property in particular, could lead to further yield compression as investors continue to hunt for yield. I also think that the rise in consumer spending predicted by the Bank of England, underpinned by the acceleration in wage pressures, is very positive for the retail segment of the market as is the upgrade in business investment. Indeed, this was the main reason why I recommended buying shares in Capital & Regional (CAL: 63p) ahead of the company's half-year results on Wednesday 12 August ('Hot property', 27 Jul 2015).
It's not the only real estate investment trust (Reit) of interest to me right now because I have been playing the upside in the improving UK regional property market through Town Centre Securities (TCSC: 310p), the Leeds-based retail and office property investor and car park operator, having first advised buying the shares at 198p ('A high yield play in the north', 18 Feb 2013). The company reports full-year results around the middle of next month and I firmly believe there is more upside to come from a holding that has so far returned 66 per cent including dividends.
That's because the yield differential between UK secondary and prime commercial property is starting to compress, according to analysts at CBRE, the world's largest commercial real estate services and investment firm. That's important because although the net initial yield on Town Centre's Securities investment portfolio was 6 per cent at the time of the last valuation in December 2014, and below the peak of 7.9 per cent at the market's trough, it's still well above the 5 per cent yield that marked the peak in 2007.
Moreover, with a third of the company's £313m book invested in its flagship Merrion Centre in Leeds, a further quarter in retail and leisure, and 15 per cent in out of town retail, then in effect almost three-quarters of the portfolio by value has a retail element, the segment of the market that is set to benefit from the improving economic trends I have outlined above. And it's not as if this is already priced into the valuation as the 800,000 sq ft Merrion Centre was last valued at £107m on a net initial yield of 6.8 per cent, a conservative valuation compared with UK shopping centre transactions in the past year. For example, the Fremlin Walk centre in Maidstone was acquired by fund management group M&G for £110m on net initial yield of 6 per cent, and FTSE 100 property giant Hammerson (HMSO: 682p) purchased the Highcross Centre in Leicester for £18m on a net initial yield of 6 per cent.
Town Centre's property book also has a decent spread of high-quality tenants, low vacancy rates and generates robust cash flows, so with investment demand for regional and secondary market properties improving, I see no reason at all why the yield compression on its portfolio should not continue for sometime yet and drive up the company's net asset value (NAV). To put this into perspective, and factoring in a loan-to-value ratio of 47 per cent and an average cost of debt of 4.2 per cent - analysts at broker Liberum Capital estimate that a one percentage point contraction in the net initial yield across the portfolio would boost the company's NAV to 417p a share, from 326p at the end of December 2014.
Liberum are forecasting a NAV per share of 350p by June 2016, rising to 391p a year later - estimates that I feel could be conservative if we see further yield compression. And with Town Centre's shares offering a 3.36 per cent dividend yield, and priced 11.5 per cent below book value estimates, the risk looks to the upside for this late-stage regional property play.
So, having updated my view at the time of the half-year results at 292p ('To bank profits or not', 5 March 2015), and seen the shares move sideways since since hitting a peak of 324p in April - a positive development in my view- I am willing to bet that the seven-year high will be taken out in the next few months. On a bid-offer spread of 305p to 310p, I rate Town Centre's shares a buy ahead of the full-year results and my year-end target price is 350p.
