Real estate and inflation

Today, the question is whether there are overvalued real estate markets in the major countries that could exacerbate a recession.

In our capital market outlook from July 2022, which you can find here we examined, among other things, how recessions have affected inflation rates over the last 50 years. In 13 recessions, inflation rates in the USA, Germany and the eurozone fell by an average of 3.2 percentage points.

This time we examine the question of whether there is a current risk that falling real estate prices will increase the risk of recession via the so-called "wealth effect" (when prices fall, homeowners feel poorer, consume less and thus weigh on the economy). The link between falling house prices and the economy has been confirmed by a number of studies. For example, Benjamin, J.D., Chinloy, P. and Jud, G.D. (2004) found that real estate prices and consumer spending are positively correlated and that falling real estate prices have a greater negative impact on consumption than falling share prices. Chen, J. (2006) confirmed this effect for Sweden from 1980 to 2004, Calomiris, C., Longhofer, S.D. and Miles, W. (2009) for the USA from 1981 to 2009.

The consequences of the collapse of a large residential real estate market were demonstrated by the US residential real estate market from 2007 onwards, when the market became too expensive as a result of politically motivated lax lending to home buyers with poor credit ratings ("subprime") despite high vacancy rates (chart 1 b). The sharp fall in prices (chart 1 a) affected highly indebted private households (chart 1 c) and banks with weak equity (chart 1 d). The financial system came under threat worldwide because the Americans had sold a large proportion of their loans to foreign financial institutions. Today, however, there is no danger from the US market. Although house prices have risen to record levels, there are hardly any vacant homes because few new homes have been built in the last 15 years (chart 4 a). In addition, US citizens' debt is low and banks have strong balance sheets.

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Rental yields are also above average in major US cities (chart 2 a) and house prices are particularly low as a multiple of the median income (chart 2 b).

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The US residential real estate market is therefore quite attractive by international standards. The absolute price increase is moderate (chart 3 a). Both relative to income (chart 3 b) and to rental income (chart 3 c), house prices in Canada, Sweden, Australia and the UK have risen much more strongly than in the USA, Germany and Japan, which has still not recovered from the collapse of the Japanese real estate bubble from 1991.

In Sweden and Canada, the markets where house prices have risen the most, there has been a lot of construction in the last 15 years, meaning that a significant fall in house prices can be expected here (chart 4 a). This risk is lower in Australia and the UK because new construction activity has not been particularly high for years. In Germany, even fewer apartments were built in 2021 than in the previous year (Figure 4 b); another significant decline is likely in 2022, as many new construction projects will be halted due to a shortage of tradespeople and unpredictable building material prices. Conclusion: Only smaller markets such as Canada and Sweden are risky.

However, the situation is different in China, the world's largest real estate market at USD 100,000 billion. Rental yields in major Chinese cities are extremely low and house prices as a multiple of the median income in the respective cities are particularly high (charts 2 a, b).

This dangerous development is due to a fundamental change in the direction of Chinese policy. Deng Xiaoping, the Chinese head of government from 1979 to 1997, made the 40-year boom in the Chinese economy possible by introducing a market economy. Since then, there had been an unspoken agreement between the Communist Party and the population to leave the Party's power untouched as long as the prosperity of the Chinese increased. However, the financial crisis of 2008 highlighted the dependence of the Chinese economic miracle on the industrialized countries: their severe economic crisis forced China to provide huge economic support in order to avoid falling into a crisis as well. Enormous financial resources were pumped into the real estate and infrastructure sectors. Experience has shown that this is where the strongest short-term growth impulses can be found. For this reason, Japan also promoted the real estate market in the 1980s, causing Japanese national debt to explode from 60% of national income at the time to 260% today. Germany made the same mistake when it allowed the East German economy to grow by 10% for four years after reunification by offering enormous tax breaks to real estate buyers. Japan is still stagnating today and Germany was the "sick man" of Europe from 1995 to 2006.

Since the financial crisis, China has channeled more than 10% of its national income into real estate investments every year; from 2012, more than 14% (see the November 2021 Capital Market Outlook, which you can find here can be found here). In the US, the figure was only up to 6% in a few years before the crisis, which was enough to trigger the 2008 financial crisis. In China, however, it is not a matter of collective stupidity, but of the Communist Party maintaining its power. The party believes it can control economic growth by steering investment. The disadvantage, however, is that many of these investments are not profitable and therefore the debts for financing them cannot be repaid from the returns on investment. Another method that reduces prosperity is China's growing isolationism, which aims to become self-sufficient in as many areas as possible. Imports as a percentage of national income peaked before the financial crisis and have fallen significantly since then (chart 5a). Productivity growth is naturally suffering as a result. China, for example, is making enormous efforts to build up its own chip industry to a top level and has already invested USD 50 billion of state money in this, albeit without much success so far. According to the American chip industry, up to 16,000 suppliers are involved in the production of a chip. No single country could cope with this (FAZ 18.8.2022). Another area of wasted capital is the "New Silk Road" project, which Xi Jinping launched in 2012. So far, USD 838 billion has been invested in infrastructure projects in developing countries, financed with expensive Chinese loans. However, problems are now mounting due to a lack of profitability. Loans with a volume of USD 52 billion have already had to be renegotiated (Spiegel, August 20, 2022).

The fact that China is now more concerned with politics and power than with economic progress is also shown by the scientific education of China's top politicians, who as of 2012 no longer predominantly studied "exact" sciences (Figure 5 b, for definition see Wikipedia: hard and soft sciences). Marxism, adapted to Chinese conditions, is now openly established as the ideological basis of Chinese politics. China is thus giving up its great advantage over the West of being led by well-educated politicians and becoming prosperous with a market economy system, and will therefore have to forego high economic growth. China may even become a second Japan.

Now let's take a closer look at the coming disaster of the Chinese residential real estate market, where the amounts wasted are many times higher than in the case of chip autarky or the "New Silk Road".

Unfortunately, China's real estate problem has several dimensions. The number of completed apartments has already been far too high in the last 15 years (chart 6 a, green line), as the number of vacant apartments is now a staggering 65 million, according to a study by investment bank Morgan Stanley from September 2, 2022. With an estimated number of apartments in China of 650 million (just over 2 residents per apartment), this would be a vacancy rate of 10%, more than three times as high as the peak value in the US since 1958, namely 2.9% during the subprime crisis (chart 1 b).

The next problem is the disparity between apartments sold and completed (Figure 6 a). The difference rose to almost 1 billion m² of living space in 2021. Assuming a generous 70 m² per apartment, this means that in a single year there are around 14 million apartments that have been paid for but not yet completed. Given the ailing state of real estate developers in China and the enormous vacancy rate, they may never be completed. Assuming that an unfinished apartment has only cost US$ 70,000 over the last 15 years, the Chinese population has already suffered losses of more than 150% of their current national income (chart 6 b), either in the form of loans taken out (chart 7 a) for which no finished apartment was obtained, or as lost savings.

The next problem is the ageing population. The number of Chinese of working age, who make up the lion's share of property buyers, has been shrinking for several years (chart 7 b). As a result, demand for residential real estate has already been falling (chart 7 b, gray line).

In view of the gloomy outlook, demand is likely to fall further. The construction industry is already preparing for this (chart 8).

Now we come to some rather good news. Unlike the Americans, the Chinese have financed their real estate bubble largely from domestic savings in the Chinese banking system, which is largely state-owned. This means that a global financial crisis like the one in 2008 is unlikely.

The foreseeable Chinese losses will have a significant impact on consumer demand, which will certainly be a problem for the German automotive industry, but should also weaken global inflationary pressure. China's consumption of numerous raw materials has been very high to date (Figure 9 a: China consumed more than twice as much cement in 2017 as the next 17 largest cement consumers).

China's share of global consumption of industrial metals, e.g. copper and aluminum, has also risen sharply to over 50% in the last 20 years (chart 9 b) and has thus contributed significantly to the price increases (chart 10).

The foreseeable sustained decline in construction activity in the housing and infrastructure sector, whose enormous size by global standards can be clearly seen in Chinese cement consumption (chart 9 a), will not only reduce demand for raw materials, but probably also their prices and mitigate the global inflation problem. This also applies to energy commodities. In the course of the energy-intensive expansion of construction activity, China has now become by far the largest energy consumer in the world (chart 11). If China's growth in the future takes place more in the consumer and service sector, as in the "old" industrialized countries, China could grow moderately in the long term and make a significant contribution to combating climate change.

With 1 gigajoule of energy, Japan and Europe generate around four times as much, while the Americans, who are not exactly known for their economical use of energy, generate two and a half times as much real economic output; the Chinese should also be able to achieve this in the long term (Figure 12).

Until then, however, the real estate problem must be solved. Since the real estate crash in 1991, government debt in Japan has risen far more sharply than in the other major industrialized countries (Figures 12 a and 12 b). The same will happen in China. In Italy, the interest rate for long-term government bonds has risen by 300 basis points since the beginning of the year, in the USA and Germany by 200 basis points and in China it has even fallen slightly. China will have to stimulate the economy by at least partially compensating its citizens for their losses and at the same time protecting the economy as a whole from a serious crisis through economic stimulus programs and low interest rates.

In summary, we expect a significant and lasting decline in Chinese economic growth, with the result that inflationary pressure, which is based to a large extent on sharp increases in commodity prices, will ease worldwide next year. This will improve the outlook for the capital markets, which have come under pressure largely due to the jump in inflation since 2021.

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You can also download the capital market outlook here.