Derivatives: Slowdown in derivatives trading may be calm before the storm

With expected value falls already priced into contracts, trading has been weak, but may pick up if total returns fall below 0%

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CBRE-GFI market commentary

January IPD All Property figures revealed a 0.2% fall in capital values over the month, indicating that we may have reached the turning point for capital values, following a marginal decline in December, writes Sam Whitham.

An income return of roughly 0.5% kept total returns positive at 0.3% on a monthly basis. Rental values fell across the board in January and have now fallen for three out of the past four months.

IPD UK managing director Phil Tily said: “Yields saw slight expansion but fragile occupier demand remains the main driver behind falling capital values.”

The non-seasonally adjusted Halifax House Price Index bounced back from a significant fall in December. UK prices on average rose 0.7%, but are still only at levels seen in mid-2009. Marginal action in HHPI contracts has caused little change in pricing in early 2012.

Activity so far this year in the property derivatives market has been subdued, which is not  surprising, as commercial  property values remain stable  to slightly weaker and rather predictable in the near term.

In other words, given the forecasts of zero or mildly negative capital growth (which are already priced into the derivative contracts), there is little compelling urgency to take on further exposure.

In the other direction, relative stability (perhaps the calm before the storm) and diminished concerns about a catastrophic deconstruction of the eurozone seem to have reduced the need to hedge exposure.

However, should there be any awkward developments in this debt-related financial crisis that cause the world’s perception to take an ugly turn, there is little doubt that it will bring price movement and the corollary step up in activity.

The pricing of one-year contracts, with a mid price of 0% total return, is pricing in a fall of around 6% in capital values. The ‘fat tail’ scenario is looming and consequently buying is somewhat sporadic and thin. We see two scenarios with very different outcomes for trading.

A wobble or minor setback in Europe could take total returns below 0% and would lead to a pick-up in trading. IPD medium-term notes will offer greater outperformance over the IPD index, which would draw in interest from asset allocators  if keener pricing were evident.

A one-year IPD linked note issued at par now provides 1% outperformance of the IPD UK All Property Index; this is a level at which deals have begun to take place. If this outperformance were to push higher, to say 2%, capital inflows into the product may increase.

In the other scenario – perhaps we could call it the disaster scenario – the market teeters over a cliff, eventually free falling without touching the sides. This could mean almost no activity, as investors are paralysed in anticipation of a significant fall in values.

Additionally, redemptions may be such that fresh exposure to real estate may be suspended to “save for a rainy day”. Under this eventuality, not even keener pricing would draw in the volumes seen in 2008 and 2009.