Derivatives: Pricing looks bright for 2011 contracts, but clouds darken on horizon

Derivatives pricing implies a positive capital return for 2011, but fears of a eurozone debt crisis have hit post 2011 pricing

CBRE-GFI market commentary

Pricing for 2011 contracts continued to rally over the past month and now provides a mid-price of 7.1% total return for the year, indicating positive capital growth for the first time this year, writes Sam Whitham. Pricing for 2012, 2013, 2014 and 2015 contracts fluctuated, but after dipping, recovered to just below mid-June’s level. IPD total returns for June were 0.7%, continuing to show a small rise in capital values on top of stable income return.

The release of CBRE’s Q2 2011 quarterly forecast revealed a prediction that total returns for each of the next five years would be higher than derivative pricing suggests. If this is correct, 2011 contact pricing should rise 1.3% before the end of the year. With 2.2% capital growth forecast for 2011, slow but steady growth is forecast to continue into the second half of the year, with roughly the same capital growth level forecast for the two halves. Total 2012 returns are forecast at 5.7%, 1.8% above IPD contract pricing. The forecast and derivatives pricing imply capital value falls of roughly 0.7% and 2.5% respectively.

Pricing for 2013, 2014 and 2015 implies roughly 5.5% total returns for each year, compared to  forecasts of 9.2% for 2013 and 8.1% for 2014 and 2015. Forecasts suggest 2012 will be the only year capital values will fall in the next five years, but derivatives show no capital growth past 2011. In the past month, pricing for 2011 contracts rose even more rapidly than the previous month, from 6.15% to 7.1%, while 2012 annual contract pricing started the month at just over 4% and fell to a 3.75% total return, before recovering to 3.9%. Contracts for the subsequent three years started the month pricing at around 5.5%, fell 0.5%, then recovered to just below 5.5%.

The non-seasonally adjusted Halifax House Price Index had its largest rise so far this year, adding 0.8%, and has now risen for six consecutive months, making the 96.25% 2011 contract price an interesting investment opportunity. The index has risen by 1.3%  in the first six months of this year, meaning HHPI derivative pricing is indicating a 4.55% fall in UK average house prices over the rest of the year. It is hardly surprising that longer-dated derivative pricing is not bullish for the next five years. Sovereign debt problems have been prominent in the news. The Greek government’s agreement to EU austerity measures initially seemed to instil a little confidence in the financial markets. But there has been further uncertainty in the past few days as the Italian and Spanish economies are brought into question again and yields on government bonds have surged.

Regardless of the continued risk to the UK’s economic and financial performance this year (much of which is provided by the eurozone), derivatives pricing and forecasts have avoided bearish levels. Property deal volumes fell to £5.4bn in Q2 2011, from £10bn in Q1. Alongside weakness in many occupier markets, this may help  explain the more bearish 2012 outlook, with residential and commercial capital values expected to fall.