What will influence capital flows in 2021? Oil to geopolitics
As models carry an inherent amount of uncertainty, the task of predicting the future when the market is faced with a major shock, such as Covid-19, is even more difficult. While our capital gravity model (which has predicted the top 10 sources and destinations of capital in 2021) includes a ‘shock’ component to capture this impact, we also highlight three further influences on capital flows over the coming year.
2 minutes to read
1. Currency and hedging benefits
Currency hedging has seen marked swings over the last few years. In May 2018, the currency hedging benefits for a US dollar investor targeting the UK on a five-year currency swap was as high as 2.3% p.a. (per annum) with an exchange rate of $1.33. By November 2020, the currency hedging benefits were closer to 0.38% p.a. at broadly the same exchange rate.
Similarly, the currency hedging benefits for a US dollar investor targeting mainland Europe in September 2018 was almost 3.5% p.a. on a five-year basis, with an exchange rate of $1.16. In February, just before the onset of the pandemic, hedging benefits were still over 2%. By September 2020, these benefits were just over 1%, with an exchange rate of $1.18.
This has the potential to impact the focus of capital flows. In core locations where prime yields can be lower than 3%, some cross-border investors have been able to find additional return through currency hedging. Without that, they may choose to direct their capital to other locations.
Some investor groups are more sensitive to changing currency impacts than others. For example, South Korean investors shifted the focus of transactions from the US to the UK (activity for which peaked in 2015/16) from 2017 onwards as sterling weakened. Last year, they shifted again to mainland Europe with $6 billion of investment to take advantage of currency favourability.
We have already seen that the US, UK and other key countries in mainland Europe are considered resilient safe-havens for capital in uncertain times. Depending on the path of the pandemic, a recovery of currency hedging benefits, along with a strengthening dollar, could further enhance investment into Europe or the UK. A weaker dollar may encourage more cross-border activity into the US.
2. Oil
As lockdown curtailed economic activity around the world, oil demand slumped. Despite there being only 254 active oil rigs in the US in August 2020 – 650 fewer than one year ago – and internationally, 743 rigs in July 2020 – down 419 on July 2019 – the oil price has dropped significantly.
At the start of the year, it was upwards of $60 per barrel. Now, it is around $45 per barrel. This may encourage oil-dependent countries to accelerate diversification plans and look for the safe-haven, long-term, secure income that real estate can provide.
3. Geopolitics and travel disruption
The last few years have seen a shifting of long-standing global ties, such as US trade agreements and the relationship between Europe and the UK. This uncertain environment has accelerated the move to more local supply chains in the service and manufacturing sectors and there could be further surprises ahead. We may see an increase in intracontinental investing over the coming year, for example, within Europe or between the US and Canada, where the potential operational barriers are lower, and risks are more readily understood. This includes well-located, income-producing real estate in safe-havens.