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Commentary on financial market developments – June 2017

Highlights:

  • US: interest rate hike by a quarter of a percentage point
  • Oil price falls below $50/barrel

Commentary:

The US Federal Reserve raised interest rates by 0.25 percent as expected. At the same time, it confirmed the outlook for further rate hikes by the end of 2017. The move did not provoke much of a reaction in the markets, as a 0.75 to 1.00 percent rate hike was expected for 2017 and is already largely priced in. More importantly, however, Janet Yellen’s outlook mentioned further gradual interest rate increases over the next few years. The Fed therefore seems to expect a gradual rise in inflation, rising wages and a good performance of the economy in the longer term.

The oil price has once again fallen well below USD 50 per barrel. Although the oil cartel OPEC is trying to reduce oil production by agreeing to limit production and thus stabilise the price on the commodity market, producers outside the cartel (with the US leading the way) have learned to be very flexible and to start production at the slightest rise in price to levels at which they are already making a profit. They are also helped by ever-improving technology that reduces the cost of extraction, and by President Donald Trump’s policy of supporting domestic miners and his withdrawal from the Paris Climate Agreement commitments. Russia in particular, whose economy is heavily dependent on oil, is suffering from low oil prices, as is Saudi Arabia, which is planning the sale of its state-owned oil company Aramco, with low oil prices depressing its valuation.

Investor’s School – Real Estate Market:

The real estate market is subject to market laws like any other market; price is also determined by the clash of supply and demand. However, a specific feature of the real estate market is the diversity of individual properties (varying in location, size, materials used, etc.) and the resulting low liquidity of specific properties.
In the Czech Republic, there is a persistent idea that real estate is a very safe asset whose price practically only increases. This corresponds to the post-revolutionary experience, when the domestic real estate market was significantly undersized and prices were practically only rising except for a relatively slight drop in prices after the financial crisis.

Czechs were thus under the mistaken impression that real estate was the best asset class, combining high yields and low risk. This is not the case, real estate is certainly an interesting investment opportunity, but investors must also take into account the cyclical development of the market. The real estate market is specific in that its fluctuations are relatively mild, but long-term. This means that real estate can grow for a long time, but in times of crisis it takes a long time to find its bottom (stock market falls are much faster and usually deeper, but so are their recoveries). This is illustrated, for example, by the US Case-Shiller real estate index for the 20 largest US cities, where house prices fell from 2006 until 2012!

It is obvious that the overheating of the US stock market was made possible by the huge mortgage boom, when almost “anyone” in the US could get a mortgage, yet a parallel (on a smaller scale, of course) is offered with the current Czech real estate market.

Record low interest rates and the growth of the Czech economy have led to new records in the volume of loans granted in recent years. The growth in demand for real estate logically leads to price increases. It is of course possible that there is still room for further growth in property prices, but it is good to remember that the property market is as cyclical as any other market. There may then be a situation where the market situation changes and an unprepared investor/household may find themselves in big trouble. Today, interest rates are still relatively low, house prices are high and the economy is in good shape. But imagine a situation where interest rates start to rise, house prices start to fall due to weakening demand and the Czech economy falls into recession. Then it can easily happen (what many households in the US do) that an investor/household lives in a property whose price is falling, mortgage payments are rising and unemployment is rising due to the poor economic situation (the household may lose income).

In the United States, the base interest rates set by the Fed are already rising, and we can see a slight increase (although the CNB is not raising rates yet) in the domestic mortgage index.

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