UK has experienced its largest interest rate increase in decades over the past two years, which has caused the house price index to fall sharply. Even though it sounds terrifying, I still believe that every crisis can be a huge investment opportunity. Because we can buy assets with cheap prices.
To take advantage of crisis, you need to know two things:
What are the causes of the crisis?
When will the price revert?
In this article, I chose iShares UK Property UCITS ETF as an example to show you how I take advantage of the crisis.
WHAT ARE THE CAUSES OF THE CRISIS?
iShares UK Property UCITS ETF seeks to track the performance of an index composed of UK listed real estate companies and Real Estate Investment Trusts (REITS). Therefore, this fund can generally reflect real estate sector’s performance in the UK.
Usually, the lower interest rates are, the lower the cost of borrowing to pay for a house is, and the more people are able to afford to borrow to buy a house. That will also mean prices will tend to be higher. We can easily tell the big index drawdown since 2021 is caused by the sharp increase in interest rate. But why interest rate has been increasing so much? Because the best way to bring down the high inflation rate is to increase interest rate. Then, why inflation in the UK is so high? Because disruption from the pandemic, along with China’s “zero Covid” policy and war in Ukraine, has pushed up freight prices, manufacture prices, and gas prices.
So, now we figured out the direct cause is increase in interest rate, and the root causes are disruption from the pandemic, along with China’s “zero Covid” policy and war in Ukraine.
However, the relation between interest rate and index price was abnormal during the 2008 financial crisis. That is because this relation is distorted by subprime mortgage crisis. In a later post, I will list previous financial crises. I think understanding financial history can help us prevent severe losses in times of crisis.
WHEN WILL THE PRICE REVERT?
To figure out this question, we need to forecast interest rate trend first. I use “Vasicek interest rate model” to forecast interest rate. The Vasicek Interest Rate Model is a mathematical model that tracks and models the evolution of interest rates.
The formula is
a = The speed of mean reversal, i.e., the speed at which the interest rate returns to its long-term mean level (b).
b = The long-term mean level of the interest rate, calculated based on historical data. All future values of rt are expected to revolve around the long-term mean level “b.”
rt = The interest rate given by the short rate.
σ = The standard deviation of the interest rate also referred to as the volatility of the interest rate.
Wt = Random market risk.
The forecast result is that in a year, the interest rate will fall to 3.41%. I pasted my calculation in the end of this article. If you are interested in this method, you can check the tutorials on YouTube.
However, we cannot rely solely on statistics method to forecast finance factors. The forecasted outcome must be supported by sound financial reasoning. This is the reason why we need to figure out the rooted causes. In this case, the statistics forecast result can convince me, because China government already abandoned zero-covid policy, and the supply chain is recovering. Also, Russia supplied 24.1% of the UK's refined oil imports in 2021, however, Russia fell to the sixth-largest import source for refined oil in April 2022 as importers seek alternatives following the Russian invasion of Ukraine. So, we can assume the effect of war in Ukraine will go down.
In the end, I want to emphasise that I don’t give any specific investment recommendation. I only use this case as an example to show you how I think. I hope this article can help you take advantage of future crisis. Also, If you have better way to forecast interest rates, please let me know.
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