Economic and Property Market Outlook Q1 2015
Global Economy
Global growth came in last year at 3.4%, the same as in the previous year, but rather than build on the improving trend seen in the first half of 2014, output slowed towards the end of the year indicating the continued likelihood of only modest growth rates for both this year and next.
Global financial conditions are expected to remain accommodative in the short term, with the gradual tightening (initially through higher interest rates) that have been anticipated for some time possibly having been put back. Any prospect of interest rates rising over the summer months appeared to have been dashed by the publication of poor US growth figures for Q1 2015, but a subsequent global bonds sell-off in early May has questioned this belief.
Growth over the first three months of 2015 disappointed in many countries, most notably in the US and the UK. Cold weather, a later Easter than last year, lower production, owing to the fall in oil prices, and unfavourable currency strengthening have all contributed to weakness in Q1 in these countries, which most analysts believe, though, will be a temporary slowdown.
Our global growth forecasts show little change from our previous forecasts three months ago. Our forecasts for Japan and the eurozone are increased by c 30 basis points over both this year and next while the almost negligible growth seen in the US in Q1 has prompted a 50 basis point cut to our US 2015 growth forecast.
Eurozone Economy
After years of virtual stagnation, there are signs that the policy impetus injected into the Eurozone economy by the European Central Bank is beginning to bear fruit. Coupled with lower oil prices, low interest rates and a weaker euro, these favourable trends are boosting most Eurozone economies. Our growth forecasts have been modestly raised for most countries this year and next, although individual country growth forecasts still vary markedly across the single currency bloc.
Despite these more favourable portents, the eurozone’s forecast rate of economic growth is still expected to remain well below trend, as are the forecasts for each of the major countries. And while our forecast for Spanish growth for 2015 has been increased to a near decade high 2.5%, one needs only recall the 4-5% annual growth recorded by Spain before the financial crisis to realise just how weak this recovery will be. In addition, Spain’s employment is also heading in the right direction. March data shows that the unemployment rate has fallen to 23% and below the psychological 25% level for the first time several years.
Consumer price growth remains limited. The most recent data shows that the Eurozone as a whole exited deflation, but the April figure for annual consumer price inflation of 0% (after four months of small reductions) continues to indicate minimal upward pricing pressures. The fall in energy prices was the biggest contributor to zero inflation: over the last twelve months, this fall has cut living costs by almost 6%, although that was offset by higher prices of food, alcohol and tobacco.
As we progress through 2015, last year’s fall in energy prices will be reversed, but only to a limited extent. Together with the modest pickup in economic activity and the prolonged impact of euro depreciation, we believe that headline CPI inflation will rise towards 1% this year, still somewhat below the ECB’s target level of around 2%.
The major concern to sentiment remains the political situation in Greece. The radical left party, Syriza, has formed a government with the mandate to attempt to renegotiate the country’s huge bailout conditions. Much talk has so far ensued, but to date it remains unclear how this situation will be resolved. Although Greece represents only a very small part of the eurozone economy, any fall out could have severe ramifications both within and outside the eurozone. A return to recessionary conditions would be likely for the Eurozone and its major trading partners (most notably the UK) were a ‘Grexit’ to ensue.
For the eurozone as a whole, we expect GDP growth of 1.5% this year, improving to 1.6% next year, still well below pre-crisis growth rates and with the driving force remaining consumer spending and exports. But growth will once again not be evenly spread. The less indebted countries will continue to see greater economic activity than those saddled with high debt levels.
The UK
The UK enjoyed its strongest economic performance last year since 2007 with growth of 2.6%. And despite the first estimate of the 2015 Q1 growth coming in at a disappointing 0.3% – half that achieved in the previous quarter – most analysts believe that the Q1 figure reflected several one-off negatives, including cold weather and a later Easter, and that growth will move back above trend in future quarters.
The successful areas of growth in Q1 – consumer spending and services – will remain the bedrock for growth over the coming years. Wage rises are now running ahead of inflation, providing a welcome boost for Britain’s hard pressed consumers. But caution remains on the impact that higher consumer spending will have on the retail market. Not all locations will benefit to the same extent, nor will all formats. One just has to consider the recent financial results from Tesco and J Sainsbury which included large-write downs of their supermarket portfolios to realise how Britain’s shopping patterns have changed in such a short space of time.
Manufacturing once again disappointed in Q1 with growth of only 0.1%. Two factors contributed to the slowdown – weakness in many of the UK export markets and the strength of sterling, particularly against the euro. While we forecast growth in many of the UK’s trading partners to pick up later this year, sterling’s strength is likely to limit any benefit.
More positive news came from the services sector, whose rate of growth in Q1 was a touch below trend at 0.6%, but which now seems to be accelerating. Recent survey data indicates that the service sector is now growing at its fast pace since last summer.
The biggest risk to our optimistic expectation for the UK had been an indecisive result at the General Election. The outcome, though, of a Conservative government with an overall, if small, majority surprised commentators and sent shares and sterling sharply higher. The hard work of governing a divided country – politically-wise – is just beginning. Europe, and in particular the fate of the eurozone, cannot be ignored while the stand-off between the ruling Syriza party in Greece and the ECB remains. Nearer to home, the Conservative victory ensures that the British electorate will be given an ‘In/Out’ referendum on continued EU membership, thereby reintroducing more uncertainty.
The UK Property Market
UK commercial property fired on almost all cylinders last year. Its total return, at 17.9% (source IPD Quarterly Index), comfortably exceeded returns from UK bonds and equities and recorded its highest annual return since 2006. However, these high rates of return owed more to the continued downward pressure on yields than on rental growth. Consequently, we remarked last quarter that it would be unlikely for rates of return to remain at such levels without a material upward shift in rental growth.
Therefore it came as no surprise that the total returns for Q1 2015 slipped a little. That quarter’s total return of 2.9% (source: IPD Quarterly Index), although still above the long term, real (inflation adjusted) rate of return, was the lowest quarterly return since Q3 2013. Transactions remained very buoyant in Q1 with continued investment interest despite the impending General Election. Although yield hardening was again evident in the quarter, rental growth is beginning to spread out and according to the IPD Quarterly Index, average rental growth turned positive in the retail sector for the first time in over two years. Office rental growth remained the strongest of all the sectors with central London once again producing the highest rates of rental growth.
In recent years, central London properties returned by far the greatest total returns, with provincial properties suffering from continued outward yield shift and falling rents. Last year, however, there were signs that the gap is beginning to narrow in line with the UK economic recovery which has been filtering out from London.
The office sector regained its position as the best performing sector over Q1 with a total return of 3.9%. The industrial sector, which performed the best over 2014, came in close behind with 3.4% over Q1 while the retail sector remained the worse performing sector with a total return of only 2.0%. Once again, however, these sectoral returns show only part of the picture. Central London properties (office and retail) are still returning the highest returns although the gap between total returns achieved in London and the south east and the rest of the UK is continuing to close. The financial results from Tesco and J Sainsbury showing a combined decline in the values of their supermarket portfolios of over £5bn once again indicate where much of the property pain is being felt.
The Q1 2015 total returns indicate that total returns this year are unlikely to reach the heights witnessed last year. We continue to believe that total returns will moderate over the course of the year, and delivering around 10% for 2015. Rental value growth will become the stronger driver than yield compression. And while we do not foresee much yield hardening in prime assets, there will be scope for yields to firm further in good, well located and well specified secondary product, particularly outside London and the south east. Interest rates will at some point rise, and this could put some upward pressure on property yields, but the marked fall in inflation expectations at least has limited any potential movement in the short term.
The risks to property lie both domestically and outwith the UK. Globally, the biggest risk remains the timing and extent of increases in interest rates. Europe remains a major concern. And while General Election had a clear result, the promised referendum on continued EU membership will be an unwelcome distraction for some time.
Central London Office Market
The central London market, both office and retail, continued to post the best total returns over the first three months of 2015. However, the spread of total returns between London and provincial properties is now at its lowest since the recovery of the UK property market in 2009.
Contributing to the narrowing of returns are the continued improvement in sentiment to regions outside the south east, where employment levels are growing faster than that of the capital and the relative shortage of property in central London coming on to the market. This latter feature, a product of the extremely low yields now available in central London, and a unwillingness by owners to sell given the difficulty of replacing the stock, limited yield compression there in Q1. In contrast provincial properties witnessed slightly stronger capital growth through yield compression in the quarter.
However, economic growth still favours London and south east over the regions, and with supply becoming ever tighter there, we seem set for another year or so of strong rental growth for prime, well configured, well located central London offices. There is now evidence that rental growth is spreading outside these prime properties, particularly in the West End, where prime vacancy rates are now below 2%.
The tight vacancy rates throughout the central London office markets remains a concern for potential tenants, moreso in the West End. In contrast, there are several potential large development sites in the City: the Riverside Development in Docklands – 5 acre site which already has planning permission for 3.5m sq ft of office and retail space – and the Pinnacle in EC2 where up to 1m sq ft of office space could be accommodated.
However, it remains unclear if or when these projects will commence. It is also prudent to comment on the downsides to our optimistic scenario for central London offices. As well as the continued turbulence from the eurozone, City proponents will be watching the decision of the Board of HSBC on whether to move their global headquarters away from London. In employment terms, as well as floorspace terms, a decision to relocate out of London will have minimal impact (HSBC only employ 250 staff in that function in London), but in sentiment terms, it could be important in whether other banks and financial companies follow suit.
Overall, we expect central London offices to deliver above average total returns this year, with capital growth being more rental growth driven than by any further yield hardening.
Research Author: Stewart Cowe
