Research Paper Q2 2015 – Economic and Market Outlook
Weakness in Q1, most notably in the US, but also in Japan, the UK and China, has prompted downgrades to full year forecasts for each of these nations, resulting in a reduction in the global outlook for the year. Despite these cuts to our growth forecasts, the underlying positive trends – accommodative financial conditions, lower fuel and energy prices, improving confidence and employment – remain intact.
The US bounced back to growth, reporting annualised growth of 2.3% in Q2. At the same time, growth in the bad weather hit Q1 was not as bad as initially feared having been upgraded from a small contraction to an annualised growth of 0.6%. Nevertheless, the still weak showing in Q1 has prompted a reduction of 60 basis points to our US GDP forecast for 2015. This year’s forecasts have also been reduced for Japan and the UK.
Our expectation for emerging economies has also been cut, reflecting the effect of reduced commodity prices and tighter financial conditions.
Risks to global growth remain slightly weighted to the downside. Recent rises in sovereign bond yields across the Eurozone will limit the upside risks to activity there but at a global level, there remains the prospect of a consumer-led boost from lower energy costs, particularly in the advanced economies.
The Eurozone Economy
Greece continues to make the headlines, but the underlying picture in Europe continues to improve. Unemployment in most countries continues to tick down, albeit slowly, while consumer and business confidence is heading in the right direction, the former on account of the lower energy price which is boosting consumer spending.
Growth is benefiting from firm domestic demand, especially private consumption and strong exports which are being helped by a weaker euro. Signs are emerging too of a pick up in investment which has been helped by improving credit conditions.
Despite these positive signs, and despite a marginal increase to our forecast growth rate next year, the outlook for activity remains well below trend across the eurozone. Our forecasts for the major European economies, France and Germany, are unchanged from those of three months ago; however, we have raised our growth forecasts for both Italy and Spain by c 30 basis points and 50 bps respectively for both 2015 and 2016 on the back of a more favourable outlook for consumer spending.
The eurozone though is still vulnerable to both internal and external shocks, the most critical of which remains the situation with Greece. A third bailout is being negotiated, but several hurdles remain before agreement will be reached – most notably the contentious raising of the retirement age. Until realisation dawns amongst its creditors that even the current debt levels are unsustainable and that a complete restructuring of its debt is urgently required – the Greek government is not raising enough tax revenues to even pay the cost of its debt, far less its other commitments – this problem will rumble on. This fact has been pointed out by the IMF, leading to concerns that they will be not be a party to the bailout.
The UK Economy
Following the disappointing growth rate of 0.4% posted in the first quarter of this year, growth in Q2 accelerated to an above trend 0.7%. While growth in Q1 was negatively impacted by several one-off factors, in particular cold weather, a later Easter and uncertainty ahead of the general election, the most recent quarter was boosted by tax cuts in the March budget which lead to a significant increase in oil and gas production.
This in turn pushed overall industrial output up by 1% in the quarter, its biggest figure for almost five years. The dominant service sector grew in line with that of the overall economy (0.7%); however construction output was flat over the quarter and the country’s manufacturing output suffered its first quarterly fall in two years.
Over the recent past, the UK economy has grown by 0.7% or more in five of the past six quarters which does suggest that the economic recovery has become well established. However, there are few signs that the economy has rebalanced in the way that Chancellor Osborne had hoped. It remains too consumer dependant (and where the immediate outlook has improved with wage growth now ahead of inflation) but there are finally signs that business investment is beginning to pick up. In addition, the outlook for exports remains dull. Sterling appreciation is compounding the problems of relatively weak export markets in Europe.
Nevertheless, consumer confidence is at its highest level for a decade. Rising employment and wage growth finally ahead of inflation together with very muted levels of inflation – a short period of deflation is in prospect in the coming months – are the key drivers of this confidence and suggests the outlook for consumer spending remains positive.
The release of commentary on interest rates, minutes of the Monetary Policy Committee meeting and future inflation expectations on what was dubbed ‘Super Thursday’ in early August indicated that the Bank of England expects interest rates to begin rising early next year. But rises will be modest, initially from 0.5% to 0.75% and by the end of next year, rates are expected to have increased to only 1%.
The UK Property Market
In line with the UK economy, commercial property total returns bounced back in the April to June quarter following a relatively soft Q1. The IPD Quarterly Index posted total returns of 3.5% in Q2, up from 2.9% in the previous quarter. It was the 24th successive quarter of positive total returns and more importantly, the ninth successive quarter of capital growth across the market. Once again, offices delivered the greatest total return in the quarter, at 4.9%, while the retail sector remained the lowest, returning 2.2%.
That offices continue to deliver the best returns is the result of continuing demand combined with limited levels of development. Tenant demand is no longer merely confined to London or even to the south east of England as take up is now increasing across a much greater spectrum of locations. London, though, remains the main focus of tenant demand, aided by record levels of office employment. Lack of available finance has been a key reason behind the dearth of new stock over the past seven or so years, but data so far this year does point to growing confidence amongst developers and a greater willingness by financial institutions to lend, although obtaining debt finance generally remains harder for speculative schemes. Consequently, developers are bringing to the table an increasing number of new projects, particularly, but not exclusively in London. Of course, the high rental levels now being achieved there are helping decision making too.
In contrast to the buoyancy of the office market, the retail sector remains in the doldrums, although we have now witnessed two successive quarters of rental growth (source: IPD Quarterly Index). However, the restructuring of the retail market, which is having to contend with fundamental changes in customers’ shopping habits (most notably through the growth of ‘online’ channels), coupled with the belief that many traditional parts of the market, in particular the ‘High Street’, is oversupplied, is likely to result in more quarters of disappointing returns for the sector as a whole.
The total returns achieved in the first half of this year indicate that the outcome for 2015 as a whole is unlikely to reach the heights witnessed last year (17.9%). However, with little sign of waning investor interest in the asset class, and with short term interest rates unlikely to rise in the coming months, property look set fair for a few more quarters of steady returns. We have increased our forecast for total returns for 2015 as a whole from around 10% to 13%, and given the positive momentum currently behind the asset class, even that revision may be on the low side. Best returns over the near term will continue to come from offices with retail sector assets showing the widest dispersion of returns.
Rental value growth will become the stronger driver than yield compression. And while we do not foresee much further 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 sometime in the future, but the marked fall in inflation expectations at least has limited any potential movement in the short term. However, risks to the property market must be factored in. We have not heard the last of the Greek debt problem, which despite agreement for a third bailout, has merely deferred the inevitable debt restructuring, while at home, the cuts to public services and jobs have yet to bite.
Central London Office Market
The central London market, both office and retail, remained the best performing areas of the market over the first six months of 2015. But, whereas previously, returns from Central London were far ahead of those in the rest of the country, the spread of total returns between London and provincial properties has fallen to its lowest since the recovery of the UK property market began in 2009.
The outlook for central London properties looks favourable, particularly over the short term. The office sector continues to generate the highest levels of total returns together with the greatest investor demand. Property’s high yield compared to other asset classes, its relatively good liquidity and for many, the UK as a safe haven to place their funds, have seen the UK commercial property market, and central London in particular, be the focus of much of their commitments. In the twelve months to the end of March 2015, total purchases of central London offices amounted to over £13bn, the highest twelve month figure on record and almost double the long term average.
Take up has also been very buoyant. According to JLL, leasing activity in the City in Q1, at 2.6m sq ft, was the highest quarterly figure for five years. This was helped by a large pre-let to Deloitte at 1 New Street Square, EC1 which alone accounted for 10% of the total floorspace taken up. The West End was not quite as strong, with Q1 take up, at 790,000 sq ft, slightly below the long term quarterly average (source: JLL May 2015), but even that amount exceeded the trend seen lately in the first quarter.
There are signs that development activity is stirring once again, but from an exceedingly low base. The immediate outlook continues to show falling vacancy rates in both City and West End markets, as forecast take up remains ahead of new supply coming on stream. The overall vacancy rate in the City has fallen to a seven year low of 5.6%, with Grade A vacancy now down to 4.1% (source: JLL May 2015). Availability in the West end edged up a tick over Q1 to 3.2% owing to the completion of four speculative schemes in the quarter.
The supply response is greater in the West End than in the City. Currently, there is over 3m sq ft of office space under construction in the former area, the highest amount for almost a quarter of a century, but that should not present many issues given that active demand remains about the same level.
With the uncertainty over the General Election now past, the growth of London office employment and the continued investment demand from both overseas and domestic investors showing no signs of abating, the immediate outlook for central London offices remains favourable. We forecast above average rates of total return for this segment of the UK commercial property for the coming six to twelve months.
Research Author: Stewart Cowe 06/08/2015