The Global Economy
China remained uppermost in investors’ minds over the festive period. The effects of the continuing slowdown in the world’s second largest economy are resonating far beyond its shores, especially from the country’s reduction in both imports and exports.
Global growth for 2015, at an estimated 3.1%, is likely to have declined for the fifth consecutive year. Developing countries have been particularly badly hit by China’s slowdown, although a modest recovery is occurring in the advanced economies. Concomitant with China’s slowdown and its rebalancing away from investment and manufacturing toward consumption and services has been significant cuts in global energy and commodity prices, which although positive for consumers, has been negatively impacting stock markets. The ending of sanctions against Iran has also boosted global oil production, with the consequent fall in prices to $30, its lowest for 12 years.
Monetary policy is progressing much as expected. The US became the first major economy to raise its interest rates in December (for the first time in almost a decade), but that apart, there seems little impetus elsewhere to do likewise. The continued dampening of inflation through lower energy prices suggests that the period of loose monetary policy in many countries will be with us for some time yet.
Overall, global growth forecasts have been reduced by 0.2 percentage points for both 2016 and 2017, to 3.4% and 3.6% respectively. If forecasts are borne out, the rate for this year would be the first year of growth for six years. Much of the cut to global forecasts is a result of weakness in developing countries, particularly Brazil, although expectations for the US have also been trimmed by a similar amount (20 basis points) over both 2016 and 2017. There, expectations of the economy building on its positive momentum seen in recent quarters have been toned down a little. Risks to the global forecasts remain weighted to the downside.
The Eurozone Economy
The eurozone has been a net beneficiary of lower commodity prices. There, the consequent stronger private consumption, supported by still accommodative financial conditions, is still outweighing the weakening in net exports.
Economic forecasts for the region have been upped by 10 basis points, to 1.7% this year, but left unchanged for next year. Spain has seen the greatest uplift to its forecast growth rate – a 20 bp increase to 3.2% last year – buoyed by increases to household consumption. Germany’s forecast has also been raised, by a more modest 10 bp this year on the back of greater consumption.
However, the European Central Bank President, Mario Draghi, has pointed out that “downside risks have increased again amid heightened uncertainty about emerging market economies’ growth prospects, volatility in financial and commodity markets and geopolitical risks”. The implication is that interest rates will stay at present, or even lower, levels for an extended period, although the inference is that the region’s monetary policy will be reassessed at the ECB’s next meeting in March.
Inflation remains well below the ECB’s 2% target. The latest, December, figure of 0.2% continues the recent trend of near zero annual rises and given the Bank’s inflation forecast for end 2016 is now well below the 1% expectation of even three months ago, it is widely expected that a further tranche of quantitative easing will be issued in March.
In addition to the downside risks for the global economy listed above, Europe as a whole is facing continued immigration from the Middle East, placing further strain of the continent’s infrastructure and social integration, not to mention government finances.
Economic growth for the fourth quarter of 2015 is expected to show a rise to 0.5%, after the dip to 0.4% in the previous quarter. Such an outcome would be lower than expected only a few months ago, but in line with recent expectations following the global slowdown. That would imply growth of around 2% – 2¼% for the calendar year – modest even by recent national standards, but still greater than that of the eurozone.
The year ended on a disappointing note. Retail sales disappointed in the run up to Christmas, while the impending referendum on remaining in the EU is causing some businesses to delay investment plans. However, the recent slide in sterling – it is down over 10 euro cents in the last three months – should assist exporters who have been suffering from the slowdown in global trade. Further weakness for orders from the North Sea oil and gas industry has also hit manufacturers in the UK, not to mention the economy of Aberdeen.
The weakness in the UK and global economies and near zero rates of inflation recently forced the Governor of the Bank of England, Mark Carney, to assert that UK interest rates would be held at their record low of 0.5% for some time to come. This came only weeks after it was thought that rates could be heading higher sometime this year. This will continue to help consumers, whose wage increases are still outpacing the rate of inflation (albeit at a slowing rate) while the jobs market remains buoyant.
Although we have left unchanged our economic forecasts for this year and next, we acknowledge that the risks surrounding them have increased somewhat to the downside.
The UK Property Market
For the last few years, commercial property returns have been driven by ever-compressing yields, particularly on prime properties. The total return for 2015 is likely to come in at around 13.5%, significantly lower than 2014’s 18%, but returns going forward are likely to be more driven by income returns than capital growth. Consequently, forecasts for this year and next show consensus returns of just over 9% and 5% respectively.
Given the weight of money still chasing commercial property, we are unlikely to see much yield softening in the coming months, though. However, pricing in most prime markets leaves little for disappointment, and the whole sector could be vulnerable to internal and external shocks – such as continuing turbulence in the oil and commodities markets, further evidence of a Chinese slowdown and closer to home, uncertainty as the EU referendum draws closer.
Although we still anticipate offices delivering the best capital growth and total returns for the next few years, retails are finally closing the gap and average returns are becoming competitive with the rest of the market. The same applies to rental growth, where for the first time in several years, the outlook for the retail sector is brighter.
That the bull run is continuing is partly down to buoyant demand and the death of new property development occurring across the country. Development is certainly increasing markedly in the central London office markets, but from a very low base, while there are few new speculative schemes underway or being planned in the provincial markets. The lack of development is highlighted by the fact that even though take up in the City of London office market over 2015 was approximately 50% bigger than its long term trend, over 85% of take up was in Grade A space. (source: Savills). A similar picture is emerging in the West End, where above average take up has reduced the vacancy rate well below 3% (source: Savills).
Central London offices and unit shops have been the clear winners in total return terms over the last few years. Indeed, the spread of total returns has shown huge disparities between the best, seen in the capital, and the worst, typically offices and retail in the smaller centres outside London. As prime properties become more dependent on rental growth to drive capital returns rather than yield hardening, we believe that the best returns over the coming couple of years may be generated by some of these currently out of favour areas of the market – prime and good, well-located secondary properties in selected parts of the country. Selected retail may also be about to return to favour, particularly now that rental values have come down to levels in many centres where retailers can trade profitably.
Commercial property sales have been increasing; sellers either taking advantage of strong profits or overseas investors being forced to repatriate capital owing to currency and economic issues at home. While these sales are improving the liquidity of UK property, there is a danger that a significant increase in the number of properties being brought to the market could dampen future rates of capital growth.
Central London Office Markets
2015 was another strong year for central London office transactions, reflecting once again the capital’s continued appeal to investors, domestic and overseas alike.
According to Savills, central London office transactions totalled £19.1bn last year, 9% down from 2014’s record year of £21bn, but still over 80% above the long term average. December proved a very busy month for deals, taking total deals in the West End above £8.5bn and in the City to almost £10.75bn in the calendar year. Transactions in both markets were down from the strong performance of the previous year, but in both cases were significantly above the long term trend (Source: Savills).
On the letting front, 2015 was also a very successful year. West End take up in the year, at 4.36m sq ft was 5% above that of the previous year’s 4.15m sq ft, 21% above the long term average and second only to the record take up of 5m sq ft recorded pre-crash in 2007. It was a similar story for City offices – another strong year of take up at 7.44m sq ft, which although 9% shy of the previous year’s record 8.20m sq ft. was over 40% above the long term yearly average. (Source: Savills) Supply remains relatively constrained in central London. At the end of 2015, total available office supply had fallen to 3.61m sq ft in the West End and 5.6m sq ft in the City, down 4% and 8% from the available stock twelve months previously. Vacancy rates have fallen to 2.9% and 4.5% respectively, down 30 basis points and 80 bps over the year (Source: Savills).
This tight supply situation should be eased this year with increasing rates of development in both markets. Almost 10m sq ft of new office space is scheduled to be under development and to be ready for occupation in the West End over the next four years, while in excess of 5m sq ft is expected to be completed in the City over the same timeframe. Ordinarily, these significant development pipelines would have been expected to severely dent rental growth prospects, but such is the dearth of existing properties and so strong is tenant demand that we anticipate that rental growth will continue over the coming four years, even if the rates of growth will be somewhat lower than evidenced recently. City and West offices had another strong year of total returns over 2015.
Both segments of the market recorded total returns in excess of 19%, while south east of England offices, so long a laggard in terms of its total returns, posted an above average rate of return of 17.4%. Our expectation is that central London offices will once again post amongst the highest total returns this year and next, though showing a narrowing differential over the rest of the market. Risks surrounding central London offices, however, have increased in recent months, with continued growth vulnerable to ongoing economic concerns over the Chinese slowdown and uncertainty over a British exit from the EU, in particular.
Author: Stewart Cowe 26/01/2016