Economic and Market Commentary Q2 2016
It will have escaped no one’s attention that the big event in the second quarter of 2016 was Britain’s referendum on its membership of the EU and the decision by the British electorate to leave. Market reaction was swift, the value of sterling tumbling immediately in overnight trading, stock markets fell initially although most have since regained these falls and share prices of domestic banks, property companies and REITs have fallen sharply.
Writing this commentary a matter of only a few weeks after the referendum, it is unclear what the short term or the longer term impact will be to the UK economy or to the property market. Most indicators point to short term uncertainty and a slowdown but until Britain signs Article 50 of the Treaty of Lisbon (the mechanism for starting the exit process) and negotiations begin, one cannot with any certainty predict the future. The decision by Britain’s new Prime Minister, Theresa May, not to sign until the New Year further lengthens the period of uncertainty.
The referendum decision resonated throughout the world. Many commentators contrasted that decision with the closer ties being set in the Americas (through the North American Free Trade Agreement) and the similar trade arrangement, the Trans Pacific Partnership, in the Far East. Initially, global markets fell across the board indicating heightened concerns about future trade, but most have recovered to pre-referendum levels.
The economic outlook has certainly deteriorated since the vote. Growth estimates have been cut for most countries and regions for this year and next, but although Britain’s growth forecast has been cut the most (by 0.9 percentage points for 2017), the UK economy is still forecast to perform better than both Germany and France.
Prior to the referendum, global growth was progressing in line with expectations. Indeed, by some measures, a few economies were performing ahead of forecasts. In Europe, these expectations remained lacklustre, while Japan was struggling to grow at a pace other than mediocre. Financial markets continued their 2016 recovery while oil prices carried on their upward trajectory. However, the vote to leave caught financial markets by surprise, most indicators beforehand suggesting a narrow win for the ‘Remain’ camp. Market reaction was swift with the value of sterling, stock markets and commodity prices all tumbling initially, although stock markets have since regained much of these losses.
While the Q1 data in general surpassed expectations, the same cannot be said about the second quarter. US growth disappointed at an annualised 1.2% while the Eurozone equally failed to build on the previous quarter with growth of only 0.3%.
The ‘Brexit’ decision has generated a marked increase in economic, political and corporate uncertainty. Business confidence globally has also taken a knock, particularly in Britain and in Europe. Taking all this into account – the slightly better than forecast growth in Q1, the marked slowing in Q2 prior to the vote to leave and the global uncertainties brought about by the decision to leave, our global forecasts have been trimmed by 10 basis points for both this year and next, to 3.1% and 3.4% respectively. Risks to the downside however have heightened. As we progress through the rest of the year, one can expect volatile markets depending on the relative strength of economic data and survey information produced.
Europe will be affected by the ‘Brexit’ decision, but given the UK’s relatively small contribution to cross border trade with Europe, any downside will be somewhat smaller than the impact on the UK. Nevertheless, our forecasts for the region as a whole have been cut by 20 basis points next year. Like many countries, the EU had been performing ahead of expectations prior to the vote, and the announcement of a stronger than expected growth in the first quarter (of 0.6%) and a slower, but still steady second quarter (of 0.3%) would ordinarily have prompted a forecast upgrade. The new uncertainties have dented growth for the remainder of the year and consequently we have left our forecast for 2016 unchanged.
The second quarter growth of 0.3% was in line with expectations, and once again that overall rate masked wide variance across the region. After posting growth of 0.7% in Q1, France showed no growth in Q2 while Germany’s growth was in line with modest expectations. Unemployment remains stubbornly high at over 10% but at least the rate of inflation edged up to 0.2% from the previous month’s 0.1%.
Post June, surveys pointed to stronger growth at the start of the third quarter. The PMI data indicates solid growth in July, in contrast to the very weak survey data for the UK.
Unsurprisingly, it is the UK which has been the most affected from the ‘Brexit’ decision. Prior to the vote, the economy had been progressing fairly strongly, and the release of data indicating that the country grew at an above consensus 0.6% over the second quarter surprised most commentators. However, it was clear from the preliminary data that the UK performed particularly strongly in the first half of the quarter with growth slowing down towards the end.
The vote, with the resultant political changes – Prime Minister Cameron immediately stood down and was quickly replaced by Theresa May, while the Opposition Labour party is undergoing its own leadership challenge – has prompted a period of uncertainty for the country. The exit negotiations are not due to start till the New Year and may take up to two years before Britain formally leaves the EU. Only after that period will Britain be able to negotiate trade deals with the constituent parts of the region. One must assume a lengthy period of uncertainty and market volatility for some considerable time.
These uncertainties have prompted the biggest downgrades to our forecasts. Instead of our previous expectation of economic growth of 1.9% this year and 2.2% for next year, we now tentatively expect growth of 1.7% and 1.3% respectively. While these are major downgrades, it is worth pointing out that these forecasts remain higher than those of France, Germany and Italy over both this year and next. The risks to these forecasts – both on the upside and downside – are much higher than previously and it is likely that sentiment will remain volatile for some time.
The sharp depreciation in the value of sterling has already had an impact on import prices, although the weaker oil price in dollar terms has lessened the impact. In contrast, the fall in sterling ought to be beneficial to exporters, but any improvement is likely to be longer in coming through. The weaker cross border trade outlook also tends to negate some of the advantages of the weaker pound. The August decision by the Bank of England to cut interest rates and announce further measures to stimulate the economy were not unexpected. The cut in base rates from 0.5% to 0.25% was the first change since 2009. Measures are being put in place to ensure that banks pass on this cut to businesses and households. Its quantitative easing programme is also being extended, by buying a further £60bn of UK bonds and £10bn of corporate bonds. These measures quickly followed gloomy purchasing managers’ surveys which indicated that the outlook and confidence of businesses had fallen dramatically since the vote.
The next few quarters are likely to see sharp swings in sentiment with consequential swings in markets, consumer and business confidence and to economic forecasts.
Market Commentary – early August 2016
As at the time of writing, we are in the immediate aftermath of the UK’s historic vote to leave the EU. The UK commercial property market had certainly been slowing in any event – April and May saw minimal capital value increases of 0.1% each month and it had been expected that capital value growth would moderate further, with rental growth and yield compression fading. Then, the results of the referendum came in……….
Post referendum there is little hard evidence in the property market to suggest that valuations have actually moved at all since the referendum. Our valuers (Cushmans) and others added a “Brexit” clause to their valuations saying that basically that they don’t really know where values are, but did not specifically mark values down post the vote. Until evidence of actual deals completing post the referendum comes through, we suspect that will remain the case.
The IPD Quarterly performance numbers back up this view. The Q2 total returns of 1.2% against a stamp duty affected Q1 of 1.1% indicates a slight weakening of capital values, but of such a small magnitude that is almost irrelevant.
Anecdotally, we have heard of transactional situations where the purchaser has said “I’ll just complete anyway” to “I want 10% off” to “I’m walking away” – so in fact the whole range of options. Acuitus, the commercial auction house, have said that they have seen no difference in levels of enquiries or investor appetite since the vote. Of course, the auction market is a slightly different market focussing on much smaller lot sizes with mainly private buyers, many from overseas, so the UK market may already look better value to foreign buyers following the fall in the exchange rate.
Some property funds have moved pricing to bid-bid, some have arbitrarily dropped values by 4 to 5% and some have halted redemptions from open-ended property funds, citing “exceptional market circumstances” but essentially to prevent unnecessary withdrawals and liquidity issues. A few funds have since re-opened funds to withdrawals.
Looking at the listed property company sector, whilst the FTSE 100 has strengthened overall, property company share prices are down since the 24th June – central London office REIT’s have been hit hardest reflecting concerns about the occupational impact of Brexit on the capital.
What is clear to us is that the economic climate has probably become a bit more uncertain and sentiment has changed and we have to reflect that in what we do. In appraising new opportunities, we are reducing rental growth estimates, increasing void/rent free allowance and edging up threshold return requirements – or a combination of all three – to reflect an enhanced level of uncertainty/risk.
The commercial property market was slowing in any event prior to the Brexit vote. In fact, investment activity has actually been on a downward trend since mid-2015, with the feeling that the slowdown perhaps also reflected concerns over pricing rather than simply jitters about the EU referendum. Looking at the longer term, the value of transactions in the year to May was still higher than in 2006 and 2007. Overseas investors remained the main buyers of UK property in May and the five largest transactions all involved an overseas buyer.
Interestingly, we have had no occupational feedback since the referendum saying “actually I’m not going to take that unit or I want a rent reduction” because of Brexit.
In short, the full impact of Brexit on the property market is as yet unknown. There is likely to be a slowdown in economic growth and an extended period of uncertainty, but probably leading to a slowdown in the commercial property market, rather than a very significant correction.
Central London offices
It would be expected that central London offices would be the hardest hit of all the segments of the UK commercial property market. Financial and business services make up a high percentage of service sector jobs and are vulnerable to Brexit consequences. Hence it was not a surprise that REITs, and in particular those specialising in central London offices, were badly hit by the ‘leave’ decision. But as indicated above, so far there is little anecdotal evidence of either the letting or investor markets being adversely impacted.
Investment remained strong in the City market, June total deals of £718m taking the second quarter total to £2.6bn (against £1.76bn over H1 2015) and posting £4.3bn of deals over the first half of the year, 50% above the long term average. In contrast, the West End was not so buoyant. Deals of £245m in June took the total Q2 transactions to £1.2bn, the lowest comparable figure since 2009. But these slowdowns reflect the general softening of the investment outlook and pricing expectations prior to the referendum rather than having anything to do with the vote itself.
Take up was down from the strong letting figures of 2015. June lettings of 4402,000 sq ft in the City and 205,000 sq ft in the West End took their respective H1 totals to 2.6m sq ft and 1.85m sq ft – down 31% and 14% from their long term averages. In contrast to City lettings, the bulk of which were for grade A space, an increasing amount of lettings in the West End were in Grade B space. That is not unsurprising given the low vacancy rate of 3.2% in that market. There has been evidence of a slight softening of prime yields in both office markets this year. These outward yield shifts have been ongoing for a few months and following the Brexit decision, one can expect some small further outward yield movement in the coming months.
Research Author: Stewart Cowe Date: 10/08/2016