Economic and Market Commentary Q3 – Nov 2016
Three months after the historic vote by the British electorate to leave the EU, we are no nearer comprehending the full implications of the exit. So far, market reaction has been orderly; sterling has been extremely weak but this has powered a rise in the stock market. Sterling’s weakness was not helped by statements from the Conservative Conference implying that a ‘hard’ Brexit would be pursued, while the strength of the stock market was helped by the more favourable conversion of overseas earnings.
Prime Minister May has indicated that Article 50 of the Treaty of Lisbon (the official mechanism for starting negotiations for leaving the EU) will be signed next March. Prior to that there will be little official information forthcoming.
Data since the vote has been mixed, but broadly supportive of continued growth in the economy, albeit at lower levels than had been previously expected. Unemployment has continued to fall over the summer, but in a worrying sign, a Markit survey suggested that the jobs market slowed significantly in July. Permanent openings have fallen to levels not levels not seen since 2009, at the height of the recession.
The collapse in the value of sterling, which has lost almost 20% of its value since the vote, has prompted higher import prices. Coupled with increasing oil and other commodity prices, that has resulted in marked increases at the petrol pump which in turn will feed through to higher inflation. And in a sign of what is to come, a spat between Tesco and Unilever over the magnitude of price increases of the latter’s products highlights what can be expected for consumers in the coming months.
Concerns of a hard Brexit prompted the bosses of a variety of employers – most notably the major banks in the City and car manufactures – to seek assurances from the government on the implications for their businesses post exit. These concerns have been lessened by the announcement that Britain’s biggest car manufacturer, Nissan, has agreed to build two new models at Sunderland securing 7000 jobs.
Our global forecasts for this year and next are unchanged, but that covers reduced activity in the advanced countries, offset by slightly stronger growth in the emerging and developing countries. Much of the hit to the expectations for the advanced countries are down to the UK’s Brexit implications which has cast a shadow over growth in the short term not just in the UK itself but across Europe as a whole. The other contributing factor to the downgrade reflects weaker than expected US activity over the first half of the year. Our 2016 forecast for the US has been cut by 60 bps to 1.6% while next year’s forecast has been trimmed by 30 bps.
These lower growth figures have continued the downward pressure on global interest rates, where the long awaited rise has been further delayed. The minutes of the September meeting of the Federal Reserve showed a narrow vote in favour of the status quo, but it has given further weight to the expectation of an increase by the end of the year, probably in December.
Offsetting the dull short and medium term outlook for the advanced economies is an expectation of a strengthening of activity in emerging markets and developing economies. We have increased our forecast for that group by 10 bps to 4.2% for 2016, which would represent the first increase there after five consecutive years of decline.
The global economy is forecast to pick up somewhat next year as the US regains some momentum, primarily through a recovery in investment. Our forecast for 2017 is a marked improvement of this year’s expected level of activity, at 3.4%, unchanged from our expectation of three months ago.
Europe will be affected by the ‘Brexit’ decision, but given the UK’s relatively small contribution to cross border trade with Europe, any downside should be somewhat smaller than the impact on the UK.
Recent survey data suggests that the Eurozone’s recovery continued into Q3 but at a very modest pace. Ahead of the formal announcement by the ECB, it would appear that GDP in the quarter will come in at around 0.3%, which would be a similar rate to that experienced in the previous quarter. The zone continues to benefit from low inflation, ultra-loose monetary policy and an improving labour market although risks remain, particularly over emerging political risks and the ECB’s decision on the future of its quantitative easing policy.
December, therefore, will be a crucial month for the Eurozone. Italy faces a crucial referendum on the 4th with the Prime Minister threatening to resign if his reform plans are not endorsed. The two decisions for the central bank are whether to impose negative interest rates at its December meeting (not everyone agrees on the benefit of negative rates) and whether to extend its quantitative easing programme past its planned ending in March next year.
Germany has had a steady third quarter. Business sentiment strengthened in September while the latest PMI (purchasing managers’ index) rose. Positive consumer sentiment over the quarter suggests that private consumption should do well. While the picture in France is not quite so positive, indications are that it should return to growth after contracting in Q2. The country’s key task is to fulfil its planned deficit reduction obligations. But given its proposed tax cuts for lower-income families and increased governmental spending, achieving this budget reduction is questionable.
Spain seems to have finally broken the political impasse that had paralysed the country for almost a year with the imminent re-election of Mariano Rajoy as Prime Minister. His biggest task will to be to ensure Spain complies with the ECB’s budget deficit targets. That looks unlikely with further cuts in government spending likely.
Many economists prior to the referendum predicted that there would be an immediate and significant impact on the UK economy in general and on consumer confidence in particular. So far that pessimism seems not to have been borne out. However that reflects the continuing vacuum in policy decision making as much as any outright positive news.
Economic forecasters have generally kept their GDP forecasts for this year unchanged (although some have been increased by 10 basis points following better than expected growth in the first half of the year) but have cut next year’s forecasts by around 1 percentage point. Our expectation for growth in 2017 has been cut to 1.1%, a cut of 20 basis points from our last forecast, and half of our expectations pre referendum.
The first estimate of third quarter GDP came in at 0.5%, lower that the previous quarter’s 0.7% but ahead of market expectations of 0.3%. Once again it was a particularly strong performance from the service sector (0.8%) which drove the economy, with output from agriculture, manufacturing and construction all contracting over the quarter. The better than expected outcome from Q3, however, does not add anything to our understanding of how the economy will perform outside the EU, nor even over the coming quarters.
Inflation has increased over the summer months. The annual rate of 1% recorded in September was the highest in almost two years and was a result of higher costs of clothes and fuel. Despite the inflationary impact of lower sterling, the UK’s Office for National Statistics (ONS) said there was ‘no explicit evidence’ the weaker pound had contributed to the increase. With sterling remaining significantly weaker than pre Brexit, one can expect inflation to continue rising to, and perhaps beyond, the Bank of England’s target of 2%.
The Bank of England cut UK interest rates to a record low of 0.25% (from 0.5%) in August, the first cut since 2009 and did not rule out a further cut. It also announced an extension of its quantitative easing programme and a £200bn scheme to force banks to pass on the low interest rate to businesses and households. Both measures are a reflection of the Bank’s view of more difficult times ahead for the UK economy.
Britain’s Prime Minister, Theresa May, announced that formal negotiations to leave the EU will be signed by March indicating that Britain will be on course to leave by early 2017. 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.
The UK commercial property market appears to have steadied after the sharp fall in values recorded in July. The average fall in the value of all property assets of 2.8% in the month was linked to Britain’s vote to leave the EU. Central London offices, which are most at risk from weaker ties with Europe, fell by 4.1% in the month. Both falls are the biggest since March 2009, at the height of the global financial crash. Fears of continued sustained weakness in capital values seem to have been dispelled by smaller falls in value in subsequent months of -0.6% in August and -0.2% in September. Total returns for the three months to the end of September have come in at -2.4%, versus +1.4% in the second quarter (source: MSCI (IPD Monthly Index)).
Much of the movement in property values has been yield driven. Since June, IPD’s initial and equivalent all property yields have moved out by 19 and 17 basis points respectively, the first outward yield shift since 2009.
The short term outlook for commercial property is certainly weaker. Consensus forecasts from the Investment Property Forum (IPF) published in September (the first since the vote) indicated that contributors had lowered their total return forecasts for this year and next by around 7 percentage points and 5 percentage points respectively (to -0.4% and 0.6%). A sentiment survey issued by the same IPF in July indicated that virtually all its contributors (96%) believed the outlook for rental growth over the next two years to be weaker than had been the case before the vote.
Having said that, anecdotal evidence from the market does not post such a negative story. Investors are wrestling with a series of issues – Brexit, currency, the soon to rise global interest rates, rising inflation – not all of which are negative influences on the domestic commercial property market, but until clarity emerges, one can understand why many investors remain cautious.
Central London Offices
Despite warnings to the contrary around the time of the referendum, the central London office market remains relatively steady. Even before the historic vote, the domestic occupational market had been slowing and many feared the worst in the immediate aftermath.
From an occupier point of view, take up in the City over the first nine months of 2016 is down by a third on that of the similar period last year. Helped the large Apple transaction (see later) West End take up is at a similar level to last year. However, it has become noticeable that potential occupiers seem to be taking longer to make occupational decisions – understandable in times of acute political and economic uncertainty. Current office requirements across central London amount to over 10m sq ft, up almost a quarter in the last 12 months, but over half these requirements have been in the market for over six months, and one third for over a year.
The major deal in September was Apple’s decision to pre-let 500,000 sq ft development at Battersea Powerstation with a view of consolidating all its present office locations there. The development is due for completion in 2021.
Meanwhile transaction volumes over the first nine months of this year are down 20% year on year in the City and down 11% in the West End. The final quarter of 2015 was a particularly strong one for investment deals in central London and it is unlikely that the total for this year will reach that of 2015. However, we note that ten deals each valued at over £100m in the West End are currently being marketed.
Two themes have become noticeable both post referendum and over 2016 as a whole; the dominance of overseas buyers and buyers’ requirements for properties with more secure income flows. An increasing number of transactions are taking place where unexpired lease lengths are over 10 years – a sign of the increasing nervousness of investors on life in Britain post Brexit.
Expectations for rental growth, capital growth and total returns for both the City and the West End have been cut significantly. According to the IPF Consensus Forecasts published in September, market expectations of total returns have been cut to -3.6% (for 2016) and -4.2% (2017) for City offices and to -3.4% and -3.7% for West End offices. Given the steadying of the market post Brexit, our view is that these reductions paint too cautious a picture, particularly over this year.
Research Author: Stewart Cowe Date: 04/11/2016