No sooner had Prime Minister Theresa May signed Article 50, which formally triggered the UK’s exit process from the EU than she called a snap general election for 8 June. Sterling’s response to the news was positive as markets focussed on the likelihood of a large Conservative majority after the poll.
Recent opinion polls are certainly indicating a large majority – in excess of 100 – as May’s personal rating remains high, which contrasts with the weak showing of the opposition. Whether this expected larger Conservative majority indicates a shift of policy towards a ‘softer’ Brexit, which has been suggested, will only emerge during future negotiations.
From an economic point of view, the timing of the election could be good news for the Government. The year has started on a noticeably weaker footing with the first estimate of growth for the January to March quarter coming in at a disappointing 0.3% (compared to 0.7% for the previous quarter). Q1 was particularly badly hit by a marked slowing in retail sales as inflationary pressures in the economy built up.
Despite the weak start to the year, more recent survey data from the UK indicates a slightly better second quarter and more in line with previous quarters. A relatively upbeat showing from the eurozone in the new year, by contrast, has given the bloc some positive news, particularly helpful in its future negotiations with Britain.
2016 was a year of significant change characterised by the rise of anti-establishment protests and though the final three months of the year signalled a recovery in growth across many economies, the yearly outcome for global growth, at 3.1%, disappointed and was the lowest outcome since the recession hit 2009.
However, with relatively buoyant financial markets and the long awaited cyclical recovery in both trade and manufacturing seemingly now underway, momentum should push this year’s global growth to 3.5%. That rate of growth remains relatively pedestrian compared to growth rates prior to the financial crash. Much of the higher growth this year emanates from the developing economies where the outlook for commodity exporters has improved.
Since the US election, the belief that fiscal policy would be loosened has contributed to a strengthening dollar and to higher Treasury interest rates. Importantly, market sentiment has been strong. Inflation, too, has been higher than anticipated across the globe as a result of higher commodity prices, but core inflation remains subdued.
The fragility of the US economy was once again laid bare when first quarter growth came in at a very disappointing 0.7% annualised, less than half that anticipated. Commentators believe this slowdown will be only temporary.
We believe that risks to our forecasts remain skewed to the downside, particularly over the medium term. Conversely, the buoyant financial markets sentiment suggests that there is more upside potential than previously. Further out, downside risk has increased somewhat. The financial policy support, in the US and China specifically, but in Europe as well, will need to be unwound or reversed at some point. Additionally, risks come from an increased chance of protectionism, leading to lower cross-border trade, the possibility of a more rapid rise in US interest rates and financial tightening in emerging economies.
The EU economy
In line with our overall belief that there will be a stronger rebound in the advanced economies, we have increased slightly our economic forecast for the Eurozone for 2017. Much of this improvement for Europe is based on a cyclical recovery in global manufacturing and trade that began in the second half of 2016. Despite this notable and welcome improvement, our forecast has only been increased by 10 basis points, to 1.7% this year, highlighting once again the challenges facing the single currency bloc.
This optimism about the strength of the Eurozone economy was matched by comments from the head of the European Central Bank, Mario Gradhi, who said that the zone’s economic recovery was becoming “increasingly solid”. It will be noted, however, that despite this greater optimism, economic growth forecasts for the next few years remain distinctly modest by historic comparison. Of greater concern to policymakers is the increase in inflation in recent months. Inflation in the Eurozone hit 1.9% in April, in line with the ECB’s target of ‘below, but close to’ 2%. Inflation at present levels is not sufficient to force up interest rates, but policymakers will be scrutinising future rates of inflation, and rates of economic growth for guidance. Already, the ECB has cut its bond repurchasing scheme and a further reduction could be sanctioned if the Eurozone’s economic recovery continues.
Economic sentiment across the Eurozone rose to a ten-year high during the quarter, while the overall unemployment rate has continued to fall and now stands at its lowest level since May 2007. But in a reminder that economic recovery cannot be taken for granted, the news that France’s economy grew by an underwhelming 0.3% in Q1, down from the previous quarter’s 0.5%, highlights the fragile nature of this recovery. The slowdown was partly down to poor consumer spending owing to unseasonably warm weather in the quarter.
The UK economy
After defying widespread predictions that the UK economy would suffer a marked slowdown post the historic Brexit referendum, signs are finally emerging that the previously buoyant activity is beginning to falter. The first estimate of growth in the January to March quarter came in at 0.3%, weaker than expected and significantly below the 0.7% recorded in the previous quarter. While the winter quarter is always liable to disappoint because of adverse weather, statisticians placed the current weakness firmly in the slowdown in consumer spending as higher inflation put the brakes on retail sales. Inflation globally has been ticking up for the best part of a year as improved corporate optimism has fuelled a boom in commodities which in turn has pushed up commodity prices. Add to that the sharp depreciation in sterling since the referendum, then it is easy to see how the consumer price inflation in the UK has risen to 2.3%, ahead of the Bank of England’s 2% target and the highest rate for more than three years.
Sterling’s decline, however, had given a boost to UK manufacturing where survey data shows the sector to be growing at its fastest pace for three years. New orders in April hit the highest levels since January 2014, helped not only by the lower value of the pound, but by better global economic conditions. This has led to ‘solid growth in new export business’ but also to a steady increase in new domestic orders.
The forthcoming general election will certainly add to the degree of uncertainty surrounding the likely growth of the economy in the short term and while opinion polls suggest that the Conservatives will return to power with a greater majority, it is unclear at present how the composition of the parliament will influence the negotiations with Europe.
We believe that the slowdown over Q1 will only be temporary and that the economy will recover its poise over the summer months. However, with global economies having entered unchartered territory in recent months – the Brexit vote, Trump’s election as President and the increasingly hostile tensions with North Korea – risks to our forecasts remain highly skewed to the downside.
Property investment across the UK remained resilient over Q1 2017 with the reduction of major domestic investors being counterbalanced by the continued interest of overseas players who accounted for slightly more than 50% of all property deals in the UK in the quarter. Offices made up the bulk of transactions in the quarter, while there were several chunky student accommodation deals. Retail deals were few and far between. It is noticeable that, although quarterly transaction volumes have remained steady at around £10bn – £11bn over recent quarters, the number of deals has declined, indicating an increase in the average lot size. This in turn has increasingly resulted in premium prices being paid for ‘trophy’ assets, these buyers often coming from abroad. The highlight of the quarter was the announcement by British Land of the agreed sale of its joint venture with Canada’s Oxford Properties – London’s tallest office property, formally known as the Leadenhall building (but more commonly referred to as the ‘Cheesegrater’) – to Chinese investors for £1.15bn, 26% ahead of its recent valuation.
Far eastern investors are still major players in UK commercial property but the recovery of the oil price has also contributed to a welcome return of middle east investors while there has been a notable increase in continental European purchasers. Such investors are seemingly paying little heed to the consequences of a hard Brexit or to risks associated with forthcoming elections in both the UK and in the continent.
Expectations in the market for rental and capital growth and total returns remain subdued. The IPF Consensus Forecasts published in November anticipated total returns for 2016 as a whole, of 0.6%. That forecast undershot the actual returns by 3 percentage points and we believe that the forecasts for 2017 are similarly pessimistic. According to the most recent IPF Consensus Forecasts, published in February, total returns for the market this year are expected to come in at only 1.3%. Already, total returns for the first three months have recorded 2.3% (Source: MSCI/IPD Monthly Index). While some weakening of the market is to be expected as details of the Brexit negotiations unfold, property valuations do have yield support, particularly as 10-year gilt yields have moved back below 1%. Sterling depreciation has made British assets cheap. With Europe still treading water, in property terms if not economically, and huge risks surrounding US policy, UK commercial property is likely still to be the market of choice for overseas investors, particularly with its steady and secure income.
Central London offices
Turnover has remained relatively buoyant over the first few months of 2017. Quarterly transactions in the West End, at £1.89bn, was the second highest ever recorded in the first quarter (beaten only by the equivalent quarter of 2016) while City transactions were broadly similar to 2016’s total which was the largest traded since Q1 2007. A feature of the central London office market this year has been how large many of the transactions have been.
As well as these resilient turnover figures, there has been a sustained interest from overseas investors, particularly from Asia. Asian purchasers made up almost half of the purchasers in the West End and two-thirds of purchasers in the City in Q1. Notably, their interest focussed on large properties; the average lot sizes of properties purchased by Asian investors in the City being £153m. In contrast, UK institutional investment in London offices has been harder to spot. There have been no purchasers yet in the West End while they have accounted for only 13% of City purchasers. However, their focus has mainly been on reducing their central London office portfolios.
Take up of space remains resilient. Tenant take up in the West End, at just over 1m sq ft was similar to that recorded in Q1 2016 while take up in the City totalled almost 1.5m sq ft, down 11% on the previous year. Both take up figures, though, were significantly higher than the long term averages. It was noticeable that the City fringe accounted for a higher percentage of take up in the quarter than the City core, a reflection of the relative scarcity of suitable product in the core.
Despite these favourable take up figures, the vacancy rate remained at 3.8% in the West End and increased to 5.5% in the City – a rise of 25% from that recorded in the City 12 months previously. Supply now exceeds 4.6m sq ft in the West End and 6.8m sq ft in the City, in both cases, over 1m sq ft higher than at the equivalent period last year.
A record rent for the West End of £190 per square foot (psf) was hit in St James Square when the Canadian company SHL took 4,000 sq ft on a ten-year lease. That deal boosted the average prime rent in the West End to £122 psf, 11% ahead of the average over 2016. Even without that deal, average prime rents in the quarter were above that of 2016. By contrast, City rents dipped slightly in Q1, where the average prime rent recorded in Q1 fell to £72 psf from the £77 psf mark of last year. Rent free periods also lengthened – a ten-year lease now coming with 22-months rent free period (the longest since Q3 2013) in the City and 19-months in the West End. Both periods are two months longer than those at the end of 2016.
Prime yields were unchanged over the quarter at 4% in the City and 3.25% in the West End.
All statistics from Savills Stewart Cowe May 2017