As was widely expected, Britain’s exit plan agreed by the EU and Britain’s negotiators was comprehensively thrown out by Parliament in what was the largest ever defeat of a motion tabled by the ruling party. It was the thorny issue of the Irish ‘backstop’ – how to ensure frictionless trade across the Irish border – which riled many MPs and brought about the humiliating defeat. Prime Minister May then achieved a victory of sorts one week later when a motion to return to the negotiating table to seek to redraft that particular stumbling block was passed.Immediate indications showed that the EU is unwilling to renegotiate a deal which they claimed had been painstakingly agreed between the parties over the past two years. But if a week is a long time in politics, the remaining days of Britain’s membership will seem an eternity. All outcomes are still possible – ranging from the most optimistic (remaining in the customs union), to a fully negotiated exit along the lines of the current negotiations, to a delay to the original 29 March exit date, through to a potentially chaotic ‘no deal’ exit.
Markets are as unsure as the general public as to the outcome, but with the deadline rapidly approaching, we can expect continued volatility as sentiment fluctuates daily. The “Great British Break Off” may have a few surprises for us yet.
Although the global economy continues to expand, growth last year was a lot weaker than had been anticipated at the beginning of the year. Growth in the first half of the year had disappointed and activity in the third quarter together with subdued early data from Q4 has done nothing to dispel the downbeat mood. While true that there were some one-off negative contributors to the downgrade – e.g. the new fuel emission standards which adversely affected German exports and natural disasters in Japan – the underlying message was one of weakening sentiment in financial markets, increasing worries about the outlook for China’s economy and uncertainties over trade policies.
The immediate concerns over the US-China trade dispute may have been put on hold temporarily but the prospect of further tensions re-emerging in the Spring continues to worry financial markets.
With the exception of the US, where activity remains robust, the rate of growth of industrial production, particularly of capital goods, has slowed. Consequently, global trade has dipped below that of 2017, and the latest figures may actually overstate the position owing to import loading ahead of the raising of trade tariffs. The softness that became apparent in H2 2018 is likely to carry over to coming quarters. We have slightly downgraded our global growth projections by 20 basis points this year (to 3.5%) and by 10 bps next year (to 3.6%). This reduction mostly reflects the deceleration of growth in the advanced economies from above-trend levels which has occurred more rapidly than previously anticipated.
This dull sentiment accords with January’s forecast by the World Bank which is warning of increasing risks, in what it calls “darkening skies”, for the world economy.
Global Economic Forecasts
% growth pa
All advanced countries
Emerging & developing countries
Source: IMF, January 2019
The EU Economy
The Eurozone has not been immune from the slowdown and indeed has seen some of the largest country downgrades compared to the previous report. As world trade has stuttered, so have many of the export markets with the export-oriented Germany having suffered the most. Dull consumer spending figures combined with exceptionally poor manufacturing data in the closing months of 2018 in many countries – not helped by a collapse in automotive industry output owing in part to new stricter emission regulations – have pushed down our forecast for growth this year by 30 bps to a lacklustre 1.6% although next year’s forecast is unchanged at 1.7%.
That growth in the single currency bloc has been slowing was evidenced in first estimates of growth in Q4, which came in at 0.2%, similar to that of the previous quarter. Aside from the slowdown most visibly seen in Germany (which just managed to avoid going into recession in Q4), the Italian economy has moved back into recession. After contracting by 0.1% in Q3, growth recorded another fall in Q4 by 0.2%. Having finally agreed a compromise budget with the EU only last month, the outlook for the Eurozone’s third biggest economy remains dull with expected growth this year and next well below 1% pa. Weak domestic demand and higher borrowing costs are weighing heavily on the economy. It is telling that the size of Italy’s economy today is still 5% below its peak, achieved over a decade ago.
Overall, our growth forecast for the Eurozone has been pared back by 30 bps to 1.6% for this year, although, again, next year’s remains unchanged at a still underwhelming 1.7%. Growth rates have been reduced for many economies. Aside from Germany and Italy, the short term outlook for France has also deteriorated, mostly on account of the impact from the ‘Gilets Jaunes’ protests and industrial action.
Eurozone Economic Forecasts
% growth pa
Source: IMF, January 2019
The UK Economy
Our expectation for growth this year, at 1.5%, is unchanged from that of our last report, while next year’s forecast has been upgraded by 10bps to 1.6%. While at first glance, these forecasts appear to be more robust than those for many other countries (many of which have been downgraded this quarter), there is substantial uncertainty surrounding them with risks substantially weighted to the downside.
The unchanged forecast for 2019 reflects the broadly offsetting positive impact announced in the November Budget with the negative effect of prolonged uncertainty about the Brexit outcome. Our baseline projection assumes that a Brexit deal is reached in 2019 and that the UK transitions gradually to the new regime. However, at the date of writing (mid February), the prospect of any such deal being reached with the EU does not look good, but as highlighted in the opening Brexit commentary, the precise nature of the ending of this rather lengthy soap opera is currently unclear. A disorderly exit, or a ‘no deal’ exit would certainly question growth rates in the coming quarters. This is the scenario painted by the Bank of England and adopted in their rather bleak 2019 GDP forecast of 1.2%. That outcome would be the lowest in a decade.
A survey by IHS Markit/CIPS shows that UK manufacturers are ramping up their preparations for Brexit by stockpiling raw materials and stocks of finished goods at unprecedented rates. While this stockpiling has positive implications in the short term, and indeed, manufacturing activity is currently outpacing that in France and Germany, actual orders, particularly for export, are struggling. As world trade experiences a distinct slowdown, UK manufacturers are being hit by a further issue as it appears that many overseas customers are becoming reluctant to place orders in case a no deal Brexit results in delays or added tariffs.
The first estimate of GDP in the fourth quarter, 0.2%, emphasised the slowdown evident globally. Manufacturing output, despite the stockpiling referred to above, was adversely affected by the global automotive downturn, but what was more worrying for Britain as it nears its European exit was the marked slowdown all parts of the economy experienced in the month of December where activity fell sharply. While monthly data is prone to volatility, and could be revised in the coming months, commentators were speculating whether this is a sign of things to come in 2019.
UK Economic Forecasts
% growth pa
Base rate (end year)
Source: IMF, January 2019
Quarterly data from MSCI mirrored that of the economy – showing a distinct slowdown in both capital growth and total returns. Returns have been falling over the last five quarters, with all property total returns in Q4 dipping to only 0.8%, down from the previous quarter’s 1.4% and more than two percentage points lower than the equivalent quarter in 2017.
Continuing the recent trend, it was the retail sector which once again dragged back the index. Not only are all retail average values still falling, the rate of decline appears to be accelerating. But given the slew of negative news coming from retailers, that is hardly surprising. Shopping centres are bearing the brunt of the valuers’ red pens: the average shopping centre values fell by over 4% in the quarter, making a fall of over 9% in the year. Average shopping centre values have now fallen by over 14% over the last three years.
In contrast, the industrial sector continues to go from strength to strength, having another outstanding quarter in which average values increased by 2.2% and bringing about a 2018 rise of more than 11%. Over the last three years, average industrials have almost doubled in value – a remarkable feat given the economic drivers for the sector: dull retail spending and manufacturing output. Yield remains the prime factor behind investors’ love of the sector together with the limited supply of suitable, well-located stock. While on many counts the sector looks expensive, in particular on yield grounds, it is difficult to see when sentiment will turn away from this part of the market.
Certainly, consensus forecasts from the IPF show contributors are still expecting the industrial sector to deliver positive rates of capital growth over the coming few years, in contrast to offices and retails where values are anticipated to start falling.
Offices delivered solid and steady, if unspectacular, returns over both Q4 and 2018 as a whole. Average capital values increased by 0.5% in Q4 and by 2% in the year. However, It was a mixed quarter for central London offices – capital growth of 0.75% in the City but a more modest 0.2% increase for West End offices.
While it is always a challenge to predict how the commercial property market will perform in the coming months and years, it has perhaps never been as challenging as it is now. With the days fast ticking down to Britain’s planned EU exit and as yet no clarity on precisely what deal (if any) will be negotiated, it is virtually impossible to determine how property will perform over the near term. Current market forecasts from the IPF display this uncertainty. The consensus forecast for total returns this year comes in at a modest 3.0%. But this figure masks a wide spread of expectations – ranging from a low of -0.2% to a high of 7.3%. Both are conceivable given specific economic assumptions. This uncertainty is also present in the expectations for future year returns. It will be an interesting, and for the present, unpredictable, few months.
Central London Offices
Take up and investment demand for central London offices remained resilient last year, apparently shrugging off the economic and political uncertainties that are besetting many other parts of the economy.
Thanks to a strong lettings market in Q4, where 2.4m sq. ft. was let (the largest quarterly figure for over four years), City take up for the year edged ahead of that of 2017, at 7.6m sq. ft. – the third highest annual total on record. The equivalent figure for the West End, though showing a 5% decline from last year’s record was still the second largest recorded.
The technology and media sector accounted for the largest amount of take up in both London markets with service office providers accounting for a not insignificant 21% of West End deals and 12% of City deals. That, though, questions the validity of the vacancy rate figures of 5.4% in the City (down 20 bps in the year) and the West End’s 3.9% (unchanged in the year. Taking into account vacant space in these serviced offices, the true vacancy rates could be approaching 1 percentage point higher in both markets.
Investment turnover also remained strong last year. City deals exceeded £12bn for only the fourth time while in the West End, £7.5bn of deals was 6.5% higher than that recorded in 2017 and the fifth largest ever annual total. The central London office market continues to attract a wide spectrum of investors. It was recorded that no fewer than 28 different nationalities had bought offices in the City last year.
While Asian investors continued to source London office properties, it was South Koreans investors who made the most inroads in 2018. They accounted for over £2.2bn worth of City trades and £540m in the West End, with one entity, Hana Alternative Asset Management, having bought six City offices in the year (including One Poultry for £182m) and were involved in Q4’s two largest purchases in the West End (including the £285m purchase of the Sanctuary Buildings in Victoria).
In line with other sectors of the market, performance of central London offices slowed in Q4. While City values rose by a solid 0.75% in the quarter, making growth of 3.1% over the year, the performance of West End offices was more pedestrian, 0.2% and 1.3% respectively.
Despite the economic and political uncertainties, rents in both sub markets continued to increase over the quarter, while there is growing evidence that rent free giveaways are also reducing. Limited stock availability is the prime reason for both factors.
Prime yields were again unchanged over the quarter at 4% in the City and 3.25% in the West End.
Research Author: Stewart Cowe 14/02/19
All investment and take up statistics from Savills, all performance statistics from MSCI.