Cordatus Economic and Market Commentary Q1 – April 2019

By May 16, 2019News

Brexit News

Despite writing this report in mid May, fully six weeks after Britain’s original date for leaving the EU, we are no further forward to knowing what form the exit will take, when it will occur, or indeed, whether it will happen at all. Prime Minister May brought her own version of the exit strategy to the House of Commons three times, suffering heavy, if falling, magnitudes of defeat while members of parliament, in an unusual move, themselves brought eight different versions of ways forward – ranging from retaining the customs union, to a no-deal solution to a further referendum – all without success. As the EU (and many frustrated voters) have said; we know what you don’t want, now tells what you do want.

The latest plan, to seek some compromise solution with the Labour party, so far does not seem either to be coming up with the goods, but this long running soap opera has a possible further five months to run, with the EU having agreed a potential delay to the end of October. It is not clear whether any progress can be made in that timeframe.

Meanwhile, the government has reluctantly accepted that the UK will have to take part in the European elections at a cost of £150m – one of many ‘one-off’ costs that the country is having to bear because of the current impasse.

Global Economy

The global economy suffered a distinct slowdown in the second half of 2018 and this feature continues to negatively impact activity this year. The state managed decline in China’s activity, where growth is forecast to dip to 6.3% this year and to 6.1% next year, is one of the key reasons for this slowdown, but the on-going trade tensions between the US and China are also not helping.

These trade tensions, together with continuing uncertainties over Brexit, are hitting business confidence. That, coupled with a slowing export market, is affecting global trade, particularly hampering export-focussing countries.

At a global level, the slowdown that has been evident for the last nine months or so is likely to trough in the middle of this year, with a gentle uptick thereafter. This improvement is predicated on some policy stimulus in China, the ending of some particular negative factors in Europe and a stabilising of conditions in some of the distressed emerging market countries such as Argentina and Turkey. Within the advanced economies, however, there is little positive momentum to note as activity is likely to gradually slow as the impact of the US fiscal stimulus fades.

Our global growth forecasts have been trimmed by 20 basis points to 3.3% for 2019 but are maintained at 3.6% for next year. The forecasts for the advanced economies, in aggregate, have also been cut by 20 bps to 1.8% this year and are maintained at an anaemic 1.7% for 2020.

We have not altered our view that the balance of risks is tilted to the downside. The key global trade issue remains the on-going trade talks between China and the US. The latter’s decision to impose higher tariffs on specific imports from China – up from 10% to 25% – is likely to prompt retaliation. Resolution of the trade tensions would give a fillip to global growth, but further escalation of these tensions and the accompanying increase in policy uncertainty would have the opposite effect. On balance, we are concerned that there still remains the distinct possibility that there will be a sharp deterioration in market conditions.

The EU Economy

The Eurozone has borne the brunt of the heaviest downgrades over the last three months. The single currency bloc has not been immune from the global slowdown but it has also been subject to some significant country issues which have combined to lower the zone’s anticipated output. Forecast growth in the Eurozone, in aggregate, has been trimmed from an already weak 1.6% for this year and 1.7% for 2020 to 1.3% and 1.5% respectively.

Germany and Italy have been particularly badly affected – the former on account of its export-oriented stance and the slowdown in the automotive industry: the latter on account of rising bond yields and the resultant impact on the cost of the country’s huge sovereign debt mountain. Our forecasts for both countries have been cut by 50 bps this year to a less than impressive 0.8% and 0.1% respectively. Even this year’s forecast may be too optimistic as the German government expects growth of only 0.5%. The March PMI reading for Germany showed a worrying fall to levels not seen since the midst of the euro area sovereign debt crisis. Forecasts for France, too, have been reduced from 1.5% to 1.3% for this year. France and Germany have also suffered a 20 bp downgrade to 1.4% for 2020.

Growth for the Eurozone as a whole in Q1 came in a little stronger than anticipated, at 0.4%, double that of the previous quarter. There were encouraging signs for the ‘big-4’ Eurozone economies where growth was higher than expected. However, this relatively positive showing is not expected to continue over the rest of the year. Italy’s economy returned to growth after two quarters of contraction, but questions still remain over the country’s medium term outlook.

Perhaps the most encouraging sign for the Eurozone is the fall in unemployment. The rate of 7.7% is the lowest since 2008, before the onset of the global financial crash and down from 8.5% in the last 12 months.    

The UK Economy

Given the negative effect that the tortuous negotiations followed by the House of Commons impasse in agreeing to any form of Brexit is having, it is understandable that British business finds the prospect of a further period of parliamentary negotiation particularly frustrating.

It remains commendable that the UK economy has remained so resilient over the last year or so, with so many questions still unanswered, especially regarding how trade will fare after Brexit. The latest IMF forecasts for the UK show a reduction from those published three month ago, but at a time when virtually all countries have suffered downgrades. For the UK activity to be broadly expanding over the next two years at the same rate as the Eurozone says as much about the UK’s resilience as the EU’s inherent economic ailments.

The UK economy rebounded in the first three months of the year, posting quarterly growth of 0.5%, significantly better than the lacklustre 0.2% seen the previous quarter. Despite this better than recent levels of growth, much of the activity was accounted for by stockpiling ahead of the UK’s original exit from the EU. The Office for National Statistics reported that “manufacturers were clearing their order books before the planned departure date”. That helped the manufacturing side of the economy to grow in Q1 at its fastest pace since 1988. While it is unlikely that this level of activity will be sustained over the rest of the year, as stocks are likely to be run down, evidence supports the belief that household consumption growth is remaining “solid” and crucially, business investment did not fall “for the first time in four quarters.”

Our forecasts for the UK for this year and next have been trimmed by 30 bps and 20 bps respectively, to 1.2% and 1.4% from those of the previous quarter, reflecting the weaker global trade position as well as Brexit-induced uncertainties. An outcome of 1.2% this year would be the lowest annual growth in a decade. These forecasts, however, are predicated on an orderly exit from the EU. Exiting without a deal, or by some other chaotic way would likely damage the economy over the short term, with consequent downgrades to the above figures.

The downside to these strong manufacturing numbers is the sharp rise in the trade deficit brought about by higher imports ahead of any possible trade sanctions on a no-deal exit. The trade deficit doubled to £18bn in the quarter, a figure which increases to an eye-watering £43bn – a record – at the trade in goods (not services) level.

Market Commentary

According to the latest, Q1 2019, MSCI Quarterly Index, capital values for the market as a whole posted a three-month fall of 0.75%. The trend in capital values has now been declining for five successive quarters, and Q1 was the second quarterly fall in a row. Capital values in the hard pressed retail sector once again contributed most to the down rating, although value declines there (2.6%) were not as bad as the previous quarter’s 2.8%. There was minimal change in all office values in the quarter, the main feature being a 0.2% fall in average city offices, the first decline there for three years. The recent outperformance by the industrial sector continued but here, too, capital growth in the quarter fell to a three year low.

Overall quarterly total returns for the market fell to 0.38% with the albeit slowing industrial sector delivering 1.7% (barely half that of Q4 2018), offices 1.1% and retail -1.3%.

Our reports in recent quarters have highlighted the problems retailers are encountering in the high street and in the retail market generally. The above MSCI figures are witness to the fundamental re-pricing of retail assets that has been underway for some time and is likely to continue for several more quarters yet. Two separate but linked reports show just what pressure landlords are having – one from PWC showing that the number of new shop openings fell to the lowest on record last year and the annual results from one of the UK’s largest shopping centre owners, INTU, which revealed that like for like rents were 6% lower than a year ago and vacancy rates had increased by 1.1 percentage points in the quarter to 4.4%.

The PwC report, which was compiled by the Local Data Company, highlighted that in 2018, an average of 16 shops a day closed across the top 500 high streets in the UK. Compounding that loss was the fact that an average of only nine shops a day opened, leading to the largest ever net annual decline of 2,400 shops last year. Data shows that while the number of shops closing has remained relatively constant over the last six years – averaging 5,700 each year – the number of new shop openings has steadily declined over that period – from 5,662 in 2013 to 3,372 last year.

While capital values have been declining in the retail sector for some time, the concern now is that capital growth in the office and industrial sectors, where the rate of growth has been slowing for over a year, turns negative. Such a scenario is already factored in to the share prices of many listed property companies and real estate investment trusts. Although take up and investment has remained fairly resilient, any such widespread value declines could have a significant detrimental impact on the current positive sentiment that the commercial property market is enjoying.

Central London Offices

The City and West End office markets experienced contrasting fortunes in the first quarter of 2019. While the City market recorded a particularly strong quarter in terms of investment turnover, Q1 take up was the weakest for six years. The West End was a mirror image with Q1 investment weak but take up very strong.

Despite these mixed results, it is fair to say that both investment and occupier markets are performing much better than could have been expected given the hiatus over Brexit and the ensuing economic policy vacuum.

Although City investment increased by over 50% versus the equivalent quarter of 2018, to £1.69bn, two thirds of that total was accounted for by the purchase by the occupier of Citigroup’s Canada Square office for £1.1bn. That aside, both the number and size of transactions is were down in the quarter. Citigroup’s purchase was no doubt a decision made in the light of changing accounting regulations which came in force this January.

By contrast, the West End had its quietest first quarter in terms of transactions for 10 years with a total of only £900m which was down roughly 25% on the same quarter last year.

In terms of occupier take up in Q1, both markets recorded similar figures of 1.2m sq ft. That represented a 20% fall in City take up from 2018, but was the highest first quarter take up in the West End for six years and 30% above the long term average. What was consistent across both markets was the small size of the average letting – 11,400 sq ft in the City and 12,200 sq ft in the West End.

According to MSCI’s Quarterly Index, average capital values continued to grow, albeit slowly, in the West End. Q1’s average growth of 0.23% brought the running 12 month capital growth to 3.9%. By contrast, average City offices slipped 0.19% in Q1 – the first fall there in values since 2016 – although growth in the last 12 months remained positive at 2.3%. The trend in both sub markets, however, is distinctly downwards.

Savills’ prime yields ticked in both market over the quarter. That in the City moved up to 4.25% while that in the West End increased to 3.75%. The 50 bp differential is the smallest in three years after narrowing from 75 bps.

All investment and take up statistics from Savills, all performance statistics from MSCI

Research Author: Stewart Cowe 13/05/2019