Economic and Market Commentary – Q1 2020

By May 11, 2020News

Brexit news

Given the huge amount of column inches that Brexit has commanded over the last four years, and particularly last year, it had to be something quite cataclysmic to take it off the front pages of the media in 2020.  And not only the front pages, but virtually every page.

The coronavirus pandemic has relegated Brexit news to a mere filler in media coverage at a time when the daily ministerial briefings, the number of new infections and deaths, the transmission rate (R0) and news about how and when the lockdown might end are far more important topics and far more pressing issues for a worried population.

However, meetings between the British and EU counterparts are still taking place.  Only now, they are happening online. But that change does not seem to have helped thaw the frosty relations between the two.  Virtual meetings have not altered the impasse that shows no signs of being broken.

Progress this year has been “disappointing” according to the EU’s chief negotiator, Michel Barnier, who also reiterated that “genuine progress” and a decision on whether to extend the transition period were both needed by June. Two further rounds of talks are scheduled before the end of the transition period. Prime Minister Johnson has again reiterated that Britain will not seek an extension to the end of the transition period in December.

May also saw the start of trade negotiations with the United States. One early stumbling block is the US farmers’ desire to increase their share of the UK market. Given the British consumers’ reluctance to accept chlorinated chicken and hormone treated beef, these talks could be just as fractious as the European ones. And with President Trump wishing to go to the electorate at the end of the year with some good news, it is unlikely that the US will easily back down.

Global economy

It is incredible just how much the world has changed over the past three months.  Our previous report did highlight the problems that the coronavirus was then causing, particularly to global supply chains and specifically to the Chinese economy, but we did not anticipate how rapidly the virus would spread and how our daily lives would be impacted.

Our previous report forecast that global output this year would grow by 3.3% – dull by historic standards, but certainly positive. Now red pens have been taken to all such forecasts: instead of growing, world output is now forecast to contract by 3%, significantly worse than at the time of the global financial crash (in the worst year of the crisis, 2009, world output dipped by less than 1%). Such a forecast puts the current global situation on a par with the Great Depression of the 1930s.

It is truly a global pandemic, the like of which has not been seen for over a century when ‘Spanish’ flu was reported to have caused the death of up to 100 million. The United Nations have reported that 81% of the world’s workforce of 3.3 billion has had their place of work fully or partly closed because of the outbreak and on an even more sombre note, the charity Oxfam warned that the economic ramifications from the spread of the virus could force more than 500 million people into poverty.

Countries in the firing line have imposed containment measures which prompted shutdowns of large parts of the economy. Coupled with these measures have been huge fiscal stimuli – which for many countries were substantially greater than those during the GFC – such as providing additional funds for health services and paying part or all of affected workers’ wages. While these measures will help in the short term, this crisis is one without precedent and one of the biggest unknowns is how long any measures designed to limit the spread of the virus will be needed. We also do not know how this situation will pan out over the course of the year.

As we write, we welcome news that some countries are beginning to ease their lockdown strategies – but any easing too soon risk the return of another wave of infections. With every country at different stages of the epidemic and with no clear ending of the crisis, it is virtually impossible to quantify the extent to which economies will be hit, and for how long any particular economy will be affected.

However, and bearing in mind the above caveats, our 2020 forecasts have been slashed across the board. Expectations for the IMF designated ‘advanced economies’ have been cut from +1.6% to -6.1% (a cut of 7.7 percentage points). Few economies will escape moving into negative territory; China, the original epicentre of the virus, is likely to grow this year by only 1.2%, significantly lower than recent trend growth of around 6%. Some of this year’s weakness is expected to be made up next year, but all forecasts – for 2020 and 2021 are subject to a higher than normal degree of risk.

Worrying though these forecasts are, it is chilling to read that the new head of the IMF, Kristalina Georgieva, has admitted that her organisation’s forecasts may well be “too optimistic”.

For what it is worth, official figures show that the US economy contracted by an annualised 4.8% in the first quarter while China, where containment measures were introduced much earlier in the year, saw its output decline by 6.8% – the first quarterly contraction there since records began in 1992.  Data from the major European countries were equally as bleak.

Global Economic Forecasts

% growth pa 2019 (est) 2020 (f) 2021 (f) 2022 (f)
US 2.3 -5.9 4.7 n/a
Eurozone 1.2 -7.5 4.7 n/a
Japan 0.7 -5.2 3.0 n/a
All advanced countries 1.7 -6.1 4.5 n/a
Emerging & developing countries 3.7 -1.0 6.6 n/a
World 2.9 -3.0 5.8 n/a
Source: IMF, April 2020

Note in view of the uncertainties surrounding economic growth in the near term, the IMF has abandoned its forecasts for 2022

The EU economy

Continental Europe has been amongst the hardest hit areas in terms of coronavirus victims and deaths. Once the epidemic spread outside China, Italy and later Spain became the focal points. Italy has been particularly badly hit and the measures taken by the Italian government, similar to those taken elsewhere, of supporting business and workers, is a burden the heavily indebted country can ill afford.

The latest GDP forecasts show that the euro-area is expected to contract by 7.5% this year with a partial rebound of 4.7% growth next year. Cumulatively, the two years imply a contraction of 2.8%, compared to a previously expected aggregate growth of 2.7% over that period. As would be expected, the economies of Italy and Spain, the most affected by the virus, see the greatest forecast contractions this year: Italy by 9.1% and Spain by 8.0%. Even with a modest rebound in 2021, both these economies are forecast to contract in total by roughly 4 percentage points over 2020 and 2021.

Even northern European countries, which so far have escaped the worst of the virus, are not immune to the sharp contractions expected this year. France and Germany are expected to contract by 7.2% and 7.0% respectively although they are both tipped to bounce back stronger and quicker than their southern neighbours.

First estimates of Q1 activity already show the scale of the downturn.  As expected, the economies of Italy and Spain contracted sharply by 4.7% and 5.1% respectively. It was France which suffered the most of all the major economies, declining by 5.8% – the largest fall since the quarterly data was published in 1949. The overall figure for the eurozone was a contraction of 3.8%. These Q1 numbers – bad as they are – are just the aperitif: Q2 declines for all countries will be significantly more negative.

Eurozone Economic Forecasts

% growth pa 2019 (est) 2020 (f) 2021 (f) 2022 (f)
Eurozone 1.2 -7.5 4.7 n/a
   France 1.3 -7.2 4.5 n/a
   Germany 0.6 -7.0 5.2 n/a
   Italy 0.3 -9.1 4.8 n/a
   Spain 2.0 -8.0 4.3 n/a
Source: IMF, April 2020        

The UK economy

The magnitude of the anticipated drop in UK output caused by the coronavirus this year is matched only by that of the huge sums of money pledged by the government to ease the financial pain of business and employees together with the open-ended budget allocated to the NHS to fight the virus.

The first quarter of the year was relatively unaffected as the bulk of the strict lockdown measures were only implemented on 23 March but the collapse of the economy this (April to June) quarter will be on an unprecedented scale, and certainly greater than anything encountered in the last 100 years. Forecasts for Q2, as collated by the BBC, range from a best of -7.5% from JP Morgan to a jaw-dropping -24% from Capital Economics.  And while it may be hoped that there will be some form of recovery in the second half of the year, the initially expected ‘V-shaped’ pattern of the economy – a sharp decline followed by an equally strong recovery – now seems unlikely with more economists favouring a double-dip or ‘W-shaped’ recession involving a second but less deadly spike of infections.

Our in-house forecasts anticipate annual GDP falling by 6.5% this year. That outcome is in the middle of the BBC’s sample (which ranges from a most optimistic -3.6% (JP Morgan) to a worst view decline of 12% (Capital Economics) but such numbers are meaningless when policymakers have so little control over the spread of the virus. Epidemiologists, just as much as economists, are necessary to determine the near-term pattern of the economy.

 There is no consensus of the magnitude of the UK GDP downturn

Some recovery is anticipated next year but it will not fully make up this year’s shortfall and we expect growth of 4.0% in 2021. Taking this year and next together, our current belief is that the UK will contract by a cumulative 2.5 percentage points; three months ago, we expected cumulative growth of 2.9%. Our revised forecasts therefore indicate a cumulative hit to the economy of almost 5½ percentage points – massive in historic terms and not dissimilar to the period of the global financial crash.  Looking at 2020 on its own, the magnitude of the contraction will not have been matched since the combination of the Great War and Spanish flu ravaged the economy over the 1918-20 period.

The drain on the country’s finances will be huge; lower corporate taxes, lower employee income tax (despite the furlough scheme) as well as funds pledged to workers, companies and to the NHS. The Bank of England did cut interest rates to an historic low of 0.1% on the day of the March budget but even so the financing of all these recently announced measures is an unwelcome additional hit to an already stretched UK government debt burden. We will all be paying for this debt for some time, even if a vaccine for coronavirus is found quickly. If a vaccine is not developed soon, the costs for the UK and other countries will become even more astronomical.

 Historic and forecast UK quarterly GDP growth

UK Economic Forecasts

% growth pa 2019 (est) 2020 (f) 2021 (f) 2022 (f)
GDP growth 1.4 -6.5 4.0 n/a
CPI inflation 1.9 1.2 1.5 n/a
Consumer spending 1.2 1.1 1.4 n/a
Base rate (end year) 0.75 0.1 0.5 n/a
Source: IMF, April 2020

As we write, the government is deliberating on the precise means to loosen the lockdown measures, allowing a return to some normality and permitting many more workers to return to gainful employment. Health issues to one side, a return to work is seen as imperative as it is revealed that the government is now paying the wages of nearly a quarter of UK jobs.  As many as 6.3 million workers (23% of the UK workforce) are receiving government money through the job retention scheme.

However, it seems that not everyone believes that the economy will quickly return to normality. A recent poll by YouGov indicates that up to two-thirds of the population would be reluctant to enter gyms, pubs or coffee shops when they reopen.

Not all parts of the economy will recover as quickly

Market Commentary

News that average commercial property valuations fell by just 2.4% over first quarter of the year may have brought some relief to investors, given the extreme volatility in equity, bond, currency and commodity prices recently. But such tranquil movements in property valuations may be short lived, particularly so if the period of lockdown in the UK is longer than initially expected.

The UK announced lockdown measures on 23 March, around the time when the valuers were beginning to issue their end Q1 valuations.  While average valuations for the market as a whole, as measured by the IPD Quarterly Index, showed a further 2.4% fall over the first three months of the year, the more frequent, but less representative, IPD Monthly Index showed that March itself accounted for that magnitude of fall.

The fall in capital values seems to be accelerating

In line with many other indicators, investment interest in UK commercial property appears robust when looking at deals over the first three months of the year. At £13.7bn (source: UK Economic and Real Estate Briefing, BNP Paribas, April 2020), investment turnover was 21% higher than the equivalent figure in 2019 and in line with the 10-year average. But deals were noticeably slower in the latter part of March. It was clear that UK institutions were particularly wary of the market in Q1, being heavy net sellers over the quarter.

 Overseas investors still remain keen on UK property

The art of commercial property valuation is a highly complex and sometimes mysterious process at the best of times, involving as a crucial crutch, the availability of similar properties with which to compare. In these more challenging times, when such comparables are few and far between and when even the previously simple task of inspecting a property is often impossible, these valuations take on a much greater degree of subjectivity. In only the fifth time in the last 150 years, the Royal Institution of Chartered Surveyors have instructed valuers to impose a ‘market valuation uncertainty’ clause, thereby stating that a higher degree of caution should be attached to the valuation of individual properties. By extension, this uncertainty to value can be extended to that of funds; the reason why many unitised property vehicles have suspended trading.

Parallels with the GFC cannot be ruled out; the fall in UK output is expected to be of a not dis-similar magnitude, but we do not foresee falls in property valuation similar to that seen a decade ago. While, arguably, commercial property valuations are stretched, and have been so for some time, the extent of over-valuation is not as bad as it was in the mid-late 2000s while crucially, the industry is not saddled with as much debt, thereby ruling out the necessity of a significant number of forced asset sales. But that is not to say that there will be no distressed sellers. Cash flow problems will surface for many investors.

Share prices of REITs were falling significantly before the lockdown; such moves tend to pre-empt a similar fall in property valuations. We pointed out in our last report that rents were declining across the retail sector while rents were virtually static in the office and industrial sectors. With little tenant demand likely in this uncertain period, it is difficult to see any improvement over the rest of the year at least: consequently, we expect rental declines across most of the market to continue in the coming months.

Average capital values in all three sectors are now declining

The retail sector will continue to see the sharpest valuation markdowns. Already we have seen a slew of retailers wishing to engage in “rent discussions” – a euphemism for at best rent deferrals or in some cases a rent reduction – some have announced further plans to downsize their portfolios of outlets, while some (most publicly and most strikingly, Primark) have revealed they have sold nothing since the lockdown. Some have requested changes to the frequency of rent payments – from quarterly to monthly – and in some cases, further concessions from monthly in advance to monthly in arrear. In an ideal world, the total rent paid under these new arrangements over the term of the lease would be unaffected, even if the timing differs, but the world at present is certainly not ideal, and some businesses will collapse before the lease ends.  It is inconceivable to believe that this sector will not continue its downward repricing over the coming months.

While it is tempting to consider that commercial property is currently competitively priced against other asset classes, given its yield premia, such an argument ignores the risk factor of tenant failure (or the reduction in rent demanded by a struggling business). This risk has never been higher and until business returns to some form of normality, this risk will remain and perhaps increase. Rarely has a portfolio’s covenant strength been so important and rarely will that of a tenant be subject to such rapid change. Businesses with reduced or minimal sales coupled with the ever-present, if perhaps temporarily reduced, overheads are not all going to come through the coming months unscathed and some, at least, will fall by the wayside. Many previously profitable entities will suffer heavy losses and at best may be forced to downsize their operations, or at worst face collapse.

The key question facing investors is how long the current exceptional period will last. If things get back to normal (or near normal) soon, and by that, say over the next three to four months, then hopefully not too many businesses will fail. If it takes much longer, we can expect a significant number of company failures, empty premises and with little demand for that space. That gloomy scenario is a reminder of the deep recession in the early 1990s.  It was initially anticipated that it would be a ‘short-sharp’ recession, one in which most companies could weather the storm; in reality, it proved to be one of the deepest and longest lasting recessions in history, wiping out numerous companies and driving vacancy rates up across the board. That period was exacerbated by a continuing development boom, which thankfully we are spared at present, but those with long memories will not want a repeat of that period.

The portfolio of the future

Much is being written about the possible winners and losers in the commercial property field: will internet/click and collect finally kill off the high street as we know it?; will there be even more demand for distribution warehouses?; what will be the optimum size of office and how should the configuration of the workspace look post crisis? Everyone will have a view about these and a myriad of similar ‘strategic’ questions.

Terry Smith, chief executive of Fundsmith LLP and star equity stock picker cautions on over-analysing the situation. In an article published in the Financial Times at the end of April, Smith believes that needless analysis is conducted on speculating on what will happen – when will the lockdown end?; what will happen to the travel and hospitality industry?; who will be the winners – makers of disinfectant and masks; drug companies? – and so on. This over-analysis sentiment, I believe, can be carried over to the commercial property market. The key question facing property fund managers just now is how secure are the tenants in one’s portfolio? At this stage, no one really knows. Covenant strength analyses are backward looking anyway. This crisis is dynamic in nature and seemingly strong businesses can collapse tomorrow. Even if one could identify potential tenant defaulters, how easy is it to remove that tenant from one’s portfolio? By selling the asset? By engineering a tenant replacement?  In this market, investors are as wary about investing in dodgy tenants as you are.

I believe that fund managers must resist buying into the latest fashion, e.g. buying properties with pharmaceutical tenants or selling those with travel agents on the lease. Rather, seek to maximise one’s income from the existing portfolio – and that may include accepting reductions in rent from certain tenants, particularly if these reductions mean the difference between collapse of the business and survival.

It is easy to predict that the retail sector will remain out of favour with investors.  The current crisis is merely accelerating a process that started over a decade ago and which has manifested in significant valuation declines already. It is also tempting to think that the industrial sector will also continue to benefit from the growth of distribution centres. But here, be wary of the yield; traditionally, industrial assets commanded significant yield discounts to the other sectors – now they stand at premia to the others. It is perhaps the office sector where the biggest debate ensues. What will be the optimum size, configuration and location of tomorrow’s occupiers? Will these discussions go the way of ‘hot desking’ which was thought to be the way forward 10 or 20 years ago but never really crystallised? Or will social distancing rules in the workplace dictate larger floorplates per employee? These are the debates landlords should be planning to have with their tenants, if not now, then when the crisis subsides. These discussions crucially should involve developers, not just at the stage of letting, but during the planning and construction stages too.

Central London offices

Not surprisingly, the short-to-medium term outlook for central London offices has changed dramatically since our last report three months ago.  We had noted the effect of the ‘Boris bounce’ in both business and consumer confidence which suggested that this momentum could well feed through to both occupier and transactional markets this year.

Indeed, there were signs of this happening in January, February and early March, although there were mixed fortunes for the City and West End markets in terms of take-up to that point. Hopes of a strong March were dashed when the full extent of the UK’s lockdown response emerged. In both markets, take up in March collapsed compared to the same month last year: take-up in the City, at just under 500,000 sq ft, was down 22% on March last year while the West End saw an even more dramatic 63% fall. Prior to March, the fortunes of both markets differed: City lettings an impressive 71% increase for the first two months of the year compared to the January and February 2019, the West End down by over one quarter. Part of the West End’s modest take-up figures is simply because there is very limited available stock for interested occupiers with current vacancy rates hovering around the 4-4¼% mark.

Central London office take up – mixed fortunes for the City and West End

There was a clearer picture when it comes to investment turnover. Transactions were already suffering the investment jitters – for example, equity markets were exceptionally volatile for much of that period. The volume of deals was already down even before the lockdown was announced. Transactions in the City and West End office markets over Q1 fell to £1.35bn and £1.05bn, down 38% and 10% respectively on the equivalent figures last year. Caution should be taken with the City figure as last year’s Q1 total included the £1bn Citibank purchase of 25 Canada Square last March.

City investment turnover collapses in March

Most of the March deals had been initiated well before the severity of the lockdown measures became apparent. Consequently, there were few deals started in the closing two weeks of the month. With many investors content just to wait and see how the landscape lies, with the timeframe and severity of the trauma to the economy still unknown, and with widely differing views as to the value of property assets in this environment, it is clear that transactions in Q2 and perhaps over the rest of the year will be severely reduced.

While new lettings may be more challenging to find in the short term, the one benefit brought by the lockdown has been the inevitable delays to the development pipeline, which will produce further constraints on future supply. This will particularly affect occupiers wishing large premises, where current options are extremely limited.

Central London office values fell in Q1, reversing a ten-year upward movement. Bar a sharp pause at the time of the EU-referendum in 2016, values have been on an upward trend since the end of the GFC-induced correction in 2009. Since then, average capital values had risen by 110% in the City and 88% in the West End before the Q1 fall of 0.2% and 0.8% respectively. It seems unlikely that values will pick up again over the course of 2020, but the underlying, if temporarily dormant, demand for space and the limited development ongoing at present should limit any further falls in valuation.

Central London office rents are falling

While the short-term prognosis for central London offices has deteriorated since our last report, particularly on account of the virus (and Brexit uncertainties are not helping), fundamentals remain relatively positive. Underlying tenant demand is strong even if letting deals are quiet just now while the delays to development completions reduces the amount of space available. Nevertheless, office values in London, like most other commercial property markets are going to have to weather some dull quarters before both the investment and occupier markets recover.

All investment and take up statistics from Savills, unless stated; all performance statistics from MSCI.

Stewart Cowe, May 2020