Wednesday, 21 December 2016

An Economist and a Financier: What does 2017 have in store?

Tune into the final instalment of 2016 of An Economist and a Financier.
The Economist

The obvious defining event close to home of 2016 was the UK’s referendum on EU membership. It pushed investors into wait-and-see mode before polling day, and piled on the uncertainty after the vote. That uncertainty is still very much with us.

Away from politics, there was a couple of upside surprises on the economics front. The Eurozone economy looks like it is actually going to grow faster than the USA’s (1.7% compared to 1.6%). This will be the first time that this has happened since 2008. On this side of the channel, not only has the UK economy performed surprisingly well since the referendum, but it is within a whisker of growing faster than the world economy as a whole. That is all interesting economic trivia but the key point is that occupier markets, both in the UK and elsewhere in Europe, were surprisingly strong all things considered.

So what does 2017 have in store? The Eurozone out-growing the USA is often a sign of impending recession (as Europe lags behind the USA in the economic cycle). That does not look to be the case this time. The US economy is looking quite positive for 2017. Europe, by contrast, faces the dual challenge of higher inflation eating into real incomes and the political uncertainty surrounding a number of major General Elections to be held in 2017. Nonetheless, Euro-area growth in 2017 might prove to be surprisingly robust in the face of political uncertainty in 2017, just as UK growth was in 2016. Surveys indicate that the Euro-area economies are ending 2016 on a high, governments are relaxing fiscal policy, if only a little, and dollar appreciation and US growth might enhance export performance. As for the UK economy, talk is still of a referendum-induced slowdown but it is not yet evident in either the official economic data or the survey data both of which continue to surprise on the upside.

My financier colleague has mentioned higher inflation, which is bound to feature in 2017, and what might happen to interest rates, so I will not repeat it, but we cannot get away from another mention of political uncertainty. In stark contrast to 2016, we actually expect a year of no surprises as far as the major European General Elections go. That does not mean that investor behaviour will not be affected. If the opinion polls are showing a close race, investors will be tempted into a “wait and see” attitude just as they were before the UK referendum (assuming, that is, that anyone watches opinion polls anymore!). At least this time around there is scope for a bounce-back if we are right about no surprises.

In the UK, uncertainty about what Brexit means will not go away. However, UK property pricing now seems out of sync with the rest of Europe. There is scope for further price adjustment but at some point the UK will start to look relatively cheap. Furthermore, political uncertainty in other major European markets might even be to the UK’s benefit in the competition for cross regional capital.

The Financier 

After a 2016 best described as “uncertain” what can we expect for 2017?  It may be unadventurous to say more of the same but I think that is what we will see.

Politics has been in focus this year, with the EU referendum and change of Prime Minister in the UK coming to the fore.  Added to this, a surprising US Presidential Election topped off the year nicely.
The uncertainty that this engendered was illustrated, at least in part, by lower investment volumes in the UK – though it must be said that the liquidity cycle was turning down from mid-2015.  In 2017 the focus shifts to Europe with elections in The Netherlands, France and Germany.  The UK is not without events, but the expected service of an Article 50 notice will only be surprising if it does not happen.

Policy revisions, and especially the expectations of a more expansionary government in the US, accompanied by rising interest rates, will likely play their part.  The UK is expected to ease, slightly, its austerity programme.  In Europe, the issue is more whether quantitative easing continues rather than whether governments will seek to promote greater economic activity.

Against this background, while talk of the end of the US economic cycle seems to have been replaced by talk of a new upswing, expectations in the UK and Europe are of continued unspectacular growth – much in line with a long, low cycle often discussed by Neil and myself.

These changes in economic policy and rising inflation expectations are pointing to rising interest rates, but these seem to me to be more of a US phenomenon than a European one. I note that recent rises in European term rates have only seen a return to pre-referendum levels (rather than what was considered normal prior to the GFC) and the forward yield curve remains very flat.

I expect the dispersion trade, which was the underlying theme of UK price movements, and activity, during 2016, to continue.  Prime, with the definition, very focused on income stability, will continue to find favour for yield hungry investors.  Price discovery will continue in more secondary and value add situations, providing evidence of falling prices but probably really crystallising what has already happened but remains hard to see.  This price discovery should lead to an uptick in volumes in less bright and shiny assets.  The more secular trends of undersupply in fit for purpose logistics and oversupply in retail will continue to work through.  Other situations will be more finely balanced with the supply/demand equation in London offices a case in point.

In terms of UK opportunities, development funding in the form of debt is very hard to come by but is generating very interesting returns for those who can provide it, often ‘real’ money investors. We are also seeing returning interest in senior debt as a real estate asset class as investors are less willing to account for growth in their returns projections and are more concerned about the risks of future price weakness.

Looking at capital flows, a reflating US may prove to be a magnet for both domestic and international capital sources.  For non-dollar allocations the recent very strong performance in continental Europe, combined with some price weakness in the UK, exacerbated by FX effects, and the more continental focus for political instability in 2017, may see the relative attractions of the UK and the continent swing back towards the UK.

Tuesday, 22 November 2016

An Economist and a Financier: A November update

With the Autumn Statement approaching, listen to the latest instalment from the Economist and Financier:

The Economist: Occupier market resilience but challenges ahead

Political uncertainty does not stop with the US and the UK. We have a referendum in Italy and a re-run of the Austrian Presidential Election in early December, both of which are expected to produce ”anti-establishment” results. And that’s before the big three of the Dutch, French and German General Elections that will take place in 2017. No doubt these elections will produce a few bouts of nervousness but, at the end of the day, it is unlikely that there will be a major change in the governments of the big EU countries, although political continuity in Italy will remain at risk.

For now though it is the US that is at centre stage. Inflation expectations and bond yields have risen in the US and elsewhere but we need to retain a sense of perspective (as my financier colleague points out). Neither can we take for granted that where the US leads, Europe will follow.

'Reaganomics’ in the early 80’s (which ‘Trumponomics’ is expected to resemble in many ways) saw a sharp gap open up between US and European bond yields and there is every reason to expect a re-run, especially with unemployment in much of the Euro area is still running at more than 10 per cent.

Back in the UK, the economy is showing notably few adverse effects from the referendum. Q3 GDP was up 0.5 per cent, a little slower than the 0.7 per cent recorded for Q2 but not disastrously so. Business surveys have recovered to pre-referendum levels and employment is still growing (although there has been a small up-tick in the Claimant Count Unemployment measure). Most remarkably, retail sales volumes are booming – up nearly 6 per cent over the year (3 month averages). Much of this is e-commerce driven but there was still enough left over to produce a healthy 3 per cent growth for bricks and mortar stores.  Few think that the current robust state of the economy will survive the ongoing tides of uncertainty unscathed in 2017 but the consensus view on economic growth in 2017 has been steadily rising from around 0.7 per cent after the referendum to 1.1per cent now.

Since the referendum, rental growth has actually accelerated in retail (CBRE Monthly Index) but has stalled in Central London and has slowed considerably for offices outside of London. Industrial and logistics rents appear unaffected and are now clearly the fastest growing rents of any sector.

There will be challenges to occupier markets ahead.  Retail may become more polarised as inflation and unemployment creep up. Sentiment in the London occupier market will wax and wane with political developments and the success, or otherwise, in winning or holding onto major tech or financial services occupiers (recent successes in the tech area have been a major boost to confidence). Regional markets are not disconnected from London but government and other pre-planned re-locations provide some insulation. At present, only industrial and logistics rental growth looks to be really robust in the face of political and economic uncertainties due largely to the sharp up-turn in e-commerce mentioned earlier.

The Financier: Uncertainty dominates, certainty comes at a premium

We might have thought that the EU referendum changed the game, but since then the US Presidential Election has generated if anything greater uncertainty.  For all that, expectations seem to be that US policy will be expansionary, possibly inflationary and consequently there are expectations of higher bond yields.  That said, the much reported “bond rout” has seen 10 year buds rise to 30bp and the 10 year gilt return to its pre-referendum level, itself an all term low at the time – perhaps we need some perspective here.

In UK real estate markets, volumes have picked up after the summer’s hiatus, but the return of activity has followed the trends established since the second half of 2015, rather than forging a new channel.  Across sectors, prime has demand but not much supply, secondary is less demanded but perhaps more available, and more value add stock has not found a level.

Unpacking this a step further.  There is capital, especially from Asia and Europe, for high quality assets – their reasons for buying have not changed and the weaker pound is an incentive for some.  What yield expansion there has been mathematically reflects reduced growth expectations.  Long income is a better bid with pricing reflecting the continuing shortage of robust income sources in the investment universe.  Value-add volumes are suffering from the underwriting conundrum. Even moderately extended timescales can impact the level of bids materially, given the underlying cost of capital.  The absence of stress means there are few forced sellers.   Consequently, the bid-offer spread remains largely uncrossed.

These patterns are mirrored in the listed markets. Real estate has underperformed as a whole, reflecting the fears of rising rates.  Secure income from less cyclical sectors has outperformed the more economically exposed.  Stocks exposed to Central London have fallen further with more value add and project finance type stocks falling the most.

What might change this and lead to a re-rating of the real estate stocks and a strong recovery in conviction, and hence activity in the physical market?  Time is one argument.  It is amazing how much uncertainty we can get used to; as the EuroZone crisis has illustrated.  However, the rolling series of political events over the next year or so and with the service of an Article 50 notice and the commencement of formal Brexit negotiations to throw into the mix I struggle to see a strong effect in the short term.  On the downside, a material weakening in economic performance or sentiment could push the physical markets towards the levels implied by the listed space.  To date, the data has been pretty robust lengthening the odds, or at least the timescale for this scenario.

Friday, 26 August 2016

An Economist and a Financier - a post-referendum analysis


Brexit: The Story So Far

It is now two months since the UK’s decision to leave the EU. Contrary to earlier fears, the sky has not fallen in and economic life goes on. However, these have been the traditionally quiet summer months so it is hard to say exactly what the impact on the market has been. Properties have traded, but some notable examples are not typical so we will have to wait until September and the end of the holiday period (and possibly beyond that) to get a fuller idea of the vote’s implications.  Given the summertime lull in investment activity, the occupier market and the state of the economy in general provide the best clues to the future.

Occupier Markets and the Economy

Leasing activity also has a traditional summer lull but the data we do have is mildly positive. London take-up increased in July from an admittedly depressed June level. Valuers have either kept rents flat or have cut them only marginally (especially in retail which does not appear to be Brexit related). As with pricing, however, valuers do not have that much post-referendum transactional evidence to go on.

Hard economic data released recently is quite good, but most of it refers to the pre-referendum period. The exceptions were the claimant count unemployment figures, where the July rate matched its June level, and retail sales, which had a bumper month in July. Worries that the Leave vote would usher in a round of job cuts, hiring and capex freezes, which would also depress consumer confidence, were overdone. So it’s been business as usual since the referendum, with the odd surprise on the upside.

Survey data has been more mixed. Like the financial markets, surveys initially reacted poorly to the Leave vote. Steep falls were recorded in both business and consumer confidence. Judging by retail sales data, weaker consumer confidence had little impact on spending behaviour. Recent surveys indicate a move back towards June levels. The end-August vintage of business surveys has yet to appear, but they will probably show some recovery from the July dip.

Despite recent benign economic news, it is simply far too early to tell if dire warnings over Brexit were heavily overdone. Article 50, which will kick off the leave exit process, will not now be served until 2017 at the earliest, maybe even later. So there will be a period of extended uncertainty, which could produce some weakening of rents as companies put off leasing decisions. The new UK Prime Minister, Teresa May, has said that “Brexit means Brexit” but in reality companies do not really know what it will entail –particularly with respect to the all-important ‘passporting rights’ and restrictions on the mobility of labour.

Companies can react to this kind of uncertainty in two ways. They can postpone decisions; or they can adopt a more business as usual approach until things become clear. There appears to be a lot of the latter going on.

However, the London property pipeline does definitely seem to have been affected by the referendum result. There is still plenty of development afoot, but there has been a shake out of the marginal riskier projects. The size of the pipeline and its impact on the supply-demand balance led to some hesitancy in the London investment market; in addition to prime Paris office yields falling below London levels (despite a far weaker growth of the occupier base in Paris). So depending on future occupier demand, rents in London could be higher in four or five years’ time than they would otherwise have been.

UK unemployment shows no signs of an increase

Capital Markets

Although worries about a sudden post referendum hit to the economy appear to have subsided, there is now greater uncertainty over future rental income. This in turn implies high yields and lower prices. It is very unclear how big this adjustment should be (but it is likely to be larger for secondary than prime markets). 

Potential buyers have not disappeared. There is still confidence in the UK market and exchange rate adjustments have made the UK more attractive, but investors are looking for a discount to reflect increased uncertainty. Most sellers, on the other hand, do not need to sell.

It will be September at least, and possibly Q4, before we will sense where prices might settle. The gap between buyers and sellers expectations might not be large. There is already evidence from the UK’s public real estate companies; share prices in UK REITs are currently down by eight per cent since 23 June with bigger falls from the London/value added/development focussed REIT; whilst there is minimal change for the more diversified and logistics focussed REITS.  Leverage by REITS makes it difficult to infer much about direct property from company valuations. REITS shares are only broadly indicative of the eventual impact on direct property pricing. Prices are also still up by over five per cent on their mid-February lows. In other words, the referendum was a negative shock but not as negative as earlier concerns about the world economy implied.

There are many other indicators of capital market behaviour. Some have improved since the referendum. Equity markets are up – and not just in the UK. This is partly because of lower expectations of interest rate rises; and partly because worries over China and emerging markets have abated for now. Long and short-term interest rates are down, as are corporate bond spreads. Remarkably, UK corporate bond yields are now lower than before the referendum.  This may reflect the anticipated impact of the new round of QE on corporate bond yields, but the corporate bond markets may also think we are in no more of a risky environment than we were pre-referendum.


Taking our favourite comparison of the yield on UK property (i.e. CBRE Average Prime Yield) and the real BBB corporate bond yield (i.e. nominal BBB bond rates less inflation expectations implicit in the gap between real and nominal 10-year gilts), the relative attractiveness of property has actually increased despite the fall in corporate bond yields. That makes property more attractive unless investors expect a recession that will more severely impede income from property than from corporate bonds. Despite the uncertainty over Brexit, there is no obvious reason why this should be the case.

Ongoing falls in yields for prime property in many European markets over the first half of the year also add to the relative value argument for UK property. There is still an abundance of capital globally which is looking for yield and a degree of security. This search was interrupted by global economic scares in H1 2016, but that has passed and yields are being driven down, especially for low risk or prime asset classes. This is not to say that there will be no price adjustment for UK property – but it might not be as big as at first feared.