FULL REPORT
The UK economy is showing clear signs of a slowdown. The April flash monthly data published by the ONS showed that economic activity fell by 0.3%, after an 0.1% fall in March. For the first time since the beginning of 2021, activities in all the three main sectors of the economy fell, led by services.
We see these developments intensifying over the coming months as the real-income squeeze begins to bite. However, we do not envisage a protracted slowdown, thanks to the resilient labour market, elevated saving rate and ongoing fiscal support to the most vulnerable households. Although we see a recessionary outcome as a possibility, we do not think it is an inevitability. Our expectation is for GDP growth this year to be c. 3.6%, with negative growth in Q2 and possibly Q3. In 2023, we see further slowdown in GDP growth to 1.5%.
One of the main reasons for the slowdown is the central bank action to control inflation. We see little respite from price pressures, with big increases in the regulated energy cap in the autumn and further upside from high food prices. Second round effects, including strong wage settlements and producer price increases, are likely to add momentum to underlying inflation in the near term. As such, we think inflation is unlikely to go back to the 2.0% target level by the end of 2023.
These outlooks underscore the Bank of England's recent hawkish stance. In five months, the central bank policy rate has rising by 115bps, one of the most aggressive tightening cycles in recent history. As the inflationary impulses continue, we expect a further 125bps increase in policy rate, taking rates to 2.50% by the end of 2023, with the slowing pace in increases informed by falling growth and inflation peaking by end 2022. If the outlook deteriorates further however, we are likely to see a much more aggressive stance, with policy rates above 3.0% by the end of the cycle.
Fixed income market are already pricing in a stronger rate increase, with the 10yr Gilt yields expected to finished 2022 at 2.5%. For real estate, such a sharp increase in benchmark rates has obvious implications for pricing.
“With inflation unlikely to return to the 2.0% target until 2024, we expect a further 125bps increase in the policy rate, taking interest rates to 2.50% by the end of 2023. Fixed income markets, however, are pricing in a much more hawkish cycle, with significant implications for real estate pricing.“
Central bank policy tightening is now in full swing, so real estate markets are now having to come to terms with rapidly rising costs. Five-year overnight index swap rates have reached 2.9%, their highest level since early 2010, having been only 1.0% at the start of the year. The benchmark 10-year government bond yield has reached 2.6%, while BBB-rated corporate bonds are approaching 5.0%. Property's average yield premium over government bonds has halved in 12 months and is now at its lowest since late 2008. In response, investors are prioritising astute stock selection.
Meanwhile, the latest producer price index figures helps to paint a stark picture of the current challenges developers are grappling with: for example, the Concrete Products for Construction sub-index shows that prices in May were 27% higher than they were a year ago. Prices for basic Iron, Steel and Ferro-Alloys are up 67%.
With the economic backdrop worsening, real estate investors are poring over the data for signs of a slowdown, but there is little sign of it (yet). In Central London, half-year City volume currently shows a 50% uplift on H1 2021 and an 11% premium on the ten-year H1 average. The supply of Grade A space remains very tight in relation to demand, while development pipelines have yet to be impacted materially by spiralling costs as developers opt to fix costs in advance. MSCI’s latest monthly data showed another strengthening in the annual returns (although the industrial total return actually fell for the first time in two years), while y-o-y rental growth continued to rise.
US financial markets may offer a hint of things to come. With the Federal Reserve signalling clearly its intent to prioritise tackling inflation, federal fund futures (market expectations of future changes in the federal funds rate) suggests that investors anticipate an economic slowdown next year, and earlier this month the 2y-10y yield curve came very across to inverting - traditionally a harbinger of recession – for the second time this year. In real estate markets, transaction yields for office and industrial assets have already repriced c. 25-50 bps.
There are snippets of encouraging data. Medium-term inflation expectations have fallen, suggesting central banks won’t have to act more aggressively and induce a recession, with its ensuing impact on leasing demand.
Prime West End yields remain firm, but our prime City office yield has risen by 25 bps to 4.0%. More upward corrections are inevitable. Obsolescence is now firmly in investor crosshairs. The challenge is to reposition portfolios now to avoid pain tomorrow.