FULL REPORT
Several indicators have begun to show economic activity easing over the summer. The PMI surveys fell in August; services declined to 55.5 while manufacturing fell from 60.4 to 60.1. Although the PMIs indicate a loss in growth momentum it is important to note that growth was expected to ease after Q2, which reflected the upside from re-opening the economy after the lockdown in the first quarter. In addition to the PMIs, the latest monthly GDP growth data for July was much weaker than anticipated, with growth of just 0.1% m-on-m, below the consensus of 0.5%. Monthly data revealed services and manufacturing output was flat while construction output declined. It is becoming more evident that supply chain disruptions are weighing on growth. As a result BNP Paribas have updated their year-end forecasts, with growth of 7% in 2021 followed by 6.3% in 2022.
The debate surrounding temporary versus persistent inflationary pressures has intensified after we saw inflation jump to 3.2% in August, up from 2.0%. The 1.2pp increase was the largest increase in annual inflation on record. Core inflation also increased from 1.8% to 3.1%. A large part of the jump was again due to base effects, where we had seen a cut in VAT last year and around this time, we also had the Government’s ‘Eat Out to Help Out’ scheme. The rise was also caused by other temporary factors, such as used car prices and the continual effect of reopening in the hospitality sector. Despite these all being temporary factors, inflation is likely to remain elevated over the next two years. One risk to the assumptions that can prove to be more persistent is the labour market. The BoE latest minutes indicate a rate hike is on the cards much earlier than most expected (Feb 2022).
The UK unemployment rate fell to 4.6% in July and employment was up 3.0%. The number of vacancies was 25% higher than pre-pandemic levels and the highest on record. However, according to the ONS, 6% of the workforce was still furloughed as of mid-August.
Although the labour market is showing strength, the number of people still on furlough is higher than expected. As the job retention scheme ends, we do expect an uptick in unemployment, and wage growth is beginning to ease (regular pay growth slowed from 7.4% to 6.8%) despite high demand for labour. This should ease inflationary pressures.
The slowdown in growth was inevitable. Looking ahead, economic growth is likely to be restricted largely due to supply constraints rather than demand. The latest PMI surveys reveal businesses reporting a loss of momentum, largely due to staff shortages and supply chain issues. This will be something to keep an eye on. Nonetheless, GDP growth of 7% is expected this year.
The UK real estate investment market continues to recover. Year-to-date volume now stands at £35.4bn, 39% and 9% up on the same period in 2020 and 2019 respectively. There is momentum across the sectors, but logistics is the big driver. At c. £10.4bn, the sector has now accounted for c. 29% of all UK investment so far this year - almost double the previous five-year average.
Momentum also continues to build in Central London. Our in-house investment deal tracker shows that c. £4.0bn of office assets have transacted in the City so far this year, already surpassing the total recorded for the whole of 2020. Approximately £9.5bn of office assets are currently for sale or under offer across Central London, a c. £1.5bn increase on the total we reported last month, indicating that liquidity is improving. Moreover, we continue to see evidence of hardening yields for best-in-class assets, particularly in the West End. One notable recent deal was BMO Commercial Property Trust's sale of Cassini House, SW1 to Hong Kong Kerry Properties for £145.5m, reflecting an initial yield of 3.2% and c. 11% uplift on the previous valuation. Google mobility data for September suggests use of workplaces in Greater London was still c. 42% below pre-pandemic levels (up from the average of -52% recorded in August), but investors are encouraged by rising demand for Grade A space and positive PMI data, while also becoming increasingly concerned with protecting against rising inflation.
Real estate is traditionally viewed as an inflation "hedge", but analysis of historic data suggests little observable correlation between rental income and CPI. The cause of inflation is much more important. Short-term spikes linked to temporary rises in energy prices and supply chain issues have little impact. However, as analysed in our Central London office yields paper earlier this year, core property values and rents (unsurprisingly) appreciate the most during periods of improving economic growth and business activity, which tend to coincide with rising inflation. In essence, real estate is an asset class for the long-term investor concerned with gaining exposure to industries driving economic growth, and temporary inflation pressures should have little bearing on core real estate allocations.
Should the current bout of inflation prove persistent, property as a long-term investment offers sufficient insulation from price rises, but asset selection, as ever, will be key. Rental growth prospects are most positive in areas benefitting from long-term demographic and economic trends, while sectors facing headwinds are unlikely to keep up with CPI over time. Logistics, Grade A offices and the Living sectors will therefore prove the most resilient, sectors where the UK real estate market shows promising prospects for growth.