How secure is economic recovery? The inside track on what 2015 may hold for the UK corporate real estate sector

 

Positive economic signs abound, but with continued uncertainty in the UK and across the world, what should investors consider? UK macroeconomist, Adam Chester, shares his views on the medium-term outlook for the UK economy and prospects for growth in the corporate real estate sector.

Adam ChesterBroadly speaking, the current economic picture is one of recovery. Gross Domestic Product (GDP) growth in the UK this year looks set to rise by over 3%, which is expected to be strongest in the G10.

Confidence remains high, with our own business barometer showing a marked rise to a 20-year high1. This occurs against a backdrop of continued and substantial monetary stimulus, with interest rates remaining at 0.5%.

Other measures support this view. We’ve seen a marked improvement in the labour market and early signs of an improvement in real incomes. Asset prices are rising, with equity markets trading strongly and house prices up about 10% year on year.

Increasing investment in the sector

Against this broad picture of the economy at large we’ve seen firm, notable improvement in the corporate real estate markets over the last couple of years. Sentiment has improved after the very sharp correction that took place in the sector. This is on the back of improved funding conditions, very low interest rates and the relatively high yields on offer.

Another key driver, particularly in the London markets, has been the inflow of foreign money. This investment has been partly attracted by the resilience of the UK economy, but also by the status of the UK as a relative safe haven.

One risk to the sector, which investors should note, is the likelihood that interest rates will start to rise in 2015. However, the Bank of England has stressed that any future increases in interest rates are likely to be gradual.

A pro-cyclical industry

Generally speaking, corporate real estate is a pro-cyclical industry. When the economy picks up, the sector starts to recover.

As we look to the year ahead across the economy as a whole therefore, GDP looks set to rise by about 3% next year. This would be a slight slowdown from 2014, largely due to a natural maturing in the economy, as the big bounce of initial recovery starts to level off.

As the recovery matures, monetary policy is expected to remain exceptionally stimulative although, as indicated, a modest rise in interest rates could come through in the first half of next year. That and the lifting of the uncertainty surrounding the referendum in Scotland bodes well for continued economic recovery in the medium-term.

Domestic risks to economic growth

The bedrock for economic recovery in 2015 is:

  • the continued maintenance or increase in business and consumer confidence
  • a strong labour market and
  • an improvement in real incomes.

There are risks to growth of course. On the domestic front, 2015 brings a general election and there remains a question mark over the possibility of an EU referendum.

From a monetary policy standpoint, one of the key uncertainties is over the prospects for productivity. To date, productivity has remained stubbornly weak. However, the hope and indeed the expectation is that productivity will recover as business investment improves.

Global challenges to continued recovery

The real risk for the UK is ensuring continued growth in a challenging external environment. Tensions in the Middle East and Eastern Europe pose a geopolitical risk to trade and asset prices, with the potential to cause a sharper correction in commodities markets and net trade.

Whilst the US is showing clear signs of recovery, this raises the spectre of high US interest rates in 2015. European growth meanwhile, remains relatively stagnant. There is also a broader question about the continued need for structural reform in the Eurozone, which could in part set off a negative demand shock in the UK, given the importance of Europe to UK trade.

Comparatively attractive asset class

For the corporate real estate sector, over the medium-term, we continue to see corporate real estate as an attractive asset class. In particular, we think the sector will be supported by continued yield compression given the relatively attractive returns on corporate real estate (of about 6.5%) compared to other asset classes.

Given the positivity that surrounds the UK economy overall for 2015, sectors such as corporate real estate, which are pro-cyclical, should continue to see growth and an increasingly stable outlook as the New Year unfolds.

Footnotes

1. http://resources.lloydsbank.com/economic-research/business-barometer-july-2014/

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