Archives for August 2013

UK Recovery – Green Shoots, but Weak Roots?

In June I published “UK Economy – Green Shoots” anticipating the improvement in the economy that has become clearer to see in the last few months. Data for the second quarter showed growth of 0.6%, a very healthy pace, house prices all over the country have begun to pick up, and shorter term sentiment indicators are showing a clear improvement in confidence across all sectors of the economy.  This blog examines the sustainability of the recovery.

Economics was coined “the dismal science” by Victorian historian Thomas Carlyle in the nineteenth century.  After five years of recession and sluggish recovery, it might be expected that the clear, recent improvements in the UK economic data would be cheered by the nation’s economists.  Sadly this has not been the case.

In 2010, when the current government took office, it had a very clear plan for bringing the UK economy back to full health. By bearing down on government spending, the public sector’s demands on the economy would reduce, and with the Bank of England pursuing a very aggressive policy of Quantitative Easing, banks would have the liquidity to lend to business.  In this way growth would return to the UK and be led by business investment and exports, offset to an extent by government cutbacks and a rebuilding of consumer savings.

The boxer, Mike Tyson, once said, “everybody has a plan until they get punched in the face”.  This theoretically sensible plan fell apart when (i) the Eurozone crisis appeared, which sent our largest trading partners into a deep and long recession, (ii) it became clear that the banking system was in fact in a far worse state than had been appreciated, and despite the extra liquidity from the QE programme, banks preferred to keep the liquidity on their balance sheets rather than lend it out for business to invest, and (iii) businesses that had borrowed to invest in the past lost their trust in the banking system and resolved to avoid being dependent on banks for financing in the future.

The result was no growth in exports, little desire to invest on the part of businesses and little desire to fund any investment by the banking system. With the government austerity programme and wage growth falling behind the rate of inflation, the UK economy showed little ability to recover, and where it did, it was at the expense of falling household savings.  In the twelve months to March 2013, UK household spending rose by £10.6bn while UK household income rose by just £2.0bn, the difference being a decline in gross household savings.

For the government, now with less than two years until the next election, the make-up of any economic recovery has become far less important than the fact there is a recovery, and in the Budget, George Osborne decided to boost house prices with “Help to Buy” schemes, which make it much easier for house buyers to borrow the funds to purchase homes.  This may well be excellent politics, in that higher house prices make for happier home-owners (who are of course also voters), but it is poor economics.

First, UK household debt is already equivalent to 95% of gross national income, which is down from 103% at the end of 2009, but is still much higher than the 63% level at the end of 1998.  There is very little capacity for household debt to rise as a share of the economy from current levels. Any consumer recovery based on increased borrowing will be short-lived.

Second, the problem with the UK housing market is not lack of demand, it is lack of supply.  France, with a population of similar size and growth to the UK, builds about 350,000 new homes each year, and the government has a target of 500,000; in the UK we are currently struggling to build much more than 100,000, and the best year in the last decade saw only 200,000 new homes built.  Yet the rate of new household formation is officially estimated at 220,000 – this imbalance between demand and supply keeps both house prices and rents very high in relation to income.

Given the political timetable, the UK economy may well see a reasonable improvement over the next two years, and after the torrid time the economy has been through in recent years, it would be churlish to be unhappy with any sort of recovery.  However, the major imbalances within the UK economy of high consumer debt, low consumer savings, substantial trade and budget deficits and surprisingly stubborn inflation have not been resolved, and this will inhibit its strength and longevity.

The domestic nature of the recovery to date means that investment implications of this recovery are that for now, as this recovery builds, UK smaller companies and commercial property should perform well.  These are the sectors of the financial markets that are more closely linked to strength in the domestic economy.  In the longer term, index-linked gilts should perform better than conventional gilts, as inflation is likely to continue to be a threat. For those with a more speculative disposition, Ladbroke’s are currently offering odds of 3/1 on a Conservative majority at the next election.

Get Real (Estate)

Returns from the UK commercial real estate market have arrived at a critical inflection point.  A year ago, the average rental yield on commercial property across all regions and types of property was 6% per annum.  However, capital values were declining by about 0.5% per month, giving a zero total return to investors.  These declines have become steadily smaller over the year and in May this year, capital values actually rose by a very small amount.  Thus total annualised returns from commercial property have risen from zero to almost 6% over the last year.

The fundamental demand outlook for UK commercial property is improving.  For the first time in several years, data from the UK economy have been starting to show a sustained pick-up in growth, and unemployment, a key indicator for property demand, has been broadly stable for some time.  In addition, the Bank of England survey of credit conditions recently showed a positive reading for the first time in three years.  The market has been held back in recent years by banks selling down the property collateral that they were forced to take up after the financial crisis – the early signs that they are now prepared to consider lending to property investors is a good indicator that they no longer believe themselves to be over-exposed to property.  In terms of supply, new construction orders are at historic lows and outside of London there is barely any new supply of commercial property coming onto the market in the next few years.

Relative to the expected returns from other asset classes available to UK investors, commercial real estate has now become much more attractive.  The Bank of England Base Rate of 0.5% is likely to remain there for several years, and interest rates on the banks’ best deposit accounts have been falling sharply this year, as the Bank of England has been prepared to provide very cheap liquidity to those banks, which are increasing their lending.  In the gilt market, investors have to lend their money to the government for about 5 years to get a yield of 1% pa, about 8 years for a return of 2% pa and about 17 years for a return of 3% pa.  With markets pricing in an expected rate of increase in the Retail Prices Index of about 3% pa, most gilts are offering negative real returns, and that is before any taxation on the interest payments.  The UK equity market has a dividend yield of about 3.5%, and we would expect long term capital growth of an additional 4%.

From June 2003 to June 2013, the IPD UK All Property index has produced a total return of 73% (about 5.7% pa), all of which has come from income over the period, which encompassed a strong bull market, a major bust and a slow recovery.  Over the long term, we would also expect some capital growth from commercial property, if only to reflect the expectation that rents should grow in line with inflation.

Income returns of 6% pa (both currently and historically) plus the possibility of some capital growth as the UK economy starts to perform a little better after several years of stagnation, provide both a healthy level of return to investors and a strong consistency (low volatility) of those returns.  UK commercial real estate is an attractive asset class, and we have moved to a Heavy exposure across our portfolios, believing that now is a good time to be building positions in the asset class.