The Next Recession?
Economies have long suffered from booms and busts. In the 20th century alone the UK economy has experienced 9 major contractions.
In the past economists claim to have identified three different types of economic cycle. A short run cycle of three or four years associated with holdings of inventories; a medium-term cycle of between 7 and 10 years associated with waves of fixed investment; and an ultra-long cycle or Kondratieff wave lasting from 50 to 80 years associated with major technological change such as canals; railways; cars; telephones; and computing and the internet.
This mechanistic approach is the basis for some of the current thinking that the next recession is nearing as the post GFC economic expansion has now lasted nine years. Adopting this type of analysis, the UK commercial property market cycle in the later part of the 20th century and onwards has lasted approx. 16 years; which would see the next market peak in 2022! (see Chart 1).
However, it is now recognized that recessions are caused by negative external shocks. The Great Depression of the 1930’s was triggered by a fall in USA share prices, which caused a banking crisis and a contraction in credit and money. This was spread around the world by a fixed exchange rate system known as the “Gold Standard” and compounded by protectionism that reduced global trade.
After a 30-year period of relative economic stability, sharply rising oil prices in 1973 and again in 1979 triggered the first recessions since the end of the Second World War. A third economic contraction in 1990 was caused by a variety of causes including a decrease in defence spending following the end of the Cold War; a further oil price shock caused by the first Iraq War; and the Savings and Loans Crisis in the USA.
The GFC of 2007 to 2009 had echoes of the 1930’s Great Depression. It again started in the USA with a fall in residential real estate prices initiating the failure of Sub-Prime Residential Mortgage Backed Securities issued by undercapitalized banks. The banking contagion spread around the world due to the globalisation of financial markets. But a 1930’s style depression was avoided as free trade policies supported the global economy and the G20 countries developed a co-ordinated response to the crisis.
Earlier this month Capital Economics hosted a conference entitled, “What will cause the next major global downturn?” The same week the Economist published a Special Report with the heading, “The Next Recession.” Both seemed to suggest that, firstly, it was just a matter of time before the advent of another economic downturn; and secondly, the tools available to policy makers to combat recession were sadly diminished.
For a number of quarters, the RICS have included views on the current stage of the property cycle in its quarterly Commercial Property Market Survey. In Q2 the Survey reported that 26% of respondents considered that the market in the UK excl. London could be in the early stages of a downturn. This was an increase from 14% of respondents who had expressed the same view in Q1. In London, 52% of contributors agreed that the market was in a downturn in Q1. This increased to 71% of contributors in Q2.
The health of the UK’s commercial property market is inextricably linked to that of the UK’s economy. The returns to commercial property correlate strongly with current GDP growth; the returns to other assets do so weekly at best (see Table 1).
The key link is through rental value growth. Open market rental values quickly adjust lower in periods of recession or economic weakness; and recover, albeit with a lag, as the economic cycle turns up (see Chart 2). Open market rental values in turn feed through into capital values. This movement is compounded by the behaviour of yields, which tend to respond in a lagged fashion to rental signals.
Once the UK withdrew from the ERM in 1992, allowing interest rates to be cut, the economy recovered strongly. The commercial property market’s recovery from the slump was equally robust. In the eight years between 1992 and the end of 2000, capital values grew by 41% or 4.4% a year. The market had to wait until 1994 for the trough in the rental cycle but thereafter rents themselves grew by 41% or 5.0% a year between the end of 1994 and 2000.
This behaviour is typical of more closed market conditions. However, faster and heavier global capital flows have increased the sensitivity to financial shocks.
In mid-2007 the nascent crisis in the USA’s residential real estate market very quickly spread to UK commercial property prices.
UK commercial property prices started to fall in June 2007. The first falls in UK open market rental values were coincident with the onset of recession in Q2 2008. By that time, All Property capital values had fallen by 19% and yields had softened by 105bps.
The principal driver in this collapse in capital values appears to have been the withdrawal of support for the UK market from overseas investors. Net investment in UK commercial real estate by overseas investors amounted to £7.3bn in Q2 2007. This fell by 71% to £2.1bn in Q2 2008 as international banks responded to losses in the USA by limiting the availability of credit worldwide.
The genesis of the next economic downturn will originate from either (1) an external shock; (2) collapsing asset prices; (3) rising interest rates; (4) trade protection; or (5) a combination of all or some of the above. Whether the event is in the USA, Europe or China, the internationalization of capital markets means it will quickly impact UK real estate.
Without doubt, the biggest external shock facing the UK economy at present is Brexit. Since June 2015 when David Cameron’s last Government was elected with a Manifesto promise of an EU referendum, year-on-year overseas net investment in UK commercial property has fallen 27% from £39bn in the 12 months to June 2015 to £29 billion in the year to June 2018.
The market response has not been catastrophic. Nevertheless year-on-year total returns have declined from 16.8% in June 2015 to 9.9% in September 2018; year-on-year rental value growth has declined from 4.1% to 1.4%; as annual economic growth has declined from 2.5% to 1.2%.
Investors in direct property assets must have long-term time horizons. Given the illiquidity of the asset class, they invest through the cycle. To hedge against any downside, it is vital to be in the right segments of the market. During the GFC, All Property values fell 44%. But 10 years later the values of Central London shops, City and West End offices, and London and South East industrials have surged passed their pre- GFC highs.