For too many years, I’ve normally admired John Plender’s pieces but I found his latest article on Brexit and the prospects for investment etc. quite odd and loose especially when he gets to commercial property. I actually agree with quite a lot of it. As he states, the consequences of Brexit are not clear-cut since there’s so many unknowns. He seems interestingly right about the large cap equity sector.
UK equities are relatively detached from the domestic economy. Companies in the FTSE 100 derive more than 70 per cent of their earnings from overseas, so geography matters remarkably little to its performance.
Hence, the 15%-20% devaluation of sterling against the dollar has resulted in large increases in the FTSE 100. He sees the devaluation as providing an opportunity for the almost mythical rebalancing of the UK economy from consumption to production and finance to manufacturing (I’ll believe it when I see it) and he pretty much welcomes a decline in London as a financial centre. He then turns to the commercial property market.
There is one UK market where geography really does matter and which has been acting as a haven for international money. That is the commercial property market. Have its attractions been seriously undermined by Brexit? Capital values tumbled after the referendum and only stabilised in late autumn. Yet the total return on commercial property in 2016 as measured by the IPD index still emerged as a positive number at 3.9 per cent because the decline in capital values was outweighed by strong rental income. That said, it is hard to see how the office market, the natural place for haven investors, will be as attractive as in the pre-Brexit world. Estate agents LaSalle, for example, are forecasting negative rental growth for prime UK offices from 2017 to 2021. A haven that threatens to deliver capital losses and negative rental income cannot qualify as a haven.
Is it fair to characterise London as a haven? Surely he means negative rental income growth? Rental income wasn’t really ‘strong’. last year . It was typical. If anything, the income return was lower than the long term average. The IPF Consensus Forecasts do imply expectations of small drops in rental values. However, the fact that capital value changes are expected to broadly match rental value changes suggests that there is little expectation of a any significant yield shift over the next five years. I tend to be wary of expectations of no change. That yield shift expectation could be badly wrong. If bond investors decide that negative real yields on UK govt. bonds are not acceptable for whatever reason, then the downside risk looks substantial. It’s the bond paradox redux.