3 minute read
The European economy continues to grow above trend rates, but investors should be wary of rising bond yields and rapid development in some markets, says Vivienne Bolla.
The European economy is approaching a turning point. On June 14, the European Central Bank (ECB) announced it would wind up its quantitative easing programme in December 2018, marking the end of a three-year period in which the bank unleashed massive monetary stimulus to spur growth across the continent.
The ECB’s decision reflects economic improvements across the euro zone. While growth fell to 0.4 per cent in the first quarter – a slowdown analysts attributed to a combination of extreme winter weather and strikes in France and Germany – all leading indicators point to continuing expansion over the remainder of the year. As of March 2018, the euro zone unemployment rate stood at 8.5 per cent, its lowest level since December 2008.
Despite a strengthening labour market, inflation remains sluggish. Headline inflation slowed to 1.2 per cent in April, lagging the ECB’s target of two per cent, while core inflation stood at 0.7 per cent. With Europe’s economic recovery still fragile, the bank has given very clear guidance on its policy intentions, signalling it will maintain interest rates at record lows into next year, despite the withdrawal of QE.
Strong occupier demand, coupled with limited development, is spurring an acceleration of rental growth across prime office property. Vacancy rates on prime offices in the EU-15 countries (excluding the UK) fell to pre-crisis lows over the first three months of 2018 (see figure 1), while year-on-year rental growth stood at 5.4 per cent. Investor demand remains strong, driven by favourable relative pricing and improving fundamentals.
Figure 1. Falling vacancy rates in European offices
European retail markets have been buoyed by robust consumer spending. However, annual rental growth rates have begun to slow and year-on-year transaction volumes decreased by nine per cent in the first quarter. The prime retail yield now stands at a record low of 3.3 per cent.
Demand for industrial space continues, as the wide yield spread to retail property and offices attracts yield-hungry investors to the sector. Over the first quarter, investment volumes were up by 28 per cent compared with 2017, while prime industrial rental growth in the EU-15 rose by two per cent year-on-year.
However, a decline in the IHS Markit euro zone Purchasing Managers Index – which fell to a 13-month low in April – may indicate a slowdown in exports that could impact the industrial sector over the coming months. IHS Markit cited the impact of strikes and adverse weather at the beginning of the year but also pointed to the uncertainties surrounding Brexit and threat of a global trade war, which could weigh on exports over the longer term.1
Risks to the outlook
The ECB’s withdrawal from bond markets could lead to a rise in yields, eroding the relative attractiveness of real estate, although this is not our core scenario. With the ECB prepared to keep interest rates low – the bank says a rate hike is unlikely until after the summer of 2019 – any rise in yields will be gradual. We expect real estate to reprice in 2018 and 2019 in line with bonds, with a moderate decompression of about five basis points expected across most markets.
A greater hazard is the development pipeline, which has become a concern in some central European markets. After a prolonged lull following the financial crisis, development is increasing rapidly in some central European cities such as Budapest, Prague and Warsaw (see figure 2), which may struggle to absorb the extra capacity. Budapest has 500,000 square metres of office space under construction, a significant increase on its current stock of 3.4 million square metres.
Figure 2. Rising supply in central Europe and Dublin
Investors should adopt an income-oriented approach to mitigate risks as the end of the cycle approaches. We recommend focusing on improving or creating income growth by seeking opportunities to actively manage, reposition and develop assets in strong locations. We expect offices in central Paris, high-street retail assets in Dublin and industrial property in Antwerp to be among the top performers by sector over the next five years.
Debt is likely to offer better risk-adjusted returns than equity as it will shield investors from the impact of expected capital declines. It should be stressed that while few markets now offer good value on a risk-adjusted basis, the relative pricing of real estate remains attractive in a historic context, with the risk premium still relatively high.
For longer-term investors, we recommend looking at thematic strategies that play against the current cycle. Focusing on structural drivers of demand, such as the continued growth of e-commerce (which will favour centrally-located logistics hubs) and ageing demographics (which will boost demand for retirement villages), should provide opportunities for patient investors over the coming years.
1 ‘Eurozone manufacturing gauge drops to 13-month low,’ Financial Times, May 2018
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at July 5, 2018. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this document, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment. In the UK & Europe this document has been prepared and issued by Aviva Investors Global Services Limited, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Telephone calls to Aviva Investors may be recorded for training or monitoring purposes. In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of any matters arising from, or in connection with, this document. Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration number200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27-13 South Tower, Singapore 048583.In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000
The name “Aviva Investors” as used in this presentation refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606