Economic uncertainty and shaky credit markets will remain key investor concerns for some time while demand for property in emerging markets will remain strong, as Fergus Hicks reports
Prior to August 2007, the outlook for the global economy was rosy. Some slowdown was expected following very strong growth in 2006, but activity was expected to remain firm. In its April 2007 World Economic Outlook the IMF forecast world growth of 4.9% for both 2007 and 2008, down slightly from 5.4% in 2006.
A year on and in the wake of the credit crisis, the world is a vastly different place. In its July 2008 World Economic Outlook Update, the IMF now expects global growth of just 4.1% in 2008 and slowing to 3.9% in 2009. This would put 2008 growth at the weakest since 2003, albeit still above the long run average and following a very strong 2004 -2007 period.
All the major economic blocs around the world are facing the same problem, though to varying degrees. Growth is slowing yet inflation is rising due to the globalised uplift in fuel, food and energy prices. US inflation hit 5.6% in July, the highest in 17 years; UK inflation is 4.4% and expected to rise; while Eurozone inflation is running at 4%, way above the European Central Bank's "below but close to 2%" target. India and China are also facing rapid price rises, with inflation running at 7.7% and 7.1% respectively. This backdrop is reminiscent of the stagflation of the late 1970s, though at this stage we are not expecting a rerun of these events.
The main difficulty for policymakers is how to respond to this unpleasant combination. The US Federal Reserve has slashed US interest rates in the wake of the credit crisis, choosing to insure itself against a very sharp downturn in the economy. Whether the policy easing has been overdone is up for debate and the US central bank is on standby to raise rates if it thinks inflation pressures are dominating slowing growth.
The European Central Bank has raised interest rates, invoking political murmuring and whispering disapproval; while the Bank of England has eased policy slightly since summer 2007, but is now grappling with high inflation and a housing market downturn.
The broad message is that 2008 and 2009 are going to be uncomfortable years for both the global economy and policymakers alike. Credit markets remain tight and no rapid return to the excesses of 2006/7 is likely. Prior to the credit crisis, ravenous demand for financial assets, including securitised debt, saw risk premia pushed down sharply.
Even when the US economy does improve, it will not necessarily be to the benefit of US consumers who have debts to repay following their spending binge over recent years. Instead, US growth will need to be export led as countries such as China and those in the Middle East begin to spend some of the vast foreign exchange reserves they have accumulated over recent years. With $1.5trn (€1trn) of foreign exchange reserves, the Chinese government is effectively holding around $1,000 on behalf of each of its citizens which could potentially be spent on US exports.
What does all this mean for property markets? For the economies of Europe and the US, the slowdown is cooling occupier demand for offices, distribution facilities and retail premises alike. This is resulting in weaker rental growth and rental declines in some centres, as has been the case in previous downturns. By contrast, occupier demand and rental growth is likely to hold up much better in emerging economies such as China, India and Brazil.
There are some markets in China and India where increased supply will hold back rents, but overall economic growth in these countries is expected to remain firm and easily outpace the US and Europe. The main challenge for the authorities will be controlling inflation, particularly in the Middle East and Asia where currencies are pegged to the dollar.
On the investor side of the market, risk premia on all asset classes have increased sharply since the credit crisis hit in 2007. Commercial property yields have risen in line and investors have been uncertain what fair value for commercial real estate is.
There has been a mismatch of price expectations between buyers and sellers and yields are adjusting accordingly. A sharp decline in commercial real estate transaction volumes has occurred as this process takes place, with trading volumes also pared back by much tighter availability of debt, which has hit leveraged deals.
Interest from Middle Eastern investors in commercial real estate is likely to be boosted by the surge in oil revenues the region has enjoyed over the past year. The impact of sovereign wealth funds and their investment activities will also be important for commercial property as an asset class going forward.
Greater interest by these entities in property as part of their portfolios could boost investment in the sector significantly. For example, if the China Investment Corporation were to diversify some of its vast holdings of US treasury bonds into commercial real estate the effect could be massive.
The key uncertainty, though, is how long and sharp the downturn in the global economy will be and when credit markets will recover.
On the basis of the latest IMF projections outlined above, growth is not expected to pick up until the second half of 2009 and early 2010. As such, business demand for commercial premises in the US and Europe is likely to remain subdued until mid-2009 at the earliest, while property demand in the emerging economies is likely to hold up much better in line with firmer growth.
At the same time, credit markets remain shaky and vulnerable to bad news. In July, investors sought reassurance from the US government over its implicit backing of Fannie Mae and Freddie Mac, the two financial giants which account for nearly half of the $12 trn US mortgage market. We can but hope that credit markets will also gradually improve through 2009 and that transactional activity in the commercial real estate market will recover as investors become more certain over pricing.
Fergus Hicks is head of forecasting and economics - EMEA, Jones Lang LaSalle