Think European cities Q4 2019 outlook
Economic momentum in Europe receded in Q2 with the growth rate in the eurozone halving to 0.2% and the United Kingdom slipping into contraction. In both cases the Q2 number was in part a correction from an overly strong Q1, but the chances of an early recovery in the eurozone in Q3 are slim. Consumers across the continent are continuing to spend but manufacturing is in a weak state, notably in Germany which is mired in recession. Whilst domestic demand is holding up well, it is not posting enough growth to overcome the headwinds from the external sector. In the United Kingdom a bounce-back in Q3 is likely, but year-on-year growth rates will remain subdued.
The weakening growth picture has coincided with moderating inflation across Europe to well below target in the eurozone and around target in the United Kingdom. The combination of softer growth, a strong exchange rate and a lack of wage pressures is set to keep inflation at very low levels into 2020. The United Kingdom is on a slightly different path with inflation moderating less, wage inflation rising and the weak exchange rate generating some upward pressure on import prices.
Falling growth and inflation have pushed the European central bank (ECB) towards a more accommodative path than we saw in the spring, abandoning its earlier stated aim to normalise interest rates. There is effectively no chance of a rate increase in 2019. Hence government bond yields have dropped to below 1%, turning negative in several countries. The changing of seats at the top of the ECB is not expected to have any significant impact on monetary policy with Lagarde already aligned with outgoing ECB President Draghi. However, Draghi faces one final battle before his term ends as he attempts to bring the rest of the ECB governing council into line behind a new stimulus package.
In the United Kingdom the Bank of England (BoE) is sticking to its policy line that tightening supply constraints point to further increases in base rate, although the negative risk from Brexit is undermining the credibility of this approach. Markets expect a cut in the event off a no-deal Brexit and stability if a deal is agreed. Benchmark gilt yields are currently around 0.5%. We expect bond yields to stay at this super-low level for longer, potentially underpinning lower real estate yields.
Office sector overview
- Job growth has been accelerating in recent years and this has translated into improved leasing activity in most cities.
- Cities that have outperformed on rents since the end of 2016 include the lifestyle cities and southern European centres with potential for catch-up.
- French centres, Frankfurt, Cologne, Lisbon and Dublin might have expected stronger rental growth, given the strength of occupier demand.
- Service sector job growth began to decelerate across most countries in 2018. With a worsening global backdrop in 2019, we need to be wary of emerging risks to leasing fundamentals.
Retail sector overview
- The consumer market remains healthy across the EU.
- In-store sales are suffering as online sales drive growth and increase market share.
- Nuveen Real Estate's risk index of retail disruption points to high risk of stress in the retail systems of Netherlands, Denmark and Poland as well as the United Kingdom.
- Not all markets are high risk, though and our risk index points to Portugal, France and Italy as markets where the growth of online sales will have the least damage on the retail system.
- Yield deterioration should be moderated in markets with a low risk of retail disruption, but we expect further value-loss across the retail sector.
Logistics sector overview
- Trade disputes and economic weakening has cast a shadow over the demand side, but currently the structural demand factors outstrip cyclical issues.
- Rental growth has picked up, although continues to remain more modest than widely assumed.
- Fierce competition between developers keeps initial rents for new buildings low, despite open-market rents rising.
- The small segment on last-mile logistics is seeing much more pronounced rental growth than big box retail, which is the vast majority of the market.
Housing sector overview
- Lower interest rates reinforces the pivot towards sectors benefiting from strong structural tailwinds.
- In all its guises, the housing sector appeals to investors who are attracted by past performance and projected resilience.
- Challenges include achieving scale and operator efficiencies.
- Pricing reflects that European markets are at different levels of sophistication and maturity.
- There is an undersupply of purpose-built build-to-rent, student housing and healthcare assets across Europe.
- Pricing is keen but value-add returns are achievable through forward funding and build-to-core strategies.
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