A recent visit to Shakespeare’s King Lear provided me with a timely opportunity to review the unpredictable nature of markets when confronted with political uncertainty.
- Growing political risk has led to defensive equity and real estate positioning
- Real estate holds up amid investor worries
- Positive fundamentals include low interest rates, solid demand and limited supply pressures
- Real estate should deliver high single-digit returns over the next 12 months
Circumstantially, a play written at the start of the 17th century, might not be the most promising place to look for explanations of current developments in global real estate and capital markets. Lear’s self-indulgence causes his moral and political authority to collapse, which unleashes chaos and incivility across his kingdom.
Over the last nine months, markets have seen politicians from Washington to Hong Kong via (Brexit) Britain and Berlin continue to challenge conventional wisdoms, undermining established certainties. This has left many investors second-guessing whimsical politicians, while confronted by cracks in traditionally accepted global institutions and relationships.
Looking at the second half of 2019, some of the optimism that returned to markets in January and February has started to give way to angst. Trade is top of investors’ minds, with the hopes pinned on central banks amid expectations they will intervene to support a slowing global economy.
At the same time, the threat of tax cuts and stepped-up regulation from authorities’ increasingly sensitive to populist sentiment has started to undermine confidence in some traditional sectors and markets. This backdrop of growing political risk at the global, national and local level, has led equity and real estate investors to position themselves more defensively as they expect short-term and long-term interest rates to fall and as they worry about recession in developed economies.
Exhibit 1: Economic policy uncertainty*
*The global policy uncertainty index quantifies media coverage of policy-related economic uncertainty, tax provisions set to expire and disagreement among economic forecasters.
Source: Bloomberg, 31 May 2019
“When we are born, we cry that we are come to this great stage of fools.”
At the start of 2019, there was a sense of trepidation among equity investors as trade worries and tightening financial conditions raised concerns that global economies were heading for recession. Nevertheless, global real estate has done well so far this year: markets in North America have been at the forefront of the rally, while only markets in the eurozone have disappointed.
The most notable performance was seen in the first quarter when real estate was one of the most prominent outperformers globally. In the US, REITs were particularly strong. Industrial and residential property sectors stood out, while the hotel and mall sectors lagged meaningfully. The higher prices enjoyed by a number of US and global REITs have led to companies taking advantage of the favourable cost of capital to raise equity and buy properties to expand their portfolios with a view to growing earnings.
Clearly, the Q2 earnings reports will be important as companies give their mid-year updates. In the REIT sector, companies have been largely optimistic on 2019, but in the broader equity market, the analyst community has been increasingly wary that companies disappoint. And noises from politicians, regulators and policymakers could substantially affect the sector’s fortunes in the coming 12 months.
Exhibit 2: Global financial conditions and global listed real estate
FTSE EPRA Nareit Global index, in euro; source: Bloomberg, 30 June 2019. The value of your investments may fluctuate. Past performance is no guarantee for future returns.
“Nothing will come of nothing”
In the play, Lear laments the lack of action (“nothing”) from his younger daughter and similarly, there is a risk that without decisive moves by political leaders as well as central banks, the threats to the global economy will continue to mount. The recent strong recovery has brought an element of calm, but political discord and policy uncertainty were never far off, creating an imposing wall of worry for real estate investors at the mid-point of the year.
- a growing list of trade disputes confronts the global economy
- there’s a rising risk of conflict in the Middle East
- the threat of regulation has spiked sharply in Europe and the US
- politicians across developed markets have a growing appetite for higher taxes on commercial and residential property.
However, the fundamentals for listed real estate remain supportive:
- interest rates are low
- demand for prime property is solid in most major markets
- supply pressures are limited
- investment and occupier demand are still at impressive levels
- capital values are forecast to rise by up to 3% in 2019 (source: Jones Lang LaSalle).
Ordinarily, listed real estate should benefit from lower bond yields, with companies with strong cash flow growth, balance sheet strength and stable and disciplined management best placed to prosper from renewed investor interest.
We expect real estate to deliver high single-digit returns over the next 12 months given these supportive fundamentals and low interest rates. Global financial conditions have loosened since the start of 2019 and should continue to do so in H2.
The risks of disruption from trade conflicts is clearly important and a further escalation could hurt equity markets across the world. Likewise, there is political risk in Europe. The UK’s unresolved position in the EU is among the region’s most pressing challenges. A no-deal Brexit looks more likely than markets are currently pricing in. It would damage the whole of Europe and not just the UK. Finally, markets face the threat of increased property regulation in both Europe and North America, which could be detrimental, particularly for apartment landlords.
At the end of King Lear, as tragedy unfolds and disorder threatens the kingdom, the king returns and despairingly attempts to restore order and authority. As markets brace for another tumultuous period of political intrigue and policy reaction, investors will be anxious for a more cathartic resolution to some of these challenges and certainly not the chaos that engulfed the misguided Lear.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.