Quarterly Economic Review - August 2010

 

6 September 2010
Source : QIB UK

Welcome to our August 2010 Quarterly Economic Review, our first as QIB (UK) plc following our recent name change from European Finance House. I am delighted that our bank has been integrated even more closely into the QIB group of companies.

We provide in this Quarterly Economic Review an overview of the condition of the main geographic areas and asset classes around the globe.

This includes a summary of the markets in interest rates, commodities and currencies, and an analysis of conventional and Islamic equities and credit markets. We also set out a detailed review of the Real Estate market in both the UK and Europe.

We hope that you will find this review of interest and will en-joy its content.

Michael Clark
Chief Executive Officer
QIB (UK) plc
mclark@qib-uk.com

Economic Review

Global Overview

Housing market worries, political tensions and weak consumer spending have all brought the global re-covery into doubt this quarter with many analysts fearing a double dip. High unemployment in both the US and Euro-zone has posed one of the biggest risks to the recovery throughout the developed world, with a figure hovering near 10% putting increased pressure on consumers who were already facing likely tax hikes.

This quarter has seen markets dominated by the European debt crisis and countries across the EU un-veiled huge budget deficits which caused currencies and stock prices to plummet. Greece caused the most fiscal concern and was the first to announce its spiralling debt levels. Its fragile economy rocked markets by unveiling a huge budget deficit which subsequently saw the single currency begin to suffer over worries that Greece's financial troubles would cause a European or even global contagion. The fiscal troubles of Greece, Spain, Italy and Portugal collectively caused a substantial decline in the single currency and saw a surge in bond markets as investors sought safety in the current times of uncertainty.

The global economy suffered as international banks became very wary over potential European expo-sure – a clear sign and example of the global contagion. The prospect of an anticipated slowdown in growth along with low inflation meant that central banks had to keep their rates at near zero levels although some countries including Sweden and New Zealand have begun raising rates.

However many major countries did exit recession in the first half of the year and economists now expect a continuation of global growth though at a relatively slower and more uncertain pace. The growth fore-cast for the global economy is low but looking further ahead into 2011, economists remain positive, ex-pecting GDP to increase by 4.2% this year and 4.0% in 2011. The IMF is more optimistic, forecasting growth to be around 4.6% in 2010 and 4.3% in 2011.

UK

The markets remained cautious over the UK economy this quarter. The most significant event was the formation of the Conservative-Liberal Democrat government, the first coalition government in the UK for over 50 years. The UK also unveiled a budget deficit which the new coalition government has acted swiftly to start to tackle. The current deficit is running at around 11% of GDP with the total deficit amount expected to hit £160 billion by the end of 2011. The country emerged from its worst recession since the Second World War in the first quarter but the economy still faced a number of hurdles. Spending cuts to the amount of £6.234 billion were announced and pledged in several areas in an attempt to reduce the UK's high level of debt. The cuts were designed to balance the UK's books by 2015, by cutting spend-ing, raising sales tax and introducing a levy on banks. Cuts are also due to be made in the civil service sector with recruitment in the public sector to be frozen.

The UK has steadily been returning to growth with the last quarter experiencing an increase in GDP of 1.1%, twice as much as initially forecast. The number rose by 1.6% on the year which is the largest in-crease for nearly 2 years but investors remained worried about the economy as the UK is expected to struggle in the second half of the year with many business surveys pointing out to an inevitable marked slowdown. Interest rates were kept at a record low of 0.5% with the big question remaining of when the BoE will decide to raise rates. The economy has struggled with inflation this quarter which was consis-tently around 1% above the government's target adding further to investor concerns.

Euro Zone

It has been a difficult quarter for the Euro-zone economy. Governments unveiling huge budget deficits and high unemployment had investors losing appetite in both Euro stocks and the single currency, with the majority shifting investments into lower risk securities and the relatively safe haven of the dollar. There was a massive Euro sell-off in mid-June, on a scale which had not been seen since September 2001. Bond prices increased as investors became increasingly concerned about the risk of contagion in Europe and moved into German bonds which experienced record high prices with record low yields.

The second half of the quarter still saw markets edgy with mixed signals coming from the world's lead-ers. The financial troubles of Greece had dominated the news as the country continued to struggle with high unemployment, and huge levels of debt. The EU and the IMF put together a $1 trillion rescue pack-age to prevent the Greek debt crisis from going out of control and harming the Euro. Many in the EU have had to take drastic measures to tackle their huge deficit with Italy following suit by unveiling EUR 24 billion worth of cuts. The Italian government said that these measures were more of a 'pre-emptive strike' in the event of any potential domestic fiscal strains.

The Spanish have also had to take drastic measures in bailing out some smaller, local banks. The IMF placed a huge pressure on the Spanish government to keep an eye on its economy stressing that ?the Spanish economy needs comprehensive and far reaching reform?. Germany launched its biggest programme of fiscal cutbacks since the Second World War. The German government has said they would stick to its austerity programme and dismissed criticism that Germany is not doing enough on economic stimulus measures. Germany currently spends about 2.1% of its GDP to reinforce economic growth and is seen as stable compared to other Euro-zone countries. The fear still remains that countries in the south of the Euro-zone could fall back into recession this year as austerity measures kick in.

US

The US economy grew again this quarter extending three quarters of steady growth but there are fears that the US recovery is now beginning to slow down with some predicting a risk of a double dip reces-sion. Sales of previously owned U.S. homes hit a 3-month low in June and new claims for jobless bene-fits rose by 2,000 to 464,000, consumer spending had also been relatively poor. The disappointing data has prompted some analysts to push back forecasts for Fed rate hikes and has led to a pickup in US Treasuries rendering consumers' attraction in the safe haven of Government bonds. There has also been tension with China - the world's largest exporter and the largest consumer of oil. The US has been pushing China to allow their currency to appreciate to help the bilateral trade deficit. At the moment the low valued Yuan is giving Chinese manufacturers an advantage. The US has said they hope the currency will appreciate naturally over a course of time.

The FED does not foresee a risk of a double dip recession and has reassured the market that they will take further steps if the economic situation worsens. Even though rates are effectively at zero, the Fed has reassured the market that there is still more they can do. The key challenge for the US in the next quarter will be to develop a convincing strategy to put its budget on a steady path without endangering the recovery.

GCC

The GCC has shown further signs of recovery this quarter with a marked increase in commodity prices and government spending. The improvement prompted the IMF to recommend the GCC states to focus on strengthening its financial industry to help foster continued growth. Issues still remain as certain insti-tutions have continued to lend more than deposits received. Others continued to struggle to cover loan losses in the flat market made difficult by the global credit squeeze. There was also a continued reduc-tion in Foreign Direct Investment (FDI), which has fallen steadily over the last two years mostly due to a lack of transparency and the absence of key market indexes.

Dubai remained a concern this quarter for investors as the property market showed weak fundamentals as well as sluggish growth according to Fitch Analysts. Markets are demanding higher risk premiums matched by an increase in Credit Default Swaps, further deteriorating the property market's ability to gain credit.

Qatar on the other hand has continued to make progress, leading the way in becoming Europe's number one property investor and the world's largest Liquefied Natural Gas exporter. The IMF expects Qatar to be one of the fastest growing economies in 2010, backed by a budget surplus of 40.2% and an unem-ployment rate of 0.5%. Analysts forecast that Qatar may reach growth rates as high as 14.5% of real GDP by the end of the year. The growth rate for all other GCC states was on average 4% and is expected to rise. The figure was severely affected by the declining confidence in the last quarter from the increase in uncertainty over both domestic and international financial markets. Global risks remained as the price of oil and gas is linked to demand from rich developed countries, which is expected to fall by 0.5% due to the expected weak growth in Europe and US. Nonetheless as a result of recent efforts to diversify the GCC econo-mies away from hydrocarbons the market expects that the GCC economies will achieve 4.3% from non-oil growth.

Asia

Navigating its way through turbulent markets in the West, growth in Asia has rebounded impressively this quarter with output returning to the pre-crisis levels of early 2008. Whilst Europe and the US suffer from sluggish growth, high unemployment and over leveraged Governments, investors have seized op-portunities in Asia reiterating how uneven the global economy has become. Countries including Korea, Taiwan, Malaysia and India have raised interest rates this quarter, an indication of the Asian recovery. This quarter has also seen China surpass Japan as the world's second largest economy with growth of 10.3%, indicating its increasingly dominant role in the world's economy.

Traditionally Asia's growth depended on exports to advanced economies, but the region had demon-strated that it has the regional demand to drive its own economic growth when backed with strong FDI. Exports on average have recovered through regional trade and there is strong evidence to suggest that Asia can now decouple from the West, as a self-sufficient engine to drive global growth.

Asian markets do still remain vulnerable to the risk appetite of foreign investors, when global markets stabilise; money can quickly find its way out as quickly as it came in. Market risk continues as the mo-mentum experienced over the last two quarters could slow with central banks and governments poten-tially tightening fiscal budgets to offset the threat of inflation. Also a large part of growth this quarter came from the production of inventory which could be an indication of short-lived confidence.

Overall the outlook remains favourable for the region; the Asian central banks have had a tough task in sustaining current growth rates with the weakening in demand for exports from western economies. The region is expected to be a key driver for global growth over the next year.

Interest Rates

(Source: Reuters)

(Source: Reuters)

(Source: Reuters)

Currency Markets

(Source: Reuters)

This quarter has seen Sterling recovering from recent losses made against the dol-lar. The pair hit a 5 month high in July buoyed by encouraging UK data, the most important of which was that the British economy grew twice as fast as expected in the last quarter. The dollar on the other hand has suffered badly with recent troubles in the housing market and rising unemployment, indicating a slowdown in the US economy. Cable ended the quarter at $1.5682.

(Source: Reuters)

Sterling has made steady gains against the Euro this quarter. The fear of contagion in Europe and the huge deficits of Spain, Greece and Portugal have not helped the single currency against most major currencies. The UK, although with a deficit of 11% of GDP is seen to be handling its deficit better than its European counterparts. The spending cuts announced by the UK government in May along with recent good data has helped Sterling achieve gains. Trading at the end of the quarter closed at EUR 0.8312.

(Source: Reuters)

The Yen has been bullish against the USD, gaining around 8% over the last 3 months. Recent US economic data has indicated a fragile US economy and investors have moved into currencies backed by stronger fundamentals such as the Yen. In addition the Yen has been driven upwards by its close connections with emerging Asian economies that have capitalised on strong consumer demand to outpace the growth of advanced economies. Trading at the end of the quarter closed at Yen 86.45.

(Source: Reuters)

The Swiss franc has rebounded strongly against the USD due to strong fundamental data. UBS and Credit Suisse the country's largest Banks announced higher than expected quarterly profits, indicating that the country's primary industry (finance) is gathering steam. The uncertainty towards the US recovery has made investors risk averse, favouring the stability of the CHF. Trading at the end of the quarter closed at CHF 1.0413.

(Source: Reuters)

The Euro suffered heavy losses at the beginning of the second quarter falling from $1.3400 to a low of $1.1878 in June due. This was due, in most part, to the Greek crisis and fear of contagion amongst other global markets. Recent poor data from the US had since led the Euro to recover some of the losses it had made. Trading at the end of the quarter closed at $1.2915.

Commodity Markets

(Source: Reuters)

The price of oil has fallen by over 10% in the last quarter due to mixed signals from the global markets. China continues to increase its consumption along with other emerging and newly industrialised nations. However the demand from advanced economies is expected to be sluggish especially from the US, the world's second largest consumer of oil. Oil demand has seen growth on one side of the world and a slow response from the other which has led to unpredictable and choppy market conditions. Like many global economies the oil market is expected to improve albeit at a slower pace. Trading at the end of the quarter closed at $78.95.

(Source: Reuters)

The price of Silver has dropped slightly this quarter from $18.77 to $17.96 but the concern over the strength of the dollar has generally seen investors selling dollars and buying commodities with a noticeable increase in price relative to the beginning of the year. Silver demand is generally quite low however with the current global volatility less known commodities are becoming popular. Trading at the end of the quarter closed at $17.96.

(Source: Reuters)

Whilst market volatility has eased this quarter (relative to 2008), gold price volatility continues. Most economies have now exited recession and the IMF forecasts slow but stable global growth. This has led to an increase in appetite for risk by investors, with many moving out of gold and back into the financial markets. There is still a threat of inflation and deteriorating Government deficits but Gold has continued to have an appeal this quarter as it is seen as a safehaven and an alternative currency for volatile markets. The price of gold in the longer-term is forecasted to hold with slight gains to be expected over the second half the year. Trading at the end of the quarter closed at $1180.40.

Credit and Equity Markets

The capital markets have been very volatile over the last three months. There were sharp falls in May-June, followed by a rebound in July. For instance, MSCI World fell by 13.12% over May and June 2010 and rose by 8.02% in July, paring some of the May-June loss. GCC markets dropped in line with the global trend in the May-June period, as MSCI GCC index was down by 13.06%. That said, stock market recovery in the GCC was weaker than that at the global level, as MSCI GCC index was up by only 4.14% in July. The German equity index DAX dropped by only 2.77% over May-June and bounced back by 3.06% in July. Islamic equity markets also fluctuated considerably over the last three months. DJIM and DJIM EM fell by 12.58% and 9.22%, respectively, in May-June and bounced back by 6.68% and 6.51%, respectively, in July.

Over the May-June period, most equity markets were severely affected by concerns regarding the negative impact on the economic growth of the European sovereign solvency crisis. On the positive side, concerns about solvency of European sovereigns caused a drop in the tradeweighted EUR exchange rate, which benefited German exporters. This is why DAX was less affected by sovereign solvency concerns than most of the other developed market stock indices.

The market sentiment improved markedly in July, in a token of approval of the austerity measures announced by European governments. In theory, fiscal tightening should slow down economic growth, all else equal. However, the announced austerity measures were necessary to avert sovereign defaults. The impact that European sovereign defaults would have on economic growth would likely be much more severe than a slowdown that may be caused by the announced fiscal tightening. Therefore, it is not surprising that the markets reacted in a positive fashion to the recently announced fiscal austerity measures across Europe.

Whilst the EUR and the GBP corporate credit markets were negatively affected by concerns about European sovereign solvency, the USD corporate credits benefited from the safehaven status of the USD. For instance, iBoxx USD corporate Index rose by 1.65% in May-June whereas iBoxx EUR index fell by 0.33% and iBoxx GBP corporate index rose by only 0.10% over the period. That said, all the three markets rose at a large clip in July. Islamic credit space sold off in May-June on the back of the increase in risk aversion, as HSBC Sukuk index fell by 0.55% over the period. However, this index posted a 2.56% increase in July, as the market risk appetite increased.

(Source: Bloomberg)

Credit and Equity Markets

(Source: Bloomberg)

(Source: Bloomberg)

(Source: Bloomberg)

(Source: Bloomberg)

Real Estate Market Update

The Story to Date - A "V-shaped" Recovery or a "U-Shaped" One?

The UK commercial Real Estate markets experienced a bull run from 2003 until 2007, fuelled by low interest rates, significant capital inflows and the ready availability of traditional and engineered financing products. The overheated market rapidly corrected in late 2007, following the collapse of Northern Rock and subsequent international bank failures, massive falls in investor confidence and the withdrawal of bank finance.

Q1 2009 marked the low point in the Prime UK Real Estate market, ending the 44% peaktotrough correction in commercial Real Estate Values that had commenced in Summer 2007. During the following two Quarters, UK domestic funds experienced a substantial inflow of monies, which prompted new Real Estate investment by institutions who had been net sellers during the previous two years. At the same time, a limited number of overseas investors undertook a small number of large, high profile investments. As a consequence, from Q3 2009 to Q2 2010, the Prime UK Real Estate markets exhibited a sharp, V-shaped recovery, accentuated by the relatively small number of available investment opportunities: Prime assets experienced 6.0% capital growth in Q4 2009 and 4.0% in Q1 2010 alone. The recent cycle is illustrated by IPD in Figure 1 below.

(Source: Reuters)

A broad range of corporate and professional commentators have suggested that since Q2 2010, this highly volatile V-shaped recovery has begun to moderate into a U-shaped one:

• Great Portland Estates plc (owners of c.£1.3bn of Central London assets) announced that it expects the market mood to become less urgent with rental growth in Central London property but little capital value appreciation.
• Helical Bar plc (one of the UK's most experienced development and investment companies) described further evidence to support our view that the previous strong recovery in property values is stalling.
• CBRE announced that its industry-wide monthly Index recorded a total 1.1% and capital growth of 0.6% in June and that after 11 successive months of yield compression, this was the first month where average yields had remained unchanged over the month - remaining at 6.9%.
• The Royal Institute of Chartered Surveyors recently advised that 7% more of its members re-ported a decline rather than an increase in nationwide tenant demand during Q2 2010, down from a positive 6% in Q1 2010.

U-shaped recoveries are less remunerative in the very short-term, than V-shaped ones. They are, how-ever, far less volatile, because they are less likely to prompt development bubbles and excessive gear-ing, in the hope of rapid short term capital appreciation. The above transformation should therefore be viewed positively.

The Winners and Losers in the U-Shaped Recovery

As described above, the rapid recent recovery in "All Property" rental and capital growth rates has recently begun to stabilise (see Figure 2).

(Source: CB Richard Ellis)

It is however critical to note that "All Property" statistics mask how the nature and extent of the recent recovery has varied, across different Real Estate sectors and locations:

• CBRE reported that in June 2010, Central London offices produced the strongest per-formance of any sector and location (see Figure 3). A more detailed analysis of the Q2 2010 Central London (City and West End) office markets follows below.
• On the basis of rental performance alone, the importance of location becomes even more self-evident (see Figure 4), with only London offices showing positive rental growth over Q1 and Q2 2010.
• On a sectoral basis, the Retail sector re-mains the worst performing of all UK Real Estate sectors from a rental growth perspective. This sector best reflects core economic trends, given that retail businesses are immediately affected by changing personal consumption and employment patterns. It is not therefore surprising that Retail Real Estate is forecast to be severely impacted by reduced government spending and higher personal tax rates, for some significant time to come.

Generally speaking, given that such substantial yield compression has already occurred since the nadir of the 2007/8 Real Estate correction, rental growth is deemed to be the key to the future shape of the commercial Real Estate recovery. With regards to investor appetite for Real Estate in general, it is worth noting that £8bn of UK commercial Real Estate was transacted during Q2 2010, compared with £5.9bn during Q1 2010 - the highest figure since Q4 2009 (see Figure 5). A significant reduction in the level of transactions during Q3 2010 is however being reported, largely in response to a reduction in available stock - although a recent cooling in investor demand has also had an effect.

West End Offices

The West End office markets began to rapidly upturn during Q3 and Q4 2009 but their recovery is now showing clear signs of transforming from a V to a U-shape:

• After exceptional performance during the last two Quarters, take-up in Q2 2010 was 1.1m sf, down 16% on the previous quarter, supported by 2.1m of active demand for space, 42% above the same quarter last year (see Figure 6).
• Vacancy rates now stand at 8.6% (8.7% in Q1 2010), with availability falling to 7.8m sf. Prime headline rents have risen for the second time this year to £82.50 psf, although average rent-free periods remain at 21 months on 10 year term-certain leases.
• Prime core West End yields currently stand at 4.25%, following a 75 basis point hardening over Q1 and Q2 2010.

This occupier-led upturn is expected to continue, albeit at a steadier pace, with restricted levels of new and refurbished space likely to extend into the foreseeable future, due to lack of development starts during 2008 and 2009. The vol-ume of space under construction fell further to just under 800,000sf – c.50% of the long-term average – during Q2 2010.

Q2 2010 saw the highest level of investment transactions in the West End since Q3 2007, at £1.7bn, however, 60% of this figure related to just three transactions and £580m was accounted for by the sale of the Knightsbridge Estate to the Olayan Group from the Kingdom of Saudi Arabia.

City of London Offices

The City Office market is showing similar signs of an occupier-led transition to a U-Shape recovery:

• Available space reduced marginally during Q2 2010 to 10.5m sf, following a sharp fall during Q1 2010 (see Figure 7).

• Prime City rents increased 13.5% (year-to-date) during Q2 2010 to £50.00 psf.
• Prime City Office investment yields reduced a further 25 basis points to 5.25% during Q2 2010.

Vacant space in the City experienced a sharp fall of 1.6m sf during Q1. During Q2, a much smaller fall was experienced, partly because the uptake in newly constructed space was offset by an increase in second-hand space - for instance, 55,000 sf was placed on the market at Moor House, ahead of Macquarie Bank's relocation to Ropemaker Place. The amount of speculative space under construction continues to dwindle, currently standing at 2.4m sf (less than one year's worth of the long-term average take-up for new and refurbished space).

Prime London Residential

Prime London residential Real Estate is now a market apart, in comparison to the national residential market: It is well insulated from the consequences of the recent nationwide recessionary collapse in the demand for houses, by the unique characteristics of Prime London Residential purchasers:

• The proportion of un-mortgaged owners in central London is 59% compared to 41% for the UK. Central London is therefore dominated by discretionary owners, who can sell when they choose to, meaning that supply can in fact fall with prices.
• As a consequence of a c.30% devaluation in Sterling over the recent period, overseas buyers have continued their return to the market: Between December 2008 and March 2009, interna-tional buyers' share of the £5m+ London market increased from 39% to 48%. By June this year it had hit 68%. The recent traumas experienced by various Euro-zone economies may however have begun to test this trend.

The only potential challenge to London's pre-eminence as a target destination for the world's super-wealthy, may come from Switzerland: Switzerland's currency is viewed as a safe-haven from the risk of Southern European Euro-zone contagion, its supply of £15m+ homes is more liquid and the Swiss edu-cational system is deemed to offer the only true alternative to England, especially for the children of the increasingly important class of Eastern European super-wealthy.

Knight Frank report that the London sales market has in fact slowed since April and that while buyer vol-umes are only down marginally from their peak, agents are reporting that buyers are more reticent to commit to purchases than they were prior to the recent General Election. As a consequence, price-rises have been sustained by the recent marked decline in supply, rather demand (see Figure 8).

Contact Us

Michael Clark Chief Executive Officer	mclark@qib-uk.com T: +44 (0) 207 268 7272
Azhar Khan Chief Financial Officer	akhan@qib-uk.com T: +44 (0) 207 268 7250
Anouar Adham Head of Asset Management	aadham@qib-uk.com T: +44 (0) 207 268 7256
Akbar Ahsan Head of Corporate Finance	aahsan@qib-uk.com T: + 44 (0) 207 268 7231
Andrew Fursman Head of Real Estate	afursman@qib-uk.com T: +44 (0) 207 268 7280
Yasser Gado Head of Treasury	ygado@qib-uk.com T: +44(0) 207 268 7290
Aleksandar Devic Fund Manager	adevic@qib-uk.com T: +44 (0) 207 268 7251
QIB (UK) plc 4th Floor, Berkeley Square House Berkeley Square London W1J 6BX	T: +44(0) 207 268 7200 F: +44 (0) 207 268 7201

www.qib-uk.com

Disclaimer:

This document has been prepared by QIB (UK) plc for information purposes only and is not intended to be used as the basis for any investment decisions. Nothing contained herein shall in any way constitute any offer by QIB (UK) plc to provide any services or products or an offer or solution of an offer to buy or sell an investment. The information contained in this report has been compiled by QIB (UK) plc from sources believed to be reliable but no representation or warranty, express or implied, is made by QIB (UK) plc, its affiliates or any other person as to its accuracy, completeness or correctness.

The content relating to the past performance of an investment is not necessarily a guide to its performance in the future. All opinions and estimates contained in this report constitute QIB (UK) plc's judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility.

QIB (UK) plc – Address and Registered Office: 4th Floor Berkeley Square House, Berkeley Square, London, W1J 6BX. Registered in England and Wales No. 4656003. This document is confidential, and no part of it may be reproduced, distributed or transmitted without prior written permission. QIB (UK) plc is authorised and regulated by the UK Financial Services Authority.