While global economics is a cauldron of indecision and questionable political leadership, having to make investment decisions in this environment is hard.  But that is what we are paid to do and if you can’t stand the heat ……

UK 10 year gilt yields have steadily reduced during the first half of 2018 and now stand at just under 1.30%.  US 10 year Treasury yields have also fallen but to a lesser degree and now stand at c2.80%.  US growth has slowed and the difference between the 10 year yield and the 2 year yield has almost evaporated suggesting that the economy may be about to turn to recession.  Our view is that the USA is indeed slowing but whether an actual recession will result is a moot point.  At the same, time trade wars have upped their ante and there is some anxiety as to how the end result will be played.

In the UK, Theresa May’s Government has at last come to agreement that a managed “softish” Brexit, is the way forward.  Or is it?  Within 48 hours of the so called Cabinet agreement, David Davis, Boris Johnson and junior ministers had already resigned and we expect more.

At the time of writing, while the Governments white paper is as yet unpublished, we believe that Brexit is heading towards a harder one.  Frankly Theresa May, what is left of the cabinet, or any one of us for that matter, can come up with any number of wish lists for exiting the European Union, but she (Mrs May) still has to get it past every one of the 27 other members, a group who have stated several times, that no cherry picking of the four fundamental principles (free movement of people, capital, goods and services) is allowed.  We imagine that dropping one of these would be fine for countries outside the EU but such a bespoke deal would come at a cost.

Throughout our investment management careers we have tried to follow the axiom that taking on risk, should reward shrewd investors.  With Brexit, the playing field is being disrupted itself and it’s a bit like playing Monopoly with a 6 year old, who has just landed on your Mayfair hotel and just flips the board up and says they’re not playing anymore.

So what if we are right and a hard Brexit persists?  This outcome, as we have stated above, is becoming increasingly likely.  We have revised our view and rather than being simply anti-Brexit, we believe that a worse situation would be the no-man’s land of a ‘hokey-cokey’ Brexit of being neither in nor out.  UK plc has some significant strengths most notably financial services including asset management, car manufacturing, the English language, a healthy IT sector, a robust legal and compliance framework for manufacturing and services along with a balance of payment deficit, all mean that countries need our cash for their goods.  Yes, stepping into a hard Brexit scenario may not be smooth or tidy but we think it is probable that new a trade deal would be carved out giving greater flexibility for trading in our goods and services in the future.  We do however remain of the view that dropping Brexit would be the best outcome and involve less disruption for business.

UK Property

Retail property continues to give investors the most angst.  The triple whammy of the public’s love of online shopping, the use of CVA’s by retailers to force landlords to reduce rents and the increasing burden of local rates persuades us that it will be a few years before news turns positive for the sector.  One interesting development however is the recently agreed purchase by M7 of a portfolio of retail warehouse assets.  At the same time an agent led fund manager has agreed to buy a shed for a record low yield.  Why should we highlight these two events?  Until now, M7 has focused on the industrial sector and kept away from retail assets.  M7 are reported to have said the purchase represents a significant yield premium over sheds and that the tenants are broadly the same, with the buildings themselves often being identical to sheds.  They suggest that down the line, a retail park may include a balance between retail warehouse units and standard warehouses.  This may well be the future.  It doesn’t however, do a great deal to address the troubles of the high street.

We are always wary of big changes to the market and the reversal of yield differential for sheds and shops is surprising, but probably not irrational.  At the end of the day, retail sales drive retail rents in addition to most warehouse rents.  The switch from the high street to out of town locations and then to online continues and is not likely to slow down soon and so M7’s acquisition is interesting.

Property Income Yields at June 2018

All Property Retail Offices Industrial
5.9% 6.0% 6.1% 5.6%

Source MSCI

Rental Growth

Our strategy of only buying property which have leases where the rent is contracted to grow has delivered a minimum rental growth rate of c2.0%p.a.  Add this onto an income return of c5% and a satisfactory total return is achieved.  Every so often we look at how this rate of rental compares with the market as shown in the table below.

Property Rental Growth at Market Level over various periods

  All Property Retail Offices Industrial
Last 12 months 1.9% 0.1% 1.6% 4.9%
Last 5 years 2.6% pa 0.4% pa 4.4% pa 3.8% pa
Last 10 years 0.0% pa -1.1% pa 0.8% pa 0.9% pa

Source MSCI

Note that over 10 years rents have been flat.  We don’t expect any change at the aggregate level looking forward.

So where now?

We have recently disposed of the office in Peterborough for a price in excess of valuation and will be seeking to re-deploy that capital into two separate investments, again in line with our declared income based strategy.  Peterborough was a large asset in terms of the overall portfolio and by splitting the proceeds into two properties, allows a further diversification of risk.  In these uncertain times with all that is happening in global politics and economics we are ‘sticking with the knitting’.

 As with most businesses, the arrival of the General Data Protection Regulations on 28 May 2018 required us to conduct a risk and privacy assessment across our processes, our data and security.  Much of the work involved seemed reminiscent of the preparation for the Millennium Bug back in 1999.  Industry wide there seemed to be a flurry of activity and emails warning of the requirement to comply.

Unlike the non-existent bug, GDPR does however provide a degree of comfort and assurance that processes have been and continue to be, reviewed in terms of privacy and security.  For us, this is an on-going and evolving process and while we are satisfied that the work undertaken allows us to be compliant, we continually review our business wide and data management, risk assessments.