Brexit Papers: Real Assets - One small sliver of sunlight
Geopolitical shocks have increasingly come to overshadow the global economy and financial markets. In the month since the Brexit decision there has been more, such as the events in Nice, Turkey and Bavaria, and a range of further risks continue to threaten, such as EU integration, China growth, Middle East tensions, the US election, and rate increases. These vary in their significance to different geographies and asset classes, as illustrated by the relationship between these shocks and the VIX index over the past 25 years.
Figure 1 demonstrates the mild impact of Brexit on financial market volatility, certainly compared with the dislocations associated with the global financial crisis. Although, mild and many markets have recovered to levels higher than before the vote, the UK departure from the EU is a multi-year process so it is far too early to class it as a non-event. The full economic and financial market impacts will only manifest themselves in the future.
Although, the nature and severity of geopolitical shocks cannot be predicted, it is possible to see how they are likely to impact. Asset class implications depend on their relationship with GDP and inflation, the pricing of the specific asset class and the severity of the macro-economic impacts. Equities and fixed income tends to be inversely related to GDP and inflation shocks respectively. ‘Private’ asset classes provide some resilience to GDP and inflation shocks. This linkage can be used to explore the impact of specific shocks on the range of different asset classes.
It remains too early to assess the economic implications. Financial markets have recovered from the short-term shock but there remains uncertainty over the process by which UK might leave the EU, and the implications of this. If the Brexit process is benign, it should have mild impacts on the global economy, with more specific implications for UK and Europe. But even in this base case they are likely to reduce global growth and increase uncertainty over the next one to two years, and there are many downside scenarios that could be considered. A summary of the potential implications is shown in table 1, demonstrating how Brexit will have the greatest impact on the UK economy.
Given the macroeconomic consequences and the relationship between economic drivers and asset classes, it is possible to analyse the implications on asset classes in the UK, Europe and globally. These are summarised in table 2, that illustrates how Brexit is likely to have a relatively mild impact on global equities and bonds, but a more direct impact on those asset classes within the UK.
It is important to recognise that these ratings are based on the outlook for ‘existing portfolios’, not the outlook for new investments. Any correction in asset class pricing might generate attractive opportunities, in other words, good vintages for investment. Potential for counter-cyclical investing is certainly the case, but the table is designed to identify the likely implications of the shocks for existing assets within the classes. Investor appetite tends to be pro-cyclical and risk averse so in an environment of heightened uncertainty and lower returns, investors will focus on those asset classes that are most resilient rather than taking on risks to exploit the opportunities.
Across the markets, there are a number of conclusions, including the negative outlook for UK asset classes, and how private debt markets are expected to be relatively resilient post-Brexit.
Within the UK, weaker economic growth will dampen the cash flows and overall performance of growth-oriented private markets.
• UK real estate: Although the market has stabilised following the correction in REIT prices and redemption pressures among unlisted open-ended property funds, the performance outlook is weak, certainly for the rest of 2016-17.
The market was already slowing after the double-digit returns of recent years, with the IPF Consensus forecasts expecting returns to average 5% for the rest of the decade. Brexit will accentuate this slowdown, with values likely to turn negative over the coming 18 months.
On the one hand, there will be upward pressure on yields (despite the lowering of bond yields) and, on the other, there will be a slowing of rental growth, particularly in the more EU-dependent sectors such as London offices.
• UK private equity: Although private equity managers place emphasis on the ability to help their investments navigate difficult economic conditions, the asset class has strong connections to macroeconomic growth, as demonstrated by their performance through previous economic downturns.
• UK infrastructure: The performance of more growth-oriented infrastructure (such as airports and ports) is strongly influenced by broader economic activity. The weaker outlook for GDP is likely to affect cash flows from these more growth-oriented assets, while more regulated assets will tend to be more resilient.
• Private debt: If there is to be a clear asset class winner from the Brexit scenario, then it is private debt. This market, that exists across corporate, real estate and infrastructure asset classes, is benefiting from structural changes that have been exaggerated by Brexit:
• Banks have reduced their debt financing and redirected funds to more established borrowers, reducing bank finance for middle-market borrowers, and for asset classes such as real estate.
• The growing scale and capability of the private debt markets. Private debt only started to become an established European asset class, following the financial crisis after the retrenchment of bank lending. Since there has been a growth of platforms and capability.
• The ability of private debt to generate attractive risk-adjusted yields. This is the case for the asset-backed real estate and infrastructure asset classes (yielding Euribor plus 250-350bps, attractive to insurance companies and banks) and for senior corporate debt (5-8% yields, with the attraction of arrangement fees) both of which have low loan-to-value ratios providing a cushion to any decline in equity values.
The analysis is high level and illustrative of the relationship between economic shocks and asset class performance and preferences. It should be taken as a framework that can help investors understand the potential implications of a specific shock and the outlook for different asset classes. The relevance will vary according to the situation of individual asset owners, based on their investment objectives, current portfolio and view on the macro economic and financial market outlook.
Despite these caveats, it is possible to draw out some implications, and to identify specific sub-asset classes that might be most relevant in the current environment.
In a context of increased uncertainty, reduced scope for growth and a ‘lower for longer’ monetary policy, there is a heightened search for yield. This is the case across all asset classes, but it places private debt, in all its forms, as one of the potential winners from Brexit.
Peter Hobbs is managing director, Niels Bodenheim is a director, and Dharmy Rai is an associate, private markets at Bfinance