The market tends to follow earnings, and consensus S&P estimates point to accelerating earnings growth of nearly 25% in 2018. These estimates have moved a meaningful 7% higher since December 31 due to the benefits of tax reform and better than expected corporate outlooks. Further, S&P 500 earnings, which are stair-stepping higher in 2018, are projected to grow again in 2019 as seen in the graph below:
With the market currently down for the year and the synchronized global economic upswing continuing into 2018, valuation has become more attractive than it was at the end of 2017.
The surprising calm that prevailed over markets for basically all of 2017 continued into January as the market went parabolic and seemingly hit new all-time highs every day. Though the earnings trajectory justified positive market action, the quick 7% return from January 1 through January 26 seemed extreme, and volatility roared back with a vengeance in late January. After a legitimate correction of 10%, the markets hit a low on February 8th, then bounced, and then swooned again into quarter end. This up and down action was a surprise to some since we had not seen a pullback of even 3% since 2016. Fed/interest rate worries, an active political news environment, and trade war concerns kept investors nervous.
Counterintuitively, the initial catalyst for the late January/early February decline was the release of strong data on employment and wages. This fueled fears of a continued rise in interest rates and a short term bump in inflation driven by improving growth, which in turn sparked worries that the Fed might feel compelled to tighten policy faster than expected. However, the inflation rate, at 1.6%, is still well below the Fed’s 2% target. Some technical, computer-driven selling exacerbated the downward pressure as well. The chart below shows how minor the recent increase in inflation was, especially in the context of the period back to the year 2000.
An uptick in inflation from very low levels is to be expected in an accelerating economy. As long as inflation doesn’t spike out of control and the Fed doesn’t hike rates much faster than is warranted, the economy and corporate profits can continue to grow, and the long bull market can continue its run.
Following a mid-quarter market bounce, the market rolled over again in March as President Trump followed through on campaign promises and sparked fears of a global trade war by announcing several aggressive import tariffs.
Trump’s initial announcement put a 25% tariff on all imported steel and 10% on aluminum (about $3 billion worth of goods), but subsequent announcements exempted key trading partners Canada and Mexico, and then, later, the EU and others. He also proposed tariffs on about $50 billion of Chinese goods, to which China retaliated by proposing duties on $50 billion of US exports. The US trade deficit with China was about $375 billion in 2017 from approximately $505 billion in imports and $130 billion in exports. Treasury Secretary Mnuchin and Commerce Secretary Ross have said that the two countries are actually talking and may seek to resolve the trade disputes at the negotiating table before they actually take effect. These protectionist moves bear watching, but we do not believe it is prudent to assume they will actually cause a slowing of global growth beyond what the market has already discounted, especially given Mr. Trump’s history of aggressive negotiation tactics.
Given the strength of the economy, we continue to believe that a total return approaching 10% is possible for the S&P 500 in 2018. Most importantly, corporate earnings are accelerating and estimates are being revised upward at a faster pace than we had originally expected.
We believe that the strong economy is likely to absorb gradual, well-telegraphed Fed rate hikes without major problems. Many market participants have warned that a misstep with tightening could harm the economy and crush the market. We do not believe that it makes sense to assume this will occur. Jerome Powell, in his first news conference, echoed Janet Yellen’s verbiage that Fed moves will be dependent on economic data, as they have been for many years now. The yield curve remains upward sloping, inflation increases are manageable, and the credit markets are well-behaved.
We continue to expect volatility will be higher this year than last year, however. After a prolonged period of extremely low volatility, we have not been surprised to see market participants overreact to what they perceive to be bad news so far in 2018. Corrections of 5-10% are normal and healthy occurrences within a bull market, and it remains unlikely that a recession and resulting bear market will occur in 2018. A deterioration of earnings and/or inversion of the yield curve would likely change our outlook and lead to shifts in portfolio positioning. We remain disciplined in the face of higher volatility, committed to a long-term time horizon, and focused on what truly matters: corporate earnings results and outlooks. These factors are currently positive.
Fixed income returns thus far in 2018 are slightly negative as interest rates have begun to move higher. The Bloomberg Barclays US Aggregate bond index has fallen 1.5% year-to-date, though the decline in Chilton’s bond portfolio has been more modest given our short duration positioning and the yield advantage from our overweight position in corporate bonds. Since the beginning of 2018, the yield on 10 year Treasuries has risen from 2.40% to 2.74%, a reflection of investor expectations for faster economic growth, higher inflation over the short and medium term, a widening budget deficit (higher Treasury supply), and Fed policy (raising rates while shrinking its balance sheet).
On March 21, the Fed hiked short-term interest rates for the sixth time since 2015. Fed Committee members are jointly predicting two additional hikes during 2018 and three more next year. However, new Fed Chairman Jerome Powell has signaled that future rate movements will continue to depend upon economic conditions, rather than a predetermined rate path based on theoretical economic models. For instance, Chairman Powell was clear in messaging that recent tariff policies have become a greater risk to the Fed’s outlook, but that these risks are offset by significant fiscal stimulus. This is important given the perception of many investors that the Fed will “overshoot” with rate hikes and prematurely push the US economy into a recession.
We continue to monitor the credit markets, and the shape of the yield curve in particular, for signs of an upcoming recession. An inverted yield curve, when longer-term rates are lower than shorter-term rates, has historically been a good leading indicator for recessions. Thus far in 2018, as mentioned earlier, the yield curve remains upward sloping. Corporate credit spreads (the incremental yield of a corporate instrument over an equivalent-term risk free, i.e. Treasury, investment) have inched higher year-to-date but remain well below pre-recession levels. If the yield curve were to invert and/or credit spreads to meaningfully widen, we would likely move to a more defensive posture across the entire portfolio.
Given our view that interest rates should continue to move higher, we have positioned the portfolio with mostly short-to-medium duration securities. As rates move higher, we plan to reinvest the proceeds from maturing bonds into longer-term, higher yielding securities. Recent purchases in many portfolios also include floating rate bonds, whose coupons adjust higher as rates rise. We continue to believe that a reasonable estimate of fixed income total returns for 2018 is in the 2.5%-3.5% range, with the bulk of return coming from interest income rather than capital appreciation. Although fixed income returns are likely to remain muted over the short-to-medium term, bonds play an important role in the asset allocation process by providing both income and stability within a diversified portfolio.
Volatility returned in the quarter as protectionist rhetoric weighed on global markets. The increase in global market volatility should not be a surprise, as the relative calm of the past two years was an aberration in the context of historical norms. In the quarter, developed markets declined, with the S&P 500 down 0.8%, US small cap stocks down 0.1%, and developed international markets dropping 1.4%. Emerging markets rose 1.4%, despite US trade sanctions, and the US dollar weakened 2.4%.
Global economic activity remains strong, with the synchronized global recovery predominantly intact. The headwinds of firming inflation and monetary tightening in the US are more than offset by the tailwinds of above-trend global manufacturing and consumption, which are driving an acceleration in earnings growth.
As mentioned above, the Trump administration’s recent tariff announcements stoked fears of an escalating trade war. However, we do not currently believe the tariffs will derail the strength of the global economy. For example, China is a net exporter and would suffer more than the US in a full trade war. If the Chinese government desires to maintain its 6.5% projected GDP growth under its latest five year plan, it is unlikely to retaliate to the point of disrupting its largest export market. The global expansion is gaining strength from international trade, although the impact of rising protectionism remains a potential risk to the overall constructive backdrop of a synchronized global recovery.
History proves that portfolio diversification may effectively mitigate risk and improve returns over the long term. The expectation of rising volatility and eventual lower than average returns in US stocks and bonds could create the exact scenario investors don’t want to see: more fear and less return. Therefore, we continue to believe a diversified portfolio is more crucial now than ever. As seen in the charts below, with valuations and dividend yields that remain more favorable for international markets, adding allocations to additional asset classes may increase yield and expected returns.
Additionally, global portfolio allocations provide exposure to faster growing markets while adding diversity to both economic and earnings cycles. We believe a portfolio diversified across geographies and asset classes should help mitigate risk and preserve capital over the long-term, while potentially generating greater current income and capital growth.
The MSCI US REIT Index (Bloomberg: RMZ) produced a total return of -8.1% in the first quarter. As of March 31, 2018, the RMZ was trading 19% below its all-time high on July 31, 2016. REITs have been hit with the perfect storm of rising interest rates, negative funds flows, and too much emphasis placed on the fact that the real estate cycle is getting mature, as evidenced by decelerating growth rates.
While we cannot say whether the market has reached a bottom, we are able to present valuation statistics that can objectively be compared to history. It is a fact that REITs are the most inexpensive they have been relative to bonds, stocks, and private real estate in at least eight years. It is also a fact that REITs have produced double-digit total returns following the occurrences when REITs have flashed such ‘cheap’ signals.
Defined as the recurring cash flow available after paying for maintenance capital expenditures, AFFO is the REIT equivalent of net income for equities. Over the past 10 years, REITs have traded at an average 5.6x multiple premium to the S&P 500 P/E ratio. We believe this is warranted due to the contractual nature of REIT cash flows, which makes REIT earnings more predictable and less volatile. However, as of March 31, the REIT AFFO multiple was 19.8x, while the S&P 500 multiple was 16.9x, resulting in a spread of 2.9x. Remarkably, August 2009 was the most recent period in which the spread was at such a low level.
Additionally, the REIT dividend yield spread versus the US 10 year Treasury yield is flashing an ‘inexpensive’ signal. As of March 31, the REIT dividend yield was 4.5%, which compared to the US 10 year Treasury yield of 2.7%, equating to a spread of 180 basis points (or bps). In contrast, the historical average spread between the two has been 120 bps, meaning the US 10 year Treasury yield would have to rise 60 bps merely to meet the historical average.
While the spread of the REIT dividend yield to the US 10 year Treasury yield is useful, there is an argument that investment grade bond yields are a better measure for REIT valuation. Over the past 25 years, the average REIT dividend yield was 5.4% and the average yield on the investment grade bond index was 6.6%, which results in a spread of -120 bps. However, as of March 31, 2018, the spread stood at -5 bps. The last time the spread was at such levels was November 2008.
Finally, in our opinion, the most practical valuation metric for REITs is Net Asset Value (or NAV). NAV measures the expected value if all of a REIT’s properties were sold on the private market at values estimated by using comparable transactions. REITs can trade at a premium or discount to NAV based on the market’s perceived direction of values or risk. REITs have traded at average 1% premium over the past 21 years. In contrast, as of March 31, REITs were trading at a 12% discount to NAV, the largest discount to NAV since December 2013. We believe that this discount is unsustainable as private investors will take advantage of the arbitrage opportunity between public and private valuations by selling assets and buying REITs, perhaps resulting in a wave of privatizations. Notably, there was over $28 billion of public REITs taken private in 2015 when the NAV discount approached double digits.
Interestingly, one has to go back to 2003 to find another time before 2008 when the investment grade bond yield spread to the REIT dividend yield and the AFFO multiple spread to the S&P 500 P/E ratio was at the February 2018 levels. Investors who bought in at such low valuations were rewarded handsomely over the following four year period. From 2003 to 2006, REITs (as measured by the FTSE/NAREIT All Equity REITs Index (Bloomberg: FNER)) produced an annualized total return of +21.9%, which compared to the S&P 500 at +14.6%.
While the pricing of properties can be influenced by factors such as interest rates, we believe that it is unwarranted for REITs to be trading at recession-like valuations at a time when they boast all-time high occupancy, positive rent growth, and a path to dividend growth of 4-5% per year. Unless a recession becomes more likely, we believe the current valuations have created an asymmetric opportunity where the upside to REIT prices is disproportionately higher than the downside.
Bradley J. Eixmann, CFA, firstname.lastname@example.org, (713) 243-3215
Brandon J. Frank, email@example.com, (713) 243-3271
R. Randall Grace, Jr., CFA, CFP®, firstname.lastname@example.org, (713) 243-3223
Patricia D. Journeay, CFA, email@example.com, (713) 243-3222
Matthew R. Werner, CFA, firstname.lastname@example.org, (713) 243-3234
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