Portfolio Insight | 4th Quarter 2018
Following a solid first nine months of 2018, the market reversed course and cascaded lower in Q4 due to, among other things, fears that a Federal Reserve misstep and trade wars would lead to a global recession in 2019. On December 24th, the S&P 500 index hit a new 52-week low just three months after hitting an all-time high in late September. The S&P 500 index total return of -13.5% for the quarter brought the total return for 2018 to -4.4%.
Top performing sectors for the year were Health Care, Utilities, and Information Technology. Leadership shifted dramatically in Q4, as interest-rate sensitive Utilities, Real Estate, and Consumer Staples sectors led the market.
Correction Catalysts
The Q4 market correction began in earnest October 3rd, when Federal Reserve Chairman Jerome Powell commented that the central bank was “a long way” from the end of its rate hiking cycle. This seemed to fuel investor fears that the Fed would raise rates too far and, eventually, push the economy into a recession. Other factors plaguing the market during the quarter included the continued reduction of the Fed’s balance sheet, trade war fears, political wrangling, softening economic data, and non-fundamental selling such as quantitative, algorithmic, and fund-redemption-induced selling.
Accordingly, the market went from an “all news is good news” mindset in Q3, to “all news is bad news” in Q4. The speed and magnitude of the downdraft were surprising given the lack of obvious severe stresses and a generally favorable economic backdrop. We believe that the market is assigning too high a probability of either mistaken Fed actions or failed trade negotiations tipping the economy into a recession, and that the other issues are transitory.
Is a Recession Nigh?
Reliable recession indicators are not suggesting much cause for concern at this time. 2019 GDP growth should fall to the 2.0-2.5% range, and earnings growth, while slowing, is likely to continue.
One of the recession/market peak indicators we focus on is the shape of the Treasury yield curve. During Q4, a section of the curve, the 3-5, actually inverted (3-year Treasuries had a higher yield than 5-year Treasuries).
Financial media, and some investors, seized on this event as a reason to expect a near-term recession and sell stocks. However, this particular spread is not commonly used as a recession indicator, and has often given false signals. We continue to focus on the widely used 2-10 section of the curve, whose spread has flattened but not yet inverted. The more predictive 2-10 spread ended the year at +19 bps, and we do expect inversion to occur in 2019. When a 2-10 inversion does happen, more market volatility is likely, but we would expect the market to eventually stabilize and move higher for another 1-2 years, as is typical before tightening credit causes a significant slowdown and recession. Based on our expectation of the timing of inversion, we currently believe that a recession and sustained bear market will not occur until 2020 at the earliest.
Cessation of Trade War Escalation
There was a positive development on the trade war front at the recent G-20 meeting as Presidents Trump and Xi of China agreed to a 90-day negotiation period and cessation of tariff increases. We were positively surprised by the result but acknowledge that details of a finalized trade agreement are still unknown.
Most companies have handled the current tariffs effectively due to strong demand for their products, their pricing power, and their ability to engineer supply chain workarounds. However, many management teams have expressed concerns about the negative impact that further escalation would have on their businesses. Further increases in tariffs would likely be problematic for the global economy, and investor concerns about this possibility contributed to the market downturn in Q4.
Though there is uncertainty surrounding the negotiations and ultimate final outcome of the trade talks, we believe that softening economic data in the US and more pronounced pressures in China will force the two countries to seek a favorable solution.
Domestic Equity Outlook
Despite significant earnings growth in 2018, S&P 500 valuation contracted meaningfully by year end. Based on our projection of mid-high single-digit earnings growth in 2019, the index currently trades at less than 15x 2019 earnings. This level of valuation is inconsistent with market action during past periods of low inflation and interest rates, which generally support above average market multiples.
A wide range of outcomes is possible, but we believe that, given the fundamental backdrop, and even with some evidence of a global economic slowdown, downside from the current depressed market level is limited. We believe a rebound in valuation and modest earnings growth will lead to at least a high single-digit S&P 500 index gain in 2019, with a ~2% dividend yield adding to the total return outlook. The positive expected return for the calendar year is also a function of the extremely oversold starting level of the index following Q4’s correction. This outlook assumes that the Fed will not force the economy into a recession and that there will be a favorable trade war resolution.
As mentioned last quarter, we have been gradually moving portfolios towards a more “neutral” positioning as economic and market cycles mature, and we are finding attractive process fits in lower volatility, non-cyclical names. Unless the economy surprises by lurching higher or lower, we will likely continue this measured transition well into 2019.
Fixed Income Outlook
The Bloomberg Barclays Aggregate index finished the year flat, making 2018 the first year since 2013 that the index did not show a gain. Although down from the November peak, interest rates finished the year higher, with 10-year Treasuries yielding 2.7% at year-end versus 2.4% at the beginning of the year. Corporate bond prices remained steady through much of the year before moving lower towards year end as uncertainty surrounding the economy, trade, and Fed policy led to a broad based market sell-off.
On December 19th, the Federal Reserve raised interest rates for a 4th time in 2018 and the 9th time since 2015 (see chart on right). Fed Chairman Powell indicated that, due to the ongoing strength of the US economy, the Fed plans to raise rates two more times in 2019, and that its balance sheet reduction plan was on “autopilot.” As a reminder, following the financial crisis in 2008, the Fed purchased government bonds to push down interest rates, which in turn helped stimulate the economy (Quantitative Easing).
However, many market participants were hoping that, given the current economic backdrop, the Fed would not only skip this rate hike, but also signal a halt to future rate increases and slow down the pace of its balance sheet reduction. Many of these same investors are now convinced that the Fed will raise rates too far and prematurely push the economy into a recession. Yet, Chairman Powell clarified in his post-announcement press conference that the committee is continually monitoring economic/market developments and will adjust policy as needed, meaning the Fed could stop raising rates. Powell also said that as long as inflation remains as low as it is, a pause in rate increases is warranted. Commentary from other Fed governors after the announcement backs this view of policy flexibility, both with rate hikes as well as balance sheet reductions. Given the influx of recent mixed economic data, we expect the Fed to slow down the pace of rate hikes and, likely, avoid a recession in 2019. 2019 may be the first year since 2015 that the Fed does not raise rates at all. In fact, the market is pricing in no more rate hikes this cycle, down from an expectation of 2-3 just a few months ago.
Given our view that interest rates will move higher over time, we continue to position our portfolio with mostly short-to-medium duration securities. The majority of the fixed income portfolio is still comprised of investment-grade corporate bonds. While prices have moved lower recently, we typically buy bonds with the intention of holding them until maturity/call, meaning investors can expect full principal and interest will be returned over time. Looking forward to 2019, we believe a reasonable estimate of fixed income total returns could be in the mid-single-digit range. While the upside potential for fixed income is less than that of equities, bonds continue to play an important role in the asset allocation process by providing both current income and stability within a diversified portfolio.
Global Markets Outlook
Global economic growth plateaued in 2018 amid heightened trade sanctions and tightening monetary policy. After the strong double-digit returns in 2017, market turbulence in 2018 led to disappointing returns across global financial markets, with cash actually being the best performing asset class for the first time since 1994. Large cap US stocks fell 4.4%, US small cap stocks declined 11.0%, developed international markets fell 13.3%, and emerging markets dropped 14.5%. The US dollar strengthened 3% in 2018, a headwind to international equity returns for US investors.
Source: Bloomberg LP
As we enter 2019, many of the past year’s tailwinds have reversed course. Growth is broadly decelerating, exacerbated by previously discussed trade fears. However, in our view, recent market declines have exceeded fundamental deterioration. Slowing global growth and tightening liquidity have raised fears of pending global recession, but fundamental data points toward continued global growth, albeit at lower rates. The good news is that from current levels, expected returns are likely to improve in 2019, driven by expanding global activity and lower valuations. We do not, however, expect the double digit returns of the past decade will continue over the next decade.
Based on our expectations for continued earnings growth and higher dividend yields, set against a backdrop of lower economic growth and the late-cycle position of the markets, we expect global markets to generate at least mid-single-digit returns over the next several years.
Continued market volatility, however, will likely test investor resolve. To brace for uncertainty, we recommend clients remain broadly diversified. For clients requiring distributions from their portfolios, we suggest keeping enough cash to sustain spending needs for at least 1-2 years.
History is on the side of long-term investors who adhere to the fundamental principles of diversification and patience. We believe broader diversification can help mitigate risk while increasing portfolio yields and expected returns. As noted before, international markets currently provide above average dividend yields with valuations that are both cheaper than the US, and below the long-term average.
Stewarding a diversified portfolio designed to meet our clients’ growth and income goals is our primary focus. As you meet with your adviser in the coming year, we ask that you ensure your portfolio is tailored to achieve your goals within your desired risk tolerance.
REIT Commentary
Volatility in the REIT space certainly ruled in 2018 once again, showing that 2017 was not a fluke. Depending on what day it was, the 2018 Chilton REIT Forecast either looked eerily prescient or completely flawed. As of December 31st the MSCI US REIT index finished the year with a total return of -4.6%, which compares to our original base case forecast of +5-10%, and revised base case forecast of +4-6% as of June 30. However, the rise in interest rates from 2.4% to 2.7% and a second half global selloff caused performance to finish within our bear case scenario of -5% to +1%.
2019 Forecast
In our opinion, the choppy yet positive economy (without a recession) could produce a near “goldilocks” environment that could drive REIT prices from a current discount of over 14% to within 3-8% of net asset value (or NAV) for the first time since 2016. If REITs achieve this by the end of 2019, and we assume a 25 bps capitalization rate increase and 3% same store net operating income growth (+3.8% with leverage), REIT prices should appreciate by 7-12%. Combined with a 4.6% dividend yield growing 5% during the year, the projected total return would be +12-17%.
Source: ISI research and Lipper as of 12/6/2018
We believe that REITs will be able to trade closer to NAV as REIT fund flows reverse course from the past four years. Over that time period, REITs struggled to trade at a premium to NAV due to massive flow of funds away from REITs. Opportunities presented by recent market volatility and discounted valuation set the stage for a potential reversal of REIT fund flows in 2019.
The forecast is supported by benign new construction, attractive valuations, and the potential for merger and acquisition (or M&A) activity. Though construction has increased steadily during this cycle, we are still below the historical average for construction starts at 1.5% of existing stock. Despite what the Fed has said about inflation remaining subdued, construction costs have increased almost 33% since 2012. The result is positive for landlords as it increases replacement costs and, in most cases, eventually leads to higher rents.
As of December 31st REIT valuations are in the “extremely” inexpensive range, which could attract generalist investors. According to ISI Research, the discount to NAV was 14%, which compares to the long term average premium of 1%. The AFFO multiple was 18.7x, which is above the 25 year average of 16.7x, but well below the 21.2x average over the past three years. Finally, the dividend yield of 4.6% compares to a 10-year Treasury yield of 2.7%, which equates to a spread of 190 bps. When compared to the 25 year average spread of 125 bps, REITs are almost 100 bps undervalued. Our research shows that a spread that is 100 bps or more above the historical average has had an 80% correlation with positive total returns over the next two years.
Finally, according to Preqin, a real estate private equity consultant, there is $294 billion in capital raised in private equity funds as of November 2018 with the purpose of investing in commercial real estate, an all-time record and up $45 billion from 2017. The volatility of REITs in 2018 and high availability of capital generated appealing scenarios for both public to public and public to private transactions. As a result, there were $87 billion in M&A transactions in 2018, the most since 2006. We believe the “wall of capital” combined with a positive US commercial real estate outlook will lead to another year of elevated M&A activity, which could be a catalyst to close the discount to NAV.
Bradley J. Eixmann, CFA, beixmann@chiltoncapital.com, (713) 243-3215
Brandon J. Frank, bfrank@chiltoncapital.com, (713) 243-3271
R. Randall Grace, Jr., CFA, CFP®, rgrace@chiltoncapital.com, (713) 243-3223
Julia J. Cauthorn, jcauthorn@chiltoncapital.com, (713) 243-3282
Matthew R. Werner, CFA, mwerner@chiltoncapital.com, (713) 243-3234
