Market action was extremely volatile and included a rapid 6% drop from the July 26 all-time high. The market righted itself and moved higher in September, ending within 2% of its peak despite continuing economic slowdown concerns and increasing geopolitical tensions, including an attack, possibly by Iran, on Saudi Arabian oil processing and production facilities.
Meanwhile, Fed easing actions, elevated global bond demand, and global growth concerns have coalesced to push down yields on fixed income around the world. The most consistently accurate predictor of eventual (usually in 1-2 years) recession and bear market, the 10-year and 2-year Treasury yield curve, finally inverted in late August after nearly a decade of flattening.
A bifurcated economy persists, with 2019 slowdowns in cyclical end markets like industrials, as shown below:
However, a persistently strong consumer is offsetting pressure in cyclical areas. Strong employment and wage growth potentially bode well for the upcoming holiday spending season, which should continue to buoy our consumer-focused economy.
The outcome of trade negotiations between the US and China remains the major risk for global economies and financial markets. Tariffs are beginning to have a negative impact on a broader swath of companies, and the lack of visibility for global multinational leaders planning for the future is a clear negative. We’re seeing more and more examples of waning confidence and a scaling back of hiring and investment plans. Citing “escalating trade conflicts,” the Organization for Economic Cooperation and Development (OECD) predicted recently that the global economy will see its weakest GDP growth since the Great Recession of ’08-’09, slowing from 3.6% in 2018 to 2.9% in 2019. This estimate has been revised downward consistently as the year has progressed.
Following continued delays and volatile rhetoric with action on both sides, it now appears to us that a trade deal is unlikely any time soon. It is possible that both Presidents Xi and Trump are unmotivated to complete a deal until closer to the 2020 election. This could change depending on the direction of the economy and the polls for the US presidential race. Major domestic corporate leaders like Apple’s Tim Cook and conservative donors like Las Vegas Sands’s Sheldon Adelson have been warning the Trump administration about the negative impacts of a prolonged trade war. However, the President continues to be aggressive with his messaging and is insistent that China and leader Xi are bearing the brunt of the impact, while the US is stronger than ever. For now, the two sides are scheduled for further face-to-face meetings in October in Washington. Despite recent accommodations by both sides, the President’s tariff hike by 5% on most Chinese goods to 30% on October 15 is still scheduled to go into effect.
With only about 13 months until the US Presidential election, the Democratic field of challengers is thinning. Joe Biden is still the favorite to win the Democratic nomination, with Elizabeth Warren rapidly gaining ground and Bernie Sanders and Kamala Harris currently fading in most polls. Seemingly determined to remove him from office before the election occurs, Democrats have recently announced a formal impeachment inquiry of President Trump. On the geopolitical front, the threat of a hard, “no deal” Brexit at the end of October threatens to put further pressure on European growth. It remains to be seen if the US or its allies retaliate, either militarily or economically, to the attacks on Saudi oil facilities.
With the market holding near an all-time high amidst a deteriorating earnings picture, a major advance into year-end remains unlikely, and the odds of an eventual recession and accompanying bear market are rising. Nonetheless, a low inflation/low interest rate environment is supportive of higher valuation. Absent a trade deal, the major question facing the market remains whether or not the Fed’s easing can arrest the downward trajectory of the economy and turn it around.
At the equity level, we continue to gradually move the portfolio toward lower volatility and less economically cyclical holdings, a process that began a year ago. Lack of visibility on a finalized US-China trade deal and the associated negative impact on company fundamentals supports this continued transition. However, the strength of the US consumer, the benefits of lower interest rates, and stable credit markets currently argue against near-term recession and against the need for more aggressive portfolio risk reduction. Further, the current slow and deteriorating growth environment actually remains “target rich” for names that fit our process with improving fundamentals, as such companies tend to stand out in even starker contrast than usual versus those that are negatively impacted by a cyclical slowdown.
Global trade and growth concerns, as well as the relative attractiveness of US bond yields compared to negative yields in many parts of the world, have helped push down domestic interest rates. The 10-year Treasury closed the quarter with a yield of 1.67%, down from 2.69% at the end of 2018. Lower interest rates have provided a tailwind for bond investors. The Bloomberg Barclays Aggregate Index rose 2.3% during Q3, bringing YTD returns to 8.5%.
On September 18, the Federal Reserve cut its benchmark interest rate for a second time this cycle, citing, in addition to trade and growth, concerns about lower than expected inflation. Fed Chairman Jerome Powell indicated that the committee will continue to evaluate incoming economic data in its future rate decisions. Even though the committee is somewhat divided on what further action the central bank should take, the financial markets are currently expecting 1-2 further cuts this year and an additional 1-2 cuts next year. While it appears increasingly unlikely that the US and China will reach a trade deal in the short-term, incremental Fed rate cutting could provide a stimulus to the US markets and economy.
Two leading indicators that have been historically helpful in predicting recessions (and subsequent bear markets) are the level of corporate credit spreads and the shape of the yield curve. Corporate credit spreads (the incremental yield of a corporate bond over an equivalent-term Treasury), remain narrow and well below pre-recessionary levels. On the other hand, our preferred yield curve metric, the difference between the yield of the 10-year and 2-year Treasuries, inverted during the quarter. This development is important since an inversion of the 10/2 yield curve has preceded each recession over the past 50+ years.
As we have written previously, the median lag between inversions and recessions since the 1960’s has been nearly 20 months, and stocks tend to rally post-inversion (median 21% return to peak after each inversion since 1965). Nonetheless, we have noted this inversion signal and are continuing the gradual defensive shift across portfolios for both equities and fixed income. While we are comfortable holding our existing bond holdings to maturity, we continue to buy short-term US Treasuries for those clients with maturing bonds or excess cash, with an eye toward redeploying that cash back into corporate bonds once a more favorable buying opportunity arises.
While acknowledging that interest rates may remain at relatively low levels for an extended period of time, we continue to position the portfolio with mostly short-to-medium duration securities to minimize interest rate risk. The majority of the fixed income portfolio is still comprised of investment-grade corporate bonds. We also continue to believe that a reasonable estimate of 2019 fixed income returns is within the mid-single digit range.
While fixed income returns are likely to remain modest 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.
Amidst slowing global growth and escalating trade war concerns, global equity markets posted mixed results in Q3. The S&P 500 led the way up 1.7%, while US small cap stocks fell -2.4%, developed international markets declined -1.0%, and emerging markets dropped -4.2%. The US dollar strengthened 2.7%, a headwind for US investors.
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 continue to expect global markets to generate mid-single-digit annual returns over the next several years.
As mentioned, we have gradually positioned client portfolios more defensively over the past year, making tactical shifts within asset classes to reduce cyclicality and duration while increasing the attributes of quality, dividend yield, and liquidity. Broadening asset allocations to include a global equity component is another defensive tool that can enhance portfolios with increased diversification, faster growth, higher dividend yields, and lower valuations.
As the Federal Reserve has embarked on an easing path to encourage growth and extend the economic cycle, it is instructive to review asset class performance during the past five easing cycles. Among major asset classes, emerging market equities actually exhibit the greatest consistency, outperforming the S&P 500 in four of the five periods. While international stocks have been more volatile than domestic stocks, history illustrates that adding non-US allocations actually helps lower overall portfolio risk, simply due to the benefits of broad diversification. We believe in common-sense constraints, adding enough international exposure to benefit, though less than the roughly half of global market value, effectively reducing but still maintaining a “home bias” to the US given higher overseas uncertainty.
The recent period of US equity outperformance over international equities is the longest such period in the past 40 years. Market leadership tends to alternate with long cycles of outperformance, and global diversification helps insulate portfolios from dependence on US markets. For example, during the period from 1999-2009, which included the Tech Bubble, the 9/11 terror attacks, and the Great Financial Crisis, the S&P 500 had its worst ten year performance since the Depression, returning -1.0% per year. In comparison, international developed markets returned +1.7% per year and emerging markets were up +10.0% per year.
History illustrates a broadly diversified portfolio reduces overall portfolio risk. Over long time horizons, investing in assets that are less correlated – that move and respond differently in different market environments – effectively improves diversification and reduces portfolio volatility. A broadly diversified portfolio means the results will neither be the best performing asset class, nor the worst, but a balanced approach providing a less volatile and more consistent outcome. Our process is to design allocations that are diversified in accordance with clients’ risk tolerance and to meet long-term goals across market environments. We encourage you to visit with your wealth adviser to ensure your allocation is congruent with your objectives.
The prospect of a lower yield environment coupled with positive near term fundamentals bodes well for the near term total return of REITs. Also, generally speaking, we believe the trade war will have no short term effect on net operating income (or NOI; rental revenue minus operating expenses). While NOI projections may not have changed, capitalization rates (or “cap rates”) may come down as the relative attractiveness of a growing yield increases versus other more vulnerable asset classes.
While we were bullish in our initial 2019 forecast for REITs to close the NAV (or Net Asset Value) discount, we also conservatively assumed that cap rates would increase by 25 bps. Given that the 10-year Treasury yield is one of the factors that influences cap rates, this assumption needs to be revisited. We now believe that cap rates are likely to decline by 10 bps as a result of the 100 bps decline in the 10-year Treasury yield. In addition, we assumed that REITs would finish the year at between a 3% and 8% discount to NAV. With REITs now trading at a premium for the first time in three years, we now believe they will finish the year between a 2% discount and a 3% premium, which equates to a change of 1200-1700 bps from the start of the year (14% discount!). Holding our other assumptions constant (1% NAV growth from retained earnings, 3.8% levered same store NOI growth, and a 5% dividend yield), the revised Chilton REIT Forecast calls for a 2019 total return between +24% and +29%.
However, this forecast could prove conservative should interest rates stay around the current level. We also look at the spread between the REIT dividend yield and the 10-year Treasury yield as a forecasting tool. From January 1995 to August 2019, the average spread between these two metrics has been 127 basis points. As shown in the chart, this spread has gapped out to over 215 bps as of September 27.
A mere return to the historical average spread holding the Treasury yield constant would necessitate an increase of 44% in the MSCI US REIT Index (RMZ). That may not happen if the market doesn’t price in the 10-year Treasury yield stabilizing at 1.7%; however, as we showed in the October 2018 REIT outlook, a spread larger than 225 bps had an 80% correlation with the future two year total return.
In addition, the interest rate savings could result in a slight increase to AFFO estimates, and the relative attractiveness of REITs could drive AFFO multiples higher. As of September 27, REITs were trading at 22x forward AFFO estimates, only slightly above the 3 year average of 21x. As recently as January 2015, the AFFO multiple got as high as 25x. At the time, the 10-year Treasury yield was 1.7%, equivalent to the 10-year Treasury yield as of September 27. Using forward AFFO estimates, REITs would have to trade 14% higher to reach 25x forward AFFO. The biggest risk to our forecast would be a significant slowdown in the economy that leads to a recession much sooner than anticipated. This would lower demand and likely lead to a rotation into cash and fixed income. Another risk would be the execution of a favorable trade deal with China that would reaccelerate the economy on a lagged basis, while also pushing up interest rates significantly higher. In such a case, REIT fundamentals would still be in great shape, but fund flows would likely leave REITs for riskier equities.
Bradley J. Eixmann, CFA, email@example.com, (713) 243-3215
Brandon J. Frank, firstname.lastname@example.org, (713) 243-3271
R. Randall Grace, Jr., CFA, CFP®, email@example.com, (713) 243-3223
Matthew R. Werner, CFA, firstname.lastname@example.org, (713) 243-3234
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