The top performing sectors in the third quarter were Financials, Utilities, and Communication Services. Stocks lagged the index the most in the Industrials, Materials, and Energy sectors. Amid increasing concerns regarding inflation, uncertain Federal Reserve policy, and the Delta variant, growth stocks maintained their late second quarter momentum and outperformed value stocks over the period. However, they faded dramatically at quarter-end when interest rates spiked higher. Similarly, large cap stocks reasserted their dominance and outperformed their small and mid-cap counterparts during the quarter.
The S&P 500 has been remarkably consistent in 2021, yielding positive gains each quarter with very little volatility. There was some minor weakness late in the third quarter, which took the index down 5% from its September 2nd peak of 4,536. The smoother market ride this year, supported by surprisingly robust earnings growth, is certainly welcomed following the historic volatility of 2020.
One reason for economic optimism going into 2022 is that GDP growth looks like it will hit a multi-decade high of around +6% this year even though many industries have still not fully recovered from the pandemic. Companies like Amazon and Costco have clearly benefitted from changing customer behavior during the last 18 months, but others, especially in the travel, leisure, and hospitality industries, are still not back to normal. COVID-19 restrictions remain in effect in some places, and completely free mobility is not occurring. For example, according to Flightaware, commercial flight data shows that global air traffic is currently more than 30% below January 2020 levels.
Another factor to consider is that temporary supply chain bottlenecks (lack of truckers, port delays, trouble finding workers, etc.) are likely pushing some potential 2021 sales (automobiles, appliances, industrial equipment, etc.) into 2022. The key point here is that end-demand remains strong.
Assuming these depressed areas eventually return to normal, and supportive monetary and fiscal policies (including infrastructure spending) persist, GDP growth can remain above average, possibly hitting +4% next year. A strong economy can of course drive strong corporate profits, which are key to further market gains.
This economic cycle has been abnormal with regards to the cause of the quick and deep recession, the magnitude of monetary and fiscal support, the rapid pace of the recovery, and intermittent headwinds such as those caused by the Delta variant. One risk to the economy and corporate profitability remains inflation, which has spiked as the recovery has gained momentum. We continue to agree with the Federal Reserve’s position that much of the current inflation will likely prove transitory as extreme demand wanes and capacity is added in certain areas. Lumber prices, for example, continued to collapse to below 2020 year-end levels during the third quarter, following an extraordinary price spike in May. The supply of semiconductors for autos remains limited, but capacity additions should improve this situation in 2022. Some inflation like wages and rents, however, is likely to stick as the job market strengthens.
From a broad standpoint, it appears that overall inflation expectations have peaked at an average of about 2.5% over the next five years. This is just above the Fed’s long-term goal but, as seen on the next page, not abnormal considering the strength of the current economic cycle and past periods like the 2000s:
Also, though the pandemic continues, the world seems to be adapting to it and avoiding the complete shutdowns of 2020, allowing for a sustained, if uneven, recovery back to normal. Though potential new virus strains could arise, so will new vaccines and therapeutics that will hopefully dampen the pandemic going forward. Good news in the short run, at least, comes in the form of declining COVID-19 cases, per CDC reports.
The Delta variant posed headwinds to the economy in late August/early September, but the recent decline in cases, hospitalizations, and deaths should allow the economy to revive and reaccelerate into year-end and 2022.
The economy looks poised to strengthen again. Consumers are in good shape, employment should improve further, and monetary and fiscal stimulus should continue. Based on current observations, we believe the market can advance and establish a new all-time high by the end of this year. Current conditions and earnings momentum could push indices up again next year as well, though gains may moderate significantly and volatility could increase. Relative to other asset classes including fixed income and cash, stocks continue to look attractive.
With a positive medium-term outlook, even as the current unique business cycle progresses to later innings, we feel it makes sense to maintain a healthy balance of cyclical value and secular growth stocks in portfolios. While we are not making major changes at this time, we have upgraded portfolios with fresher stock ideas that possess material catalysts. Despite the heady gains of the last several years, we continue to find attractive names that possess solid upside, giving us confidence in the sustainability of the current bull market.
Rising interest rates have put a dent in fixed income returns thus far in 2021, especially for longer-term bonds. The Bloomberg Barclays Aggregate Index, a blend of government and corporate bonds that contains a substantial number of long-term bond holdings, was essentially flat in the quarter (up 0.05%), but is down 1.55% year-to-date. Fortunately, given the relatively short maturities of most of our holdings, nearly all of our individual corporate bond positions have shown positive total returns year-to-date. Investors must be aware that a rising interest rate environment puts holders of longer-term bonds at risk of price declines. While Treasury yields still remain low in historical terms, the move in 10-year Treasuries from 0.93% at year-end 2020 to 1.52% at the end of the quarter has put pressure on bond prices.
The rebound in interest rates since the beginning of the year has been driven by several factors: improved future economic growth prospects, higher inflation expectations, an expected pullback of future Federal Reserve bond buying (“tapering”), and the prospect of the Fed hiking rates in the not too distant future. Since the onset of the pandemic, in addition to cutting short rates to zero, the Fed has been buying $120 billion of Treasury and agency mortgage-backed-securities each month. These incremental purchases help push up the value of these bonds and, in turn, pull down interest rates (also known as “quantitative easing”). With the consistently improving economic picture in the US, it is now highly likely that the Fed will decrease, or taper, the amount of bonds purchased on a monthly basis, starting perhaps as early as November. This monthly tapering will likely continue until the Fed is no longer purchasing any more of these bonds, likely sometime around the middle of 2022. Once the tapering is complete and the Fed is confident that US economic conditions (employment in particular) have sufficiently recovered, the Fed will likely begin to raise short-term rates, probably in late 2022 or early 2023.
Effective Federal Funds Rate
While we continue our research for new fixed income ideas, we have remained on the sidelines when it comes to purchasing new positions. Prices remain elevated (and yields exceptionally low), for short, medium, and long-term bonds. Our plan remains the same: use any material volatility-related price disruptions to deploy cash from client fixed-income allocations. The vast majority of our fixed-income allocations remain comprised of short-term investment-grade corporate bonds that we intend to hold to maturity. While the total return potential for these bonds is generally limited, fixed income continues to play an important role of providing both income and stability within a larger diversified portfolio.
US large cap stocks (S&P 500) regained leadership relative to their smaller US and international counterparts during the quarter, as US small cap stocks fell 4.4%, international developed finished down 0.3%, and emerging markets fell 8.0%. Headwinds for non-US investments include the strengthening US dollar, COVID-related slowdowns across much of Europe and Asia, and a significantly tighter regulatory environment in China. Nonetheless, the medium-term outlook for international market equities remains solid, given the improving economic and corporate earnings picture, and the willingness of most global central banks to keep interest rates low for the foreseeable future. Generationally low interest rates are supportive of higher levels of equity valuation and are the primary reason we continue to favor stocks over bonds, even in international markets.
While non-US equities have materially underperformed their US counterparts for several years, this may not necessarily remain the case moving forward. International valuations, as measured by forward price-to-earnings ratios, remain materially cheaper than US indices. Similarly, international dividend yields are much higher than those in the US. A key reason for recent US outperformance has been the willingness of investors to pay up for higher growth companies. Unsurprisingly, as interest rates rise, investors have historically been less willing to pay up for higher valuation growth stocks. If interest rates were to continue to move higher, investors could shift away from higher valuation/growth US markets into cheaper international markets.
With the S&P 500 still sitting near an all-time high, now may be a good time to review your financial plan with your wealth advisor. Diversification across multiple asset classes could make sense depending upon your investment horizon and risk tolerance. In particular, with interest rates so low and the high likelihood of fixed income returns remaining muted, it could make sense to evaluate moving bond allocations into income focused stocks, REITs, etc.
In 3Q, the MSCI US REIT Index produced a total return of 1.0%, though the price movements were somewhat volatile due to the ebb and flow of COVID cases, inflation data, and other global geopolitical headlines. Year-to-date, the RMZ has produced a total return of 23.0% through September 30th. In spite of the excellent year-to-date performance, we believe that a forward three year annualized total return profile of 7% to 9% is reasonable or even into the double digits if inflation persists.
Our conviction in the attractive risk-adjusted return for REITs is based on six key points. First, the lack of yield around the world and in most asset classes has made REITs and other yield alternatives a “hot” asset class. In fact, in the year-to-date period, REIT mutual funds and ETFs have experienced net inflows for the first time since 2014. Remarkably, the $11.4 billion of inflows would be the second best year in history if the number holds through the end of the calendar year.
Second, REITs are inexpensive compared to fixed income and could potentially be used as a fixed income alternative. As of September 30th, the spread between the REIT dividend yield and the US Corporate BAA 10-year Index was -38 basis points (or bps), which compares to the historical average of -106 bps, as shown in the figure below. Therefore, the REIT yield would have to fall by almost 70 bps to equal the historical average, which would result in a REIT price increase of 31%.
Third, REITs should be a beneficiary of the material fiscal stimulus actions ramping the reopening of the economy. The continued loose monetary policy should keep interest rates low but could create above average inflation over the next few years. In our almost 50 years of investing in equity REITs, we have witnessed that real estate has offered a good hedge against inflation, as higher rents and replacement costs have resulted in dividend growth that has exceeded inflation.
Fourth, the rapid increase in construction costs should weigh on new construction, preventing any oversupply risk for the foreseeable future. Consequently, this should result in an attractive supply and demand dynamic for the near to intermediate term for virtually all property types.
Fifth, predictability of above average dividend growth is near an all-time high. The extremely low payout ratios will give REITs the flexibility to increase payouts while still retaining a significant amount of free cash flow. When coupled with cash flow growth that will be among the highest we have seen due to the economic recovery underway and the capture of deferred rent from 2020 (due to the shutdown), risk of dividend cuts is nearly zero, and many REITs will increase the dividend higher than historical averages just to maintain the current payout ratio. Notably, our own internal models suggest 6% or more in annual dividend growth for the next three years from the REIT composite holdings as of September 30th. Many participants maintained dividends and a few REITs even increased dividends last year due to growth in earnings. As a result of these actions and the corresponding cash flow growth, dividend payout ratios now sit at 69% of adjusted funds from operations (or AFFO), a record low.
Sixth, the typical real estate cycle lasts seven years, and we are barely one year into the current cycle. Though this cycle may be shorter than historical cycles due to the V-shaped recovery, the dynamics of commercial real estate take time to play out given long leases and construction timelines. As a result, we are confident in the near and intermediate outlook for US REITs, especially for investors that are looking for yield.
Bradley J. Eixmann, CFA, firstname.lastname@example.org, (713) 243-3215
Brandon J. Frank, email@example.com, (713) 243-3271
Robert J. Greenberg, CFA, firstname.lastname@example.org, (713) 243-3218
Matthew R. Werner, CFA, email@example.com, (713) 243-3234
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