The S&P 500 index closed out March at 2,834, with a total return in the quarter of 13.6%. Top performing sectors for the quarter were Information Technology, Real Estate, and Industrials. The largest Q1 sector laggards included Health Care, Financials, and Materials.
As noted in last quarter’s commentary, the market ended 2018 gripped by investor panic which put the S&P 500 at a valuation level that seemed to presage a looming recession. In a dramatic about-face, the Federal Reserve, reacting to slowing growth and tame inflation, reversed its tightening bias early in 2019 and now, many investors believe, could begin cutting rates within the next year. This more accommodative Fed has removed some fear from the market that higher rates could irreparably harm the economy. Notable progress on a US-China trade agreement has lessened fears of a destructive trade war.
The speed and magnitude of the market rebound have been almost as surprising as the precipitous decline witnessed at the end of last year. Recession fears are still top-of-mind for many investors, but the market has been persistently climbing the proverbial “wall of worry.”
Into April, it is evident that the lagged effects of higher interest rates, tariffs, and geopolitical issues such as Brexit paralysis are dampening global economic activity and slowing earnings growth. However, it is not a given that these issues will persist or lead to a recession, and global central banks and governments are reacting with more dovish language and actions as well as fresh stimulus in places like China.
The market for initial public offerings (IPOs) has opened back up, with No. 2 ridesharing company Lyft (NASDAQ: LYFT) leading the charge at the end of the first quarter. Many companies are poised to enter the public markets following a relatively quiet 2018 as their venture capital sponsors are ready to cash out a decade into the current bull market. So, expect to see many “unicorns,” or companies that have achieved at least $1 billion of market valuation, that you may have heard of, such as No. 1 ridesharing company Uber, rental marketplace AirBnB, and image-sharing social media company Pinterest, grab headlines as they pitch their stories to investors and become listed.
Many of these companies are not yet anywhere near profitability and will not be for the foreseeable future. Once profitability emerges, we anticipate evaluating and monitoring many of these new issues for possible eventual inclusion into our portfolios if they fit our investment process.
Despite decelerating global growth, we still expect earnings to grow in the mid-high single-digit percent range this year. Earnings estimates have moved lower as they often do early in a new year, and valuation has expanded but is not at an unreasonable level considering the relatively subdued current state of inflation. Having generated double digit gains already, with the Federal Reserve stepping aside for now, a further push beyond the all-time high (about 3% above the March 31st level) is dependent on whether or not trade wars are resolved and global growth can rebound following its recent soft patch. There are some indications that this could occur in 2019 as areas that have been weak recently, such as housing, are bouncing back due to lower interest rates.
In general, equity portfolios are positioned in a neutral manner with a slight tilt towards growth-oriented mega caps. We currently favor new ideas that are defensive non-cyclicals and/or have long-term secular tailwinds at this stage of the cycle as opposed to adding fresh cyclical exposure. We believe that such positioning is warranted unless the economy makes a significant and sustainable move up or down. We still do not anticipate a recession emerging until 2020 at the earliest.
Bond prices rebounded during Q1 from the declines seen late last year, corporate bonds in particular. The Bloomberg Barclays Aggregate index, comprised of both government and corporate bonds, increased 2.94% in Q1. The return in the Chilton bond portfolio was even higher given our overweight position in corporate bonds. Interest rates moved modestly lower during the quarter as investors continue to digest signs of a slowing global macro environment. The yield on 10-year Treasuries closed the quarter at 2.41%, down from 2.69% at year end. The relative attractiveness of US Treasury yields was also a factor given that the yields of many bonds in Europe and Asia remain negative.
On March 20th, the Federal Reserve left interest rates unchanged amid a dimmer outlook for the US economy. Several recent economic reports such as consumer spending, housing starts, business fixed investment, and consumer confidence have been worse than expected (along with a weaker global growth outlook – Europe in particular). The central bank, which in late 2018 planned for two rate hikes in 2019, said it now expects no interest rate increases this year. Fed Chairman Jerome Powell also indicated that the Fed would stop shrinking the size of its bond portfolio in September, which should help depress longer-term interest rates. 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. The financial markets are now anticipating 1-2 rate cuts this year, a substantial swing in sentiment given that 6 months ago investors had assumed 1-2 rate hikes in 2019.
The credit markets still are not suggesting a recession is likely in the near term. This is important since recessions generally cause sustained bear markets. The two leading credit indicators we monitor are credit spreads and the shape of the yield curve. Corporate credit spreads (the incremental yield of a corporate bond over an equivalent-term risk free, i.e. Treasury, investment), remain well below recessionary levels, as seen below:
An inverted yield curve, when longer-term rates are lower than shorter-term rates, has preceded each recession in the past 50+ years. Our favored yield curve metric, the difference in yield between 10-year and 2-year Treasuries, has historically been the most accurate in predicting recessions (other measures occasionally give false signals). This section of the yield curve, which has flattened for several years as the Fed raised rates, has not yet inverted. As we have previously discussed, since the 1960s, the median time lag between a yield curve inversion and the start of a recession is nearly 20 months. In addition, stocks tend to rally post-inversion (median +21% to peak after each inversion since 1965). Nonetheless, when the yield curve inverts and/or credit spreads meaningfully widen, we will likely accelerate our defensive shift across the entire portfolio.
Similar to our equity portfolio, we have begun the process of marginally reducing risk in our bond portfolio. While we are comfortable holding our existing bonds to maturity, for some clients with maturing bonds or who have excess cash, we have begun to buy short-term US Treasury securities. Our reasoning is as follows: 1) after several years of rate hikes, the yield on short-term Treasuries is reasonably attractive, 2) the incremental yield available by buying corporate bonds is minimal due to their recent rally, and 3) in the event of a market disruption, we could sell our Treasury positions (which would likely rally) to purchase attractively priced corporate bonds.
Given our view that interest rates are likely to move somewhat higher over time, we continue to position the portfolio with mostly short-to-medium duration securities. The vast majority of the fixed income portfolio is still comprised of investment-grade corporate bonds. We continue to believe that a reasonable estimate of 2019 fixed income total returns is in the mid-single-digit range. 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.
The first quarter of 2019 highlighted that volatility works both ways, as global markets rebounded sharply from last quarter’s panic-induced downturn. Large cap US stocks increased 13.6%, US small cap stocks rallied 14.6%, developed international markets rose 10.2%, and emerging markets increased 9.9%. The US dollar stabilized in Q1, rising 0.2%, a pause in the strengthening seen in 2018.
The rapid ascent in global markets during Q1 was driven by several factors, including central banks (led by the Federal Reserve) pivoting to a more accommodative stance, broadly oversold market conditions at the end of 2018, and optimism that forward indicators may point to reacceleration of growth in 2019.
Much of the ongoing growth slowdown that began in late 2018 was driven by policy actions such as the US/Chinese trade dispute, tightening global monetary policy, the US government shutdown and European uncertainty with Brexit. Corporate earnings reports highlighted the impact of these factors in quarterly conference calls, and earnings expectations have been revised lower in 2019. The key question is the degree that these cyclical headwinds are transitory, and solved by policy resolution, or if they are more structural in nature.
Several of these cyclical headwinds are abating, and forward-looking indicators are showing improving conditions. Global central banks remain accommodative, with a focus on maintaining economic growth. Led by the Federal Reserve pivoting 180 degrees to a more dovish posture on rates, the European Central Bank (ECB) and China followed suit in easing monetary policy. Chinese fiscal stimulus is beginning to take effect, and an eventual trade resolution with China appears more likely than not.
We believe that most of these known headwinds are transitory, and global growth is likely to improve, albeit at slower rates than seen in the past decade. Recent global purchasing manager (PMI) data for March show broad-based improvement in manufacturing activity, especially in the US and China, confirming the potential for global growth to resume.
Following strong performance to begin 2019, we saw several clouds of policy uncertainty clearing, supporting an improving global growth outlook. However, contentious debates remain on trade, Brexit, and 2020 US elections driving forward policy uncertainty.
Brexit remains a wildcard for Eurozone growth. The delay in the proceedings to date exacerbates uncertainty regarding whether or not the UK will remain in the European Union (EU). European growth remains anemically below trend, impacted by Brexit preparations, slowing world trade, and political instability within member countries. In the US, political discord, and the potential for a change in policies resulting from the 2020 Presidential election could elevate market volatility.
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 at least mid-single-digit returns over the next several years. As always, we advise clients to remain broadly diversified, and prepare for volatile markets. A broadly diversified asset allocation, with enough cash to help clients sleep well at night can provide the proverbial umbrella to weather future market volatility.
In the quarter ending March 31, 2019, the MSCI US REIT Index produced a total return of 16.3%, completely eliminating the losses from the fourth quarter of 2018. Our forecast of full year total returns in the +12-17% range appears to have been close, though it is early to pat ourselves on the back. The main driver of the strong Q1 performance was the change in tone from the Federal Reserve, which now assumes zero rate hikes for 2019, compared with two previously. In addition, Q4 earnings season was strong, resulting in a majority of earnings beats, and 2019 guidance was nowhere near as bad as the Q4 performance implied. Even so, we are confident that initial 2019 earnings guidance may prove conservative, leading to guidance raises throughout the year across most sectors.
In March, the Chilton REIT team participated in the Citi Global Real Estate Conference in Fort Lauderdale, FL, attended by over 185 CEOs of real estate companies from around the world. The conference confirmed our confidence in the positive near term outlook for high quality US real estate, and gave us new insight into several companies and sectors.
Owners of all regional shopping centers are in the midst of a multi-year transformation. The uncertainties related to retail tenants and other risk factors, such as high leverage, have created a negative sentiment among public REIT investors. As a result, the public mall REITs traded at an average discount to net asset value (or NAV) of 26%* as of March 26, 2019. In the midst of all the negatives, we believe investors are not giving enough credit to “town centers,” effectively serving as a downtown in middle-markets and often are more vital to its community than the “Class A” mall in a major metropolitan area. As a result, there are numerous examples where local municipalities have contributed financially to ensure the success of the local mall. We see evidence that this is working, and believe that further transformation through experimentation of new retailers and alternate uses will preserve the value of these malls.
In office, we continue to believe the strongest markets remain on the West Coast. The demand drivers from technology, media, and life sciences stand out in an environment of limited supply. Accordingly, we expect above average rental growth for the foreseeable future.
The apartment REITs provided an update on year-to- date same store revenue growth, showing 2019 guidance may have been too conservative. In particular, Camden (NYSE: CPT) CEO Ric Campo emphasized that, thus far, 2019 is the third consecutive year that the first quarter showed accelerating same store revenue growth.
Lodging REITs were some of the hardest hit in Q4, some of them dropping by over 30% during the short period. However, most have rebounded in 2019 despite not much of a change in earnings expectations. We were able to conduct a property tour of The 1 Hotel South Beach, a recent $610 million acquisition by Host Hotels (NYSE: HST). HST is particularly bullish on Miami hotel performance in 2020 given that the Super Bowl will be held in the city during the busiest quarter of the year.
Industrial REIT fundamentals remain the best outside of the tower space, but we felt that management teams were increasingly managing investor expectations for future rent growth. Pricing and rental growth remains strongest for “last mile” properties in high-income urban areas, but the outlook appears increasingly bright for temperature controlled warehouses, as well.
Our meetings with data center REITs left us with two main takeaways. First, 2018 was the best year ever for data center leasing, both in the wholesale and network-dense market segments. Second, our meetings strengthened our belief that the days of double-digit development yields are behind us. However, data center development yields are still above all other sectors, and we believe they will not have a problem filling the development pipeline given the growth in demand from the cloud.
*Straight average of Chilton NAVs for PEI, CBL, SRG, SKT, WPG, SPG, MAC, and TCO
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
Julia J. Cauthorn, firstname.lastname@example.org, (713) 243-3282
Matthew R. Werner, CFA, email@example.com, (713) 243-3234
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