Portfolio Insight | 2nd Quarter 2020

After finishing the first quarter at depressed levels, growing evidence of an economic recovery as well as highly supportive government monetary and fiscal stimulus helped drive the S&P 500 20% higher in Q2, its biggest move in over twenty years. Remarkably at one point, the index even revisited unchanged territory for the year. However, the total return for the benchmark through the first half of 2020 was -3.1%. No doubt, this was a surprise to many market participants who had been startled into more cautious outlooks. Volatility remained above average but fell steadily from the historic levels of late Q1.

By sector, the biggest gains came from first quarter laggard Energy, as well as persistent winners Information Technology and Consumer Discretionary, while performance lagged the most in Utilities, Consumer Staples, and Health Care. Growth stocks continued their remarkable run of outperformance versus value stocks.

V, L, W, U, Swoosh, Square Root, Stair-step???

The great economic debate in Q2 and now into Q3 is the shape of the recovery (and how to label it) following the unprecedented pandemic shutdowns forced around the world in 1H20. Everything from credit card spending and business formation to miles-driven and even Open Table restaurant reservation trends suggest a recovery is well underway. Economic data such as employment, consumer spending, and industrial activity are improving from the virus-induced lows of Q1. From here, the pace of recovery will be highly dependent on the development of a therapeutic and/or vaccine, and by trends in new cases/hospitalizations.

Corporate Survival

Earnings revisions for companies were slow to be moved lower earlier this year and paint a stark picture of COVID-19’s effect on corporate America, but they now appear to be bottoming. While it is important to note that many industries like airlines, restaurants, and cruise lines have endured substantial hits to their financial well-being and will perhaps never be the same, a large percentage of companies, particularly in the technology and communication services spaces, have benefitted from the slowdown or will be unaffected in the long run. Recall that the economy was humming along pretty well, justifying new all-time market highs, before the virus hit. Many companies were in good shape entering the downturn, and a good number of them have seen a steady recovery in business following the shutdown-induced recession. A clear and somewhat surprising theme on first quarter earnings calls was the emergence of “green shoots” in April and May.

Pandemic and Election Updates

While many areas of the country have seen daily cases and deaths drop consistently, certain areas, including Texas, seem to have infection rates and hospitalizations moving in the wrong direction. Though the (arguably greater) harm to economies and social well-being make complete lockdowns seem unlikely again, some states and localities have paused or rolled back their re-openings, which could stall the recovery. Hopefully, this is just a break before the recovery resumes sometime later in the summer, but it could make investors cautious following a strong Q2.

Further, investors will have to deal with the buildup this quarter towards what promises to be a highly divisive US presidential election. Although polls were wrong in projecting that Hillary Clinton would defeat Donald Trump in 2016, most of them currently predict a Joe Biden victory over Trump in 2020. It appears that Biden’s priorities would be taxes (at least partially reversing Trump’s tax cuts by raising them), energy (greater investments in green technologies) and trade (possible reversal of Trump’s tariffs on China). It is worth noting that, despite the investor angst and market volatility that often accompany elections, the stock market has been able in the past to do well under both Democratic and Republic administrations.

Domestic Equity Outlook

The mounting evidence of a durable recovery from this year’s major economic and market shocks keeps us optimistic about the future. However, we remain vigilant with regards to the ultimate trajectory of improvement, given the risks associated with a potential resurgence of COVID-19 and potential changes in government. We will eventually have to deal with simmering long-term issues such as the rising levels of global government debt, but low inflation and interest rates coupled with a recovering economy and an aggressive “do whatever it takes” Federal Reserve are supportive of a reasonably high market multiple for now. Volatility is likely to remain high through November at least, driven by COVID-19 case trends, prospects for a vaccine, and election headlines. Barring some new shock, however, we would not be surprised to see the market retest its 2020 “unchanged” mark before potentially hitting new highs in 2021.

As mentioned last quarter, we have begun gradually shifting the portfolio back towards a more cyclical posture. As the economy reaccelerates, we are finding a number of new ideas that fit our process, which focuses on companies with improving business momentum and solid upside potential. In many cases, we are able to harvest valuable tax losses for clients while simultaneously upgrading the portfolio with new ideas that have similar upside, lower risk, and fresher, more meaningful, or potentially more durable catalysts.

Fixed Income Outlook

Corporate bond prices rebounded during Q2 while   government bonds continued their multi-year rally. The Bloomberg Barclays Aggregate Index, comprised predominantly of government bonds as well as corporate bonds, rose 2.9% during the quarter, bringing its YTD return to 6.1%. Interest rates remained relatively flat during the quarter as the yield on 10-year Treasuries closed the period at 0.66%, compared to 0.68% at the end of Q1, and down sharply from 1.92% at the end of 2019. Shorter-term Treasury yields remain exceptionally low these days, with yields at <0.20% annually for maturities of 3 years or less.

The bounce back in corporate bond prices can be attributed both to the improvements in US economic data since March and to the actions of the Federal Reserve. The Fed has continued to support the US economy through a number of unprecedented measures including keeping interest rates close to zero, pumping trillions of dollars of liquidity into the system, and, most recently, by buying individual corporate bonds and ETFs. The inclusion of another substantial buyer in the bond market has pushed bond prices up, and bond yields down, to levels not seen in history. Recent commentary from Chairman Jerome Powell suggests that low interest rates are here to stay, at least through 2022.

This across-the-board bond rally creates a problem for investors: reinvestment risk. Over the past several years, when bonds matured or were called, we could comfortably reinvest the proceeds into new fixed income securities yielding between 2-4%. Today, most investment-grade bonds with a maturity of less than 3 years have a yield of <1%. (The exceptions would be higher risk companies such as those in the energy patch or highly indebted companies.)  This presents a poor risk/reward scenario for many investors, which some participants have characterized as “return-less risk.”  As a result, we have chosen to not immediately reinvest the proceeds from maturing/called bonds, and will instead look to deploy the cash if/when bond prices sell off (and yields improve) as a result of future volatility.

While it is likely that interest rates will remain low for quite some time, we continue to position our portfolio with mostly short-to-medium duration securities to minimize interest rate risk. The majority of the fixed income component of portfolios is still comprised of investment-grade bonds. While the longer-term upside potential for fixed income today is less than that of stocks, bonds play a critical role in the asset allocation process by providing both current income and relative stability within a diversified portfolio.

Global Markets Outlook

As infection rates began to subside and the world emerged from lockdowns, global markets posted their strongest rally in decades. For the quarter, US small cap stocks led with a 25.4% gain, US large cap stocks represented by the S&P 500 rose 20.5%, emerging markets gained 18.1%, and international developed markets rose 15.1%  The dollar weakened by 2.2% in the quarter, providing a tailwind for US investors in foreign markets.

Source: Bloomberg L.P.

Turning a Corner

The sharp economic contraction from COVID-19 containment policies quickly drove the US and the world into a recession. As we enter 2H20, we continue to believe the recovery could be sharp as well given the rapid policy responses globally and lack of excesses in the economy. However, the cone of uncertainty on the pace of the recovery remains wide. As the world reopens, we see the global outlook predicated on three primary factors: first, controlling the spread and impact of the virus; second, continued supportive monetary and fiscal policy; and third, the pace of recovery in economic activity and corporate earnings.

Given the rapid policy responses globally and lack of excesses in the economy, the global backdrop appears to be improving. A successful therapeutic and/or vaccine and rapid curtailment of the virus frame a bullish case, while rising infections and a second wave of the virus are a clear negative risk.

Evolving Implications from the COVID-19 Pandemic

As the world quickly adapted to the spread of the virus and resulting shutdowns, several trends emerged that we believe are likely to become structural changes. The COVID-19 pandemic and lockdowns accelerated the shift to cloud computing, e-commerce, and digital payments. Ease of access to online workflows with ubiquitous internet access transformed corporate and consumer usage, creating new habits and remote working arrangements. Globally, e-commerce is gaining share, to about 15% of retail sales in the US and over 25% in Asia. We believe that the convenience and cost savings of e-commerce, coupled with lingering concerns of virus risk, should sustain the shift to online activity.

The unprecedented fiscal and monetary stimulus in response to COVID-19 are now estimated at near $11 trillion globally, according to the IMF. This tsunami of liquidity is effectively sustaining economic activity and accelerating the recovery. In the near term, the velocity of the increase in the money supply is curtailed, as most of it is sitting in bank reserves, and is thus not yet inflationary. On the fiscal side, rising budget deficits will likely be addressed with further debt and/or potentially higher taxes.

Prepare for the Unexpected

The range of possible outcomes remains wide, and the violent downturn and subsequent snapback rally in 1H20 demonstrate the need to both prepare for the unexpected and maintain an allocation appropriate for your risk tolerance.

With ultra-low interest rates designed to support economic growth, yields on fixed income and cash remain relatively unattractive, though these instruments still have value in the role of portfolio stabilization. Equity markets appear expensive relative to history with reduced forward earnings due to the pandemic. However, stock markets are forward looking mechanisms and appear to be looking out to an earnings recovery coupled with “lower for longer” monetary policy supporting an economic rebound and higher valuations.

International equity markets remain attractive, with higher dividend yields, lower valuations, and an earlier recovery from the virus pandemic. This year specifically, international allocations can reduce exposure to potentially diminished US corporate earnings, in the event that Democrats make strong electoral gains and subsequently raise taxes.

In constructing resilient portfolios, history proves that a broadly diversified portfolio across and within asset classes reduces overall portfolio risk. And, a diversified portfolio allows investors to prepare for the unexpected by protecting downside with defensive assets and benefitting from the growth of global capitalism.

REIT Commentary

In the second quarter, the MSCI US REIT Index (Bloomberg: RMZ) produced a total return of +11.7%. Year to date, the RMZ has produced a total return of -18.4%. As the market has had some time to digest and flesh out some of the likely scenarios for COVID-19 and its effects on the economy, we believe opportunities abound for active managers.

Although it is still difficult to determine where the entire sector should trade given the uncertainty of timing for a vaccine and the consequences of reopening (or reclosing), we can at least assess REITs on a relative basis. In particular, we are able to assess the near-term and long-term risks of the underlying property types to determine if the market has priced them correctly against each other. Thus far, we have used our proprietary Essential REIT Evaluation tree to determine the relative risk of senior housing, skilled nursing, apartments, and single family rentals. Relevant financial metrics and risk assessments for these sectors can be seen in Figure 1:

Apartments

Due to the high quality balance sheets, low payout ratios, access to capital, and the “essential” nature of a home, apartments have low near-term and long-term risk. Furthermore, as this pandemic and looming recession will only further exacerbate the supply and demand imbalance for housing in this country by shutting down new construction, we argue that long term fundamentals have only improved since the beginning of the year. Of course, a recession will hurt occupancy and rent growth in the near term, especially on new leases. However, this is mitigated in our opinion by the relatively inexpensive valuations.

Single Family Rentals

Going into 2020, American Homes 4 Rent (NYSE: AMH) and Invitation Homes (NYSE: INVH) were enjoying record occupancy rates due to their status as an affordable alternative for families unable to afford a home purchase. Demographics are on the side of single family as millennials are entering “primetime” for starting families. Demand levels could even spike upward if the pandemic forces a shift away from urban, coastal living as their portfolios are tilted toward the suburbs in cities with lower housing costs such as Atlanta, Phoenix, Dallas, and Las Vegas. Adding support to rentals is the tightened availability of mortgage financing for home purchases due to lenders imposing tougher underwriting standards including income tests and down payment requirements. Therefore, in our opinion, near-term and long-term risk are both low.

Senior Housing

Historically, one of senior housing’s most lauded attributes has been its private payer model that was less susceptible to government reimbursement challenges and “stroke of the pen risk.”  Being a relatively non-cyclical business, there was a steady rent stream through economic cycles-until now. COVID-19 has flipped the private payer positive into a negative because it is less likely to have a backstop should tenants come under severe financial stress. COVID-19 headwinds come at time when REITs have already been seeing pre-pandemic rent coverage levels decline over the last decade due to increased supply and rising expenses. Thus, while senior housing is essential for the long term, we believe it carries above average near-term risk.

Skilled Nursing

In contrast, skilled nursing facilities receive 30% of payments from Medicare and 50% from Medicaid, and as a result have received government aid from the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) legislation of $4.9 billion. This equates to $50,000 per facility and an additional $2,500 per bed. In contrast, senior housing only sources 2% of its payments from Medicaid and nothing from Medicare. Thus we believe government aid reduces the near-term risk for skilled nursing facilities to average. Long term, this also carries little risk.

The 2021 cash flow multiples of the above sectors are ranked as follows, from highest to lowest: single family rentals, apartments, senior housing, and skilled nursing. Our analysis contends that skilled nursing should be ranked higher than senior housing, thus meaning that skilled nursing is relatively attractive.


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

Matthew R. Werner, CFA, mwerner@chiltoncapital.com, (713) 243-3234

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