Portfolio Insight | 3rd Quarter 2017

A few short-lived bursts of volatility in August, caused by North Korean provocation and two devastating hurricanes, represented only a brief pause in third quarter market momentum.

The S&P 500 index closed at 2,519 at quarter end, posting a 4.5% total return for Q3 and bringing 2017 year-to-date gains to 14.2%. Accelerating domestic earnings growth, tame inflation, low interest rates, a weaker dollar, and global economic strength have supported the market’s march to all-time highs. Cyclical sectors like Energy, Industrials, Materials, and Information Technology as well as Financials outpaced the broader market in the third quarter.

 

More of the Same

Market participants have continued to ignore political discord, geopolitical issues, and lack of policy implementation. The largest pullback for the S&P 500 in 2017 has been only 3%, and September typically marks the end of the most challenging seasonal period of the year. Investors who followed the traditional “sell in May and go away” strategy would have missed out on significant continued gains.

Despite the government’s inability to enact any meaningful pro-growth policies so far, it is clear that consumers and corporations are confident. The expectation that taxes will not go higher and regulations will not become more onerous, set against a backdrop of solid credit and employment conditions, has awakened animal spirits. In fact, the economy, which grew at a 3.1% clip in Q2, is doing quite well on its own ahead of stimulus.

 

Body Blows to Texas and Florida

Natural disasters happen from time to time, but 2017 is the first year on record in which two Category 4 storms have made landfall in the continental United States. Hurricane Harvey hit home with our employees and clients and will continue to affect the Houston area for years to come. After making landfall near Rockport, TX on August 25, Harvey spent the next five days meandering slowly around southeast Texas, releasing trillions of gallons of water and causing a flooding catastrophe. Tens of thousands of homes, businesses, and other structures in America’s fourth largest city were flooded, causing major disruptions in production, shipping, and consumption of goods. Energy infrastructure and ports shut down, roads closed, and residents were displaced.

Just two weeks later, another Category 4 hurricane, Irma, hit Florida just east of Key West, causing extensive power outages, wind damage, and flooding. Large cities such as Miami were spared major catastrophic damage, but there was significant economic disruption throughout the Southeastern US.

The ultimate economic impact of Harvey and Irma remains to be seen, but current estimates are in the $150-$200 billion range, and Q3 GDP growth is expected to be diminished by up to 0.8%. Natural disasters tend to negatively impact the economy in the short run due to employment and retail sales disruption, but they can eventually lead to a spike in growth as homes are rebuilt, autos are replaced, etc. We are confident that Texas and Florida can rebuild and regain the growth momentum that has bolstered the nation’s economy for many years.

 

Industrial Revival

A robust and widespread industrial renaissance, driven by increased activity in the oil patch as well as an upswing in global agriculture and mining, is finally underway. Recent Purchasing Managers’ Index (PMI) and capital expenditure data as well as company results have confirmed meaningful improvement in the sector, which had lagged the current economic upturn.

The price of WTI crude oil rose from the low $40’s in June to over $51 at the end of September. Strengthening demand, normalizing supplies, and talk of OPEC output cut extensions have buoyed the commodity, and energy companies have outperformed following a difficult first half of the year. We continue to believe that oil prices will drift higher as supply and demand continue to rebalance.

 

Domestic Equity Outlook

Despite the longevity of the current bull market, we see little evidence of an approaching recession, and the objective markers that would normally foreshadow a bear market are not present at this time. Corporate financial results and commentary continue to suggest that the run has legs despite the bearish prognostications of many market watchers. Until the data on profitability, inflation, interest rates, credit stress, or company commentary changes materially, we will maintain this stance.

We remain vigilant for signs of emerging problems, especially an inversion of the yield curve, which usually precedes a recession but seems unlikely to occur until mid-2018 at the earliest. Even if there is an inversion, markets would typically move higher for at least another a year before eventually rolling over. One potential recessionary catalyst might be sharply higher
inflation and interest rates resulting from greater than expected pro-growth reform or fiscal stimulus while the economy is strong and Texas and Florida rebuild.

All this being said, the strong market move so far in 2017 leads us to expect only modest further gains until there is clearer line of sight to implementation of tax reform, deregulation, and/or infrastructure spending. Short-term volatility and a shallow pullback are to be expected at some point. Despite the relatively high valuation of the S&P 500, our unbiased, process-driven research across a wide range of asset classes continues to yield many new individual ideas with improving business trends and significant upside.

 

Fixed Income Outlook

Investment-grade, high-yield, and municipal bonds all continued to move higher throughout the quarter. The Federal Reserve, having undertaken two rate hikes in the first half of the year, left short-term interest rates unchanged during the quarter. On the heels of geopolitical uneasiness, hurricane damage fears, and tax reform uncertainty, the yield of the benchmark 10-year Treasury fell from 2.31% on June 30 to a bottom of 2.05% in early September before bouncing up to 2.33% at quarter end. While the impact on price has been small, we continue to monitor our municipal bond holdings that may be impacted by Hurricane Harvey.

We continue to believe that interest rates will move higher over the medium-to-long term due to improving global economic growth and Fed policy. The timing of the Fed’s next rate hike remains somewhat uncertain, though market participants put the chances of a December hike at approximately 71%. What is certain is that the Fed will begin the process of reducing the size of its $4.5 trillion balance sheet. After reducing short-term rates to essentially zero during the financial crisis, the Fed also began buying Treasuries and mortgage-backed securities in order to lower a wider range of interest rates and stimulate a broader swathe of the economy (a process known as quantitative easing). Since 2014, the Fed has reinvested the proceeds of its maturing bonds in new bonds, thus keeping its overall holdings steady. Starting this month, the Fed will let its balance sheet gradually decline by allowing a predetermined amount of bonds to mature every month without reinvesting the proceeds. These actions could create some additional volatility in the bond markets and will likely lead to higher interest rates since a major buyer of bonds will have left the market. We continue to position the portfolio in anticipation of higher rates over time by keeping maturities relatively short. Since we buy each bond with the intention of holding until maturity, rising interest rates only cause temporary “paper” declines because the face value of each bond is returned at maturity.

Credit spreads for investment-grade bonds, meaning the incremental yield that investors demand over an equivalent-term risk free investment, are near multi-year lows (see chart below). This indicates that the level of stress in the corporate bond markets remains low today. Factors that help explain why investors are comfortable with credit risk include: the synchronized global economic recovery, record corporate earnings, low corporate leverage levels, and a relative lack of near-term debt maturities (over the past several years, many companies extended the maturities of their debt while simultaneously lowering interest costs). While we continue to believe that fixed income returns will likely be modest over the short-to-medium term, bonds still play an important role in the asset allocation process by providing both current income and portfolio stability.

Synchronous Global Recovery

Global (non-US) equity markets continued their leadership in Q3 with developed markets up 5.5% and emerging markets up 8.0%. The US dollar has weakened about 8% in 2017, providing a tailwind for US investors in international markets and for US multinational companies.

In September, freight and logistics company FedEx reported that global trade is the strongest since 2011. The global recovery is increasing in strength and breadth, and we are seeing evidence of improving global demand in company reports as well as broad economic data. For the first time in many years, all major country PMI’s are indicating expansion, and the International Monetary Fund (IMF) expects the synchronous global recovery to accelerate into 2018, with emerging market economies leading the growth.

As always, an unforeseen shock could trigger a correction in equity markets. However, a downturn would likely be short-lived unless precipitated by a full blown global recession, which we currently view as a low probability given the strengthening economic recovery.

 

Global Allocations

There are several reasons a global portfolio allocation may make sense for some clients today. First, while US stocks appear somewhat expensive relative to history, international valuations are in line with long-term averages, and international markets should benefit from faster growth and a recovery from an earnings trough. Second, we continue to believe that US equity returns will begin to normalize to a 5-7% range, below the averages seen over the past decade. Fixed income returns could continue to be muted by generationally low interest rates and a Fed rate hiking cycle. Lower expected returns in these two major US asset classes suggest that some clients might require a broader asset allocation to achieve their goals and objectives. Third, falling correlations across asset classes should accentuate the benefits of diversification, which Nobel laureate Harry Markowitz called “the only free lunch in investing.” During the financial crisis, markets moved in tandem, exhibiting high correlations and limiting the power of diversification. Today, global cross-asset correlations are near post crisis lows, and portfolios with global diversity should benefit.

 

CCM Global Asset Class Capabilities

Chilton possesses the expertise to develop portfolios to meet client return objectives using a global asset allocation model. We complement our internal strategies for US equities, fixed income, and REITs with allocations to broader asset classes such as US small-cap, international, and emerging markets. We seek to optimize portfolios to achieve the highest long-term risk adjusted returns across a variety of asset allocations.

Chilton portfolios are designed for long-term capital appreciation and current income using securities across multiple asset classes, thus increasing the investable opportunity set to meet specific client needs while reducing portfolio risk. We believe diversifying across global asset classes can increase yield and expected returns while reducing portfolio dependence on US markets.

 

REIT Commentary

The MSCI US REIT Index produced a total return of 0.9% in the third quarter. As of September 30, the MSCI US REIT Index has generated a total return of 3.6% year to date, which compares to 14.2% for the S&P 500. Despite a strong Q2 earnings season by REITs, their underperformance can likely be attributed to the anticipation of further interest rate hikes. As mentioned earlier, though the Fed decided against raising rates in the third quarter, commentary from the FOMC meeting in September significantly increased the probability of a hike in December.

The most significant events during the quarter were Hurricanes Harvey, Irma, and Maria. The effects have been far-reaching, destroying homes and impairing businesses. The economic impacts will endure for months, while personal losses may be permanent.

Some observers may be surprised to learn that REITs with exposure to Texas and Florida significantly outperformed the benchmark in September. First, any destruction creates at least a temporary decline in supply. Second, there are hardly any property types that experience lower demand. In fact, several property types can experience significant demand spikes. We believe the lodging, multifamily, and self-storage sectors should benefit near term, while data centers may benefit longer term.

We expect lodging demand to increase significantly for both the short and intermediate term when a disaster displaces residents in a market with high population density. For example, during the week of September 3-9, Houston RevPAR (or Revenue Per Available Room) was 106% higher in 2017 than in 2016 due to Hurricane Harvey, according to Smith Travel Research. In analyzing the periods before and after Hurricanes Katrina (2005), Sandy (2012), Andrew (1992), and Ike (2008), the surrounding hotel markets had a significant boost in RevPAR for at least the next three months, and sometimes for much longer.

In the wake of a disaster, apartment fundamentals typically experience an uplift due to the need for temporary housing by displaced residents as well as laborers looking to help rebuild. For example, when Florida was hit by multiple hurricanes in 2004, Camden’s (NYSE: CPT) Tampa and Orlando markets had an average increase of 150 basis points (bps) in occupancy from Q3 to Q4 as compared to a 90 bps decline for the overall same store portfolio. As of September 19, CPT’s Houston portfolio has already witnessed a significant increase in demand from Hurricane Harvey, with occupancy rising to 98% versus 93% before the storm.

In our view, self storage fundamentals are driven by available supply and the four D’s of demand- Death, Divorce, Downsizing, and Dislocation. When a market is hit by a natural disaster like a hurricane, dislocation is almost inevitable. As people await home repairs, many have resorted to self storage as a short term solution for storing their belongings that were salvaged. Dave Rogers, the CEO of Life Storage (NYSE: LSI), said that incoming calls for people looking for storage in Houston were up 15 times in Houston over the same period in 2016, and that LSI’s Houston occupancy had risen to 98% now from 93% as of Q2.

Though more difficult to measure in the short and medium term, data center REITs may be one of the biggest beneficiaries of disasters over the long-term. Many companies that have internal data centers may not recognize the benefits of outsourcing data storage until a disaster cuts power or personnel access at exactly the time it cannot afford to lose it. In particular, the data center REITs can now point to 100% uptime during Hurricanes Harvey and Irma.


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

Patricia D. Journeay, CFA, pjourneay@chiltoncapital.com, (713) 243-3222

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

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