Portfolio Insight | 4th Quarter 2017

Robust corporate earnings results, the strongest holiday spending in six years, and significant tax reform powered the market to a 6.6% total return in Q4.

The S&P 500 index closed 2017 at 2,673, posting a heady gain of 21.8% for the year. The best performing sectors for the year were Information Technology, Consumer Discretionary (Amazon, in particular), and Materials. These three sectors, as well as Financials, led the market in Q4.

A Banner Year

2017 was one of the least volatile market years on record, with no S&P 500 pullbacks of even 3% and stock gains in every single month. This was a surprise in the face of political fighting, natural disasters, and geopolitical risks but supported by strong global economic growth, subdued inflation, and low interest rates.

Boosted by momentum following the 2016 presidential election and the pro-business policies of the current administration, the economy picked up its pace early in 2017 – and never let up. Confirmation of meaningful tax reform in Q4 provided another catalyst.

Bubbly Bitcoin

Even 20%+ equity returns can’t steal the headlines from another high profile, high volatility asset class in recent months, however. Bitcoin “mania” reached a fever pitch during Q4. After starting the year below $1,000, speculators boosted the price of the virtual currency to nearly $20,000 in November before selling it down to near $14,000 at year-end (see below). With such eye-catching price movements, many investors may worry they’re missing out on the bonanza. We’d propose caution.

Bitcoin is a virtual cryptocurrency traded publicly on a digital block-chain, or distributed ledger that is controlled by users. Because of extreme volatility and lack of government backing as legal tender, bitcoin is not broadly used as a medium-of-exchange, and very few merchants currently accept it. There is, in theory, a limited supply of virtual coins which are “mined” by computers solving problems of increasing complexity. However, a major risk is that the supply won’t remain fixed in the future. Furthermore, new cryptocurrencies seem to be popping up every day.

From an investment standpoint, there is no reasonable way to value cryptocurrencies, and unlike gold, which has value as jewelry and in industrial applications, bitcoins do not store any value. Cryptocurrencies enable illegal money transfer and are also vulnerable to hacking. If someone breaks into your “digital wallet,” they can steal your cryptocurrency – and banks, credit card companies, and governments will not reimburse you. Governments could eventually decide to outlaw bitcoin, or even offer their own competing digital currencies, which could render other digital currencies, such as bitcoin, worthless.

In another sign of the mania, some companies started simply changing their names to include references to block-chain technology – and were rewarded with huge stock gains. One example is Long Island Iced Tea Corp., which saw its stock move from $2.44 to $6.91 in one trading day after it announced a shift in focus from making iced tea to exploring opportunities in block-chain. Echoing concerns of Warren Buffett and others, the SEC recently warned investors of the dangers of speculating in what is, at present, a largely unregulated market. However illogical the bitcoin market seems, the underlying block-chain technology is interesting as a potential source of investment opportunities (just not, at this stage perhaps, in the form of an iced tea company).

Tax Cut Catalyst

In late December, President Trump signed the most significant tax reform for both businesses and individuals since the mid-‘80s. Highlights include a reduction in the corporate tax rate from 35% to 21%, the lowest level since 1939, and a lower, one-time repatriation tax to encourage US companies to bring overseas cash hoards back home.

The major reduction in corporate tax rate, ability to repatriate overseas cash, and deduction of costs of depreciable assets in one year (as opposed to the previous, multi-year amortization standard) should lead to favorable, earnings-accretive actions by businesses. These actions, in turn, could give a meaningful boost to the economy. More profitable companies can increase wages, pay bonuses to workers (AT&T and Comcast have already announced just such measures, for example), invest in equipment, pay dividends, or buy back stock. The ultimate economic impact of tax reform remains to be seen, but we believe that it can fuel further gains for the market.

At the individual level, income tax rates will be reduced, with the middle class likely seeing significant benefits. More disposable income could lead to even stronger consumer spending than we have seen recently.

Domestic Equity Outlook

The market tends to follow corporate earnings, and thanks to an already strengthening economy and significant tax reform, profits should accelerate in 2018. A risk is that the tax cut benefits, added on top of an already strong economy that is benefitting from an industrial rebound and deregulation, could boost inflation to a point where the Fed would become more aggressive with interest rate hikes. A significant increase in borrowing costs could negatively impact demand for goods and services by consumers and businesses, leading to a recession-led bear market. However, we believe this is unlikely to happen in 2018.

The current environment is conducive to another year of positive gains, although perhaps not as positive as those of 2017. A total return for the S&P 500 approaching 10% is possible, though we are on high alert for factors that could derail the market, and we expect to see volatility and a correction at some point. Mid-term elections, faster-than-expected rate increases, or war with North Korea could cause a downdraft.

With tax reform as its most recent catalyst, the US stock market continues to be a good place to generate meaningfully positive returns. Despite the longevity and surge of the current bull market, we continue to find companies with significant catalysts and upside as we build smart, risk-managed portfolios to help clients achieve their objectives.

Fixed Income Outlook

Fixed income returns were positive once again in 2017, as investors benefitted from both interest income and capital appreciation. Longer-term interest rates ended the year slightly lower than where they started, while solid company fundamentals continued to drive corporate credit spreads tighter. Tightening corporate credit spreads (meaning the incremental yield of a corporate instrument over an equivalent-term risk free, i.e. Treasury, investment) and lower interest rates have been tailwinds for the bond market in recent years, but this may not persist into 2018. Due to the relative health of the economy, it is likely that spreads will remain low and trade in a relatively narrow range for most of the year. Interest rates should move higher over the medium-to-long term due to improving global economic growth and Fed policy. Fiscal stimulus from the recently implemented tax bill, higher commodity prices, and potential wage pressures from a tight labor market could also push inflation/rates higher.

In February, Jerome Powell will replace Janet Yellen as Federal Reserve Chairman. Markets have reacted favorably to Powell’s appointment given that he is likely to adopt Yellen’s dovish framework of gradual increases to short-term interest rates and gradual reductions to the Fed’s balance sheet. As with the Yellen Fed, the pace of rate hikes under the Powell Fed will be highly data dependent, thus lowering the chances of an overly aggressive hiking cycle that could potentially push the economy into a premature recession. Nonetheless, the market expects the Fed to raise short-term interest rates an additional 2-3 times in 2018. Since longer-term rates are unlikely to move up as quickly as short-term rates, the yield curve is likely to flatten. If the yield curve were to actually invert, we would likely adopt a more defensive posture across the entire portfolio. It’s important to note, however, that while inverted yield curves are generally a good indicator of an upcoming recession, the lag time between inversion and recession is typically 1-2 years.

Given our view that interest rates should move higher over time, we continue to position the portfolio with mostly short-to-medium duration securities. As rates move higher, we plan to reinvest the proceeds from maturing bonds into longer-term, higher yielding securities. We also continue to utilize floating rate bonds, whose coupons adjust higher as interest rates rise. Looking forward to 2018, we believe a reasonable estimate of fixed income total returns in 2018 could be 2.5%-3.5%, with the bulk of return coming from interest income rather than capital appreciation. While fixed income returns may remain modest over the short-to-medium term, bonds continue to play an important role in the asset allocation process by providing both current income and portfolio stability within a diversified portfolio.

Broadest Global Growth in a Decade

The global synchronized recovery continues to strengthen. In 2017, for the first time in over a decade, economic activity accelerated across all major developed and emerging markets simultaneously. The lingering economic impacts of the Great Financial Crisis, the commodity crash, the Eurozone malaise, and the Chinese slowdown all abated in 2017, driving global expansion in industrial production and consumer spending.

The corresponding recovery in earnings growth powered strong equity returns in 2017, with international markets outperforming the US. Emerging markets led the pack at +37.5% while developed international markets rose 25.7%. This compares to the S&P 500 at +21.8% and US small cap stocks at +14.6%. Moreover, the US dollar weakened 8% in 2017, which further boosted international equity returns for US investors.

Outlook for Global Markets

We are optimistic that improving global economic conditions should sustain broad corporate earnings growth into 2018, continuing a favorable environment for global equity markets. In the US, tax reform could lead to a 10% earnings boost to S&P 500 earnings in 2018, and US small cap companies, with their higher domestic exposure, may see a mid-teens earnings benefit.

However, consistent with our view that US stock returns are likely to eventually revert to a lower long-term trend, and with bond yields near generational lows, we believe that a broader asset allocation might be required to meet some client goals and objectives. The US economy is currently in the midst of its 3rd longest expansion period since 1900, implying that the US economy is further along in its recovery cycle than the global economy. This distinction is evident in market performance over the past decade. As seen in the chart above, total returns for international markets grew 2-3% per year over the past ten years, while US markets grew 8-9% per year. US corporate earnings are setting new highs, while international earnings expectations are still 20% below previous peaks. Valuations for international markets are in line with long-term averages and at a wider than average discount to the US. With lower valuations, faster growth, and a recovery from an earnings trough, we believe international markets may continue to catch up to the US.

As mentioned earlier, a primary risk to this outlook is an acceleration in inflation, causing central banks to tighten too aggressively, which could derail the bull market. According to Ben Graham, “the essence of investment management is the management of risk, not the management of returns.” Even in the midst of a bull market, it is critical to maintain proper diversification and asset allocation. We are constructing broader asset allocations to mitigate the impact of the next downturn, while meeting our client’s long-term goals.

REIT Commentary

The MSCI US REIT Index produced a total return of +1.4% in Q4. For 2017, the MSCI US REIT Index generated a total return of +5.1%. Despite finishing the year within our projected range of +5-7%, REIT performance could be characterized as “unremarkable” when compared to the S&P 500’s total return of +21.8% for the year.

However, REITs provide a completely different risk-return profile than traditional equities. While they can produce returns of similar volatility (the best REIT was up over 50% in 2017 while the worst was down over 80%), the cash flow streams are more stable. Revenues may not double or triple as they can for tech companies in the S&P 500, but they also generally have a much smaller downside. As long as REITs can produce dividend growth above inflation with a low risk profile, the sector will be an attractive long-term investment, marked by short-term changes in valuation.

As we head into 2018, we believe the risks associated with REIT dividends and dividend growth are near all-time lows. Balance sheet strength, portfolio quality, and payout ratios have never been better. One way to quantify the perceived risk of REITs is through the difference between the REIT dividend yield and the US 10 year Treasury yield, or the “spread.” A higher spread would indicate that investors would like a bigger cushion over a risk-free investment due to a higher perceived risk, and vice versa. As of December 31, 2017, the dividend yield of the MSCI US REIT Index was 4.1%, which compared to a yield of 2.4% for the US 10 year Treasury bond. The 170 bps spread between the two compares to the historical average of 110 bps.

Even with the low risk associated with REIT dividends today, we assume no change in the dividend yield spread in 2018 in each of our scenarios. In our base case scenario where the US 10 year Treasury yield finishes the year between 2.4-2.6% and REITs grow dividends by 5.7% (Citigroup estimate), the total return for REITs would be in the range of +5-10%.

Our base case of +5-10% is supported by a net asset value (or NAV) approach as well. As shown in the chart below if we assume NAV growth of 5% through levered same store net operating income growth of +3.7%, additional return of +1.6% from the reinvestment of free cash flow, and no change to capitalization rates (or “cap rates”), the total return would be +9%. Even if cap rates were to rise 25 bps, the total return would be +4%.

In both cases, there is an assumption of no change to the NAV discount. This is similarly conservative given that REITs were trading at a 6% discount to NAV as of December 31, 2017, which compares to the historical average of a 1% premium.

Our assumptions may prove conservative given the positive effects attributable to tax reform. First, the bill does not repeal any of the benefits currently available to REITs. Notably, there is no change to their business interest deductibility, deferred taxes on like-kind exchanges, or tax-exempt status.

Second, the reduction in corporate taxes for non-REITs should boost overall demand for commercial real estate across all property types. Furthermore, retail real estate should benefit from the expected rise in disposable income by consumers.

Third, the bill reduces the maximum tax rate that an individual will pay on the “ordinary income” portion of REIT dividends. Averaging about 70% of the dividend historically, the ordinary income portion was historically taxed at an individual’s top marginal rate, which was 39.6% in 2017. The bill proposes that REIT ordinary income be treated as “pass-through income,” which is subject to a 20% deduction. When combined with a new top bracket tax rate of 37%, the new maximum tax rate on REIT dividends is 29.6%, and the after-tax yield for REIT investors rises by almost 30 bps. In theory, the base case scenario presented above could support a 10 year US Treasury yield 30 bps higher due to this change, creating an even larger cushion to our conservative outlook.

In addition, the tax bill could increase demand for multifamily, particularly in states with high state and local taxes (or SALT). Limiting SALT deductions to $10,000 and deductibility of interest on mortgages with $750,000 (versus $1 million prior) in principal will tilt the scale further toward the decision to rent instead of buy. We are overweight the multifamily sector in the Chilton REIT Composite.

 


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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