Portfolio Insight | 4th Quarter 2019

 
After a harrowing end to 2018, which left the S&P 500 at a depressed starting point, an accommodative Federal Reserve and progress on trade wars drove the index to new all-time highs in 2019. Stocks gained ground each quarter, including a +9.1% fourth quarter move, finishing the year with a +31.5% total return, the strongest gain since 2013.

The top performing sectors for the year were Information Technology, Communication Services, and Financials, while the worst performing sectors were Energy, Health Care, and Materials. For the fourth quarter, Information Technology, Health Care, and Financials stocks led the way, while Real Estate, Utilities, and Consumer Staples lagged. Notably, value stocks enjoyed a strong resurgence of performance relative to growth stocks in the back half of the year, beginning a trend that could continue.

Signs of Stabilization

The lingering effects of Fed tightening in 2018 and the anxiety of persistent trade tensions combined to slow the global economy in 2019. Industrial cyclical companies, predominantly in the energy, materials, industrials, and technology areas, felt the impact most keenly. As 2020 begins, however, there are signs of global growth stabilization and Manufacturing PMIs, New Export Orders, and OECD Composite Leading Indicators are recovering. Continued monetary stimulus and trade war de-escalation could contribute to a meaningful re-acceleration of global growth in 2020.

Trade War Relief

Days before new tariffs on $160 billion worth of Chinese imports were set to go into effect, the US and China agreed in principle to a “phase one” trade deal, removing a potential market concern before year end. The deal took threatened December 15 tariffs off the table, left $250 billion taxed at 25% (instead of the threatened 30%), and halved the 15% duty on about $120 billion of Chinese goods. Presumably, China has agreed to increase its total purchases of US goods and services by at least $200 billion over the next 2 years, including $40-$50 billion of agricultural products. China also made meaningfully positive commitments regarding financial services access as well as intellectual property protections, currency management, and forced technology transfers.

“Phase two” negotiations are expected to begin after the first deal is signed in mid-January, and might attempt to tackle tough topics like data localization, cyber intrusions, and the curbing of Chinese subsidies to state owned firms. Trade war de-escalation is clearly positive for the global economy.

Another positive development on the trade front was the US House of Representatives’ recent passage of the United States-Mexico-Canada Agreement (USMCA), a replacement for NAFTA that is expected to pass the Senate in early 2020 and be ratified by the countries involved shortly thereafter. It enjoyed strong bipartisan support in an otherwise toxic political environment and should be a material catalyst to US employment and overall economic growth.

Election Expectations

2020 promises to be a circus from a political standpoint. Joe Biden remains the frontrunner to be the Democratic presidential nominee, while Elizabeth Warren, after significant gains three months ago, has dropped precipitously in popularity and now polls below Bernie Sanders at the national level. The stock market has largely ignored the impeachment of President Trump, and the Senate has always been unlikely to convict and remove him. Further, the time-consuming impeachment inquiry appears to have possibly benefited Trump, as public support for the action and removing the President from office appears to have fallen since the initial announcement, especially in key battleground states. A head-to-head election between Trump and Biden could be a toss-up, with a possible edge going to Trump if the economy remains reasonably strong up to decision day.

Across the pond, Boris Johnson’s conservative party secured a landslide victory in the recent UK election, bringing some clarity to the Brexit question. Markets welcomed the reduced uncertainty, though the terms of the departure must still be finalized.

Domestic Equity Outlook

While the S&P 500 ended 2019 near an all-time high following a +31% run, we believe the outlook for total return over the next year is less favorable than it was a year ago, but still positive.

A potential re-acceleration of the economy following the recent short-term easing of trade tensions, along with low likelihood of a near-term recession, bode well for continued stock market gains in 2020. The US consumer should remain strong due to low unemployment, wage growth, low interest rates, and benign inflation. If those more cyclical areas of the economy (industrials, materials, etc.) that have been hampered by trade wars inflect higher, modest earnings growth is likely to continue. Multiple expansion is unlikely, though low inflation and an “on-hold” Federal Reserve support the current market valuation. In sum, earnings growth and dividends alone can support positive mid-single-digit type total market returns. Greater upside would likely require a significant pick-up in economic growth, while a re-escalation of trade wars would probably skew returns lower.

We are maintaining fairly balanced equity portfolios, composed mostly of high quality core stocks with some high growth and deep value names around the edges. Our recent research efforts have focused on smaller large-cap-core and value names, as a lasting pick-up of economic growth could favor such businesses. Regardless of stock style box categorization, we always seek catalyst-driven stories with attractive upside and portfolio fit considering relevant risk exposures.

Fixed Income Outlook

Following a late 2018 sell-off triggered by uncertainty surrounding the economy, trade, and Fed policy, fixed income returns in 2019 proved to be a pleasant surprise, with the Bloomberg Barclays Aggregate Index rising 8.7%. Returns were propelled by a rebound in bond prices and continued downward pressure on interest rates. 10-year Treasuries yielded 1.92% at year-end versus 2.69% at the beginning of the year. It is worth noting that the 10-year yield actually bottomed in early September at 1.45% as pessimism over a trade deal and global growth concerns spooked the markets.

On October 30, the Federal Reserve cut its benchmark interest rate for the third time this cycle, as shown in the chart on the right. Fed Chairman Jerome Powell indicated that the committee is unlikely to cut rates any further unless the economy weakens significantly. The committee is also of the opinion that this rate level is sufficient to support moderate economic growth, maintain a solid job market, and keep inflation in check. The financial markets agree with this assessment and are predicting no further Fed action during 2020.

We have continued the process of marginally reducing risk in our bond portfolio. We find an unfavorable risk/reward for many corporate bonds, especially high yield, given the recent rally in bonds and late stage of the economic cycle. While we are comfortable holding our existing bonds to maturity, for those clients with maturing bonds or who have excess cash, we have been buying short-term US Treasury securities. Our reasoning is as follows: 1) the incremental yield available by buying corporate bonds compared to Treasuries is minimal due to their recent rally, 2) the absolute yield of short-term Treasuries is modestly higher than money market rates (the yield on 3-month Treasuries at year-end was 1.55% while the yield for a money market is closer to 1.32%), and 3) in the event of a market disruption, we could sell our Treasury positions (which would have likely rallied) to purchase attractively priced corporate bonds.

While it is possible that interest rates may remain at relatively low levels for an extended period of time, we are still positioning the portfolio with mostly short-to-medium duration securities to minimize interest rate risk. The majority of the fixed income portfolio is comprised of investment-grade corporate bonds that we intend to hold until maturity. Looking ahead to 2020, we believe a reasonable estimate of fixed income total returns could be +2-4%. While the upside potential for fixed income is less than that of stocks, bonds continue to play an important role in the asset allocation process by providing both current income and stability within a diversified portfolio.

Source:  Board of Governors of the Federal Reserve System

Global Markets Outlook

Global markets thundered ahead in Q4, driven by de-escalation of the global trade wars, easy monetary policy, and an improving global growth outlook. Emerging markets led the way up 11.7%, US small cap stocks rose 9.9%, US large cap stocks represented by the S&P 500 rose 9.1%, international developed markets rose 8.2%, and US small cap stocks rose 9.9%. The US dollar weakened by 2.8%, providing a tailwind for US investors in foreign markets.

Capital markets in 2019 exhibited remarkable strength, though this is not unusual in a late cycle environment with low interest rates driving valuation expansion. For the full year, US large cap stocks led with a 31.5% gain, US small cap stocks rose 25.5%, international developed markets grew 22.8%, and emerging markets rose 18.6%.

Source: Bloomberg L.P.

Following nearly two years of weaker global growth and manufacturing activity, the strong finish for 2019 was predicated on emerging green shoots of an economic recovery. The expansion appears intact with a partial trade deal, synchronized global easing, and pro-growth election rhetoric in the US potentially driving an acceleration of global economic activity into 2020. Based on our expectations for continued earnings growth and higher dividend yields, set against a backdrop of improving economic activity and the late-cycle position of the markets, we continue to expect global markets to generate mid-single-digit annual returns over the next several years.

Preparing for Volatile Markets

We do not believe, however, that the strong returns in 2019 and the improving growth outlook constitute an “all clear” signal for investors. As mentioned before, the risk of political uncertainty, lingering global trade disputes, and the pace of global growth remain in flux. The future is uncertain, but we do know that nothing lasts forever. The world is cyclical. A recession will eventually arrive and induce a bear market. Recent Mideast tensions could escalate further. As such, positioning for volatile markets requires continued vigilance and a focus on the things within our control.

We advise clients to prepare for uncertainty in multiple ways. First, thoughtful reflection on the purpose and goal of investment portfolios allows us to develop a wealth plan according to our client’s risk profile. When markets do correct, we must remember that market ebbs are normal, and that volatility often exacerbates our behavioral and cognitive biases. To prepare for uncertainty, we highlight the benefit of diversification and a broader asset allocation. For risk-averse clients, we suggest reducing downside with defensive assets, such as a mix of cash and bonds, to mitigate equity drawdowns. Finally, we must strive to stay focused on events within our control. We can’t control the markets, but investors can control spending, savings, and tax-efficiency. Integrating multiple areas of our client’s lives and developing a goal-based plan to invest in volatile markets is a central facet of how we help our clients achieve their investment goals.

As the decade draws to a close with markets near all-time highs, reflecting on asset returns by decade is instructive. What a difference a decade makes! Ten years ago, the S&P posted one of the worst ten year periods on record. Despite the “lost decade” that included 9/11 and the Great Recession, long-term capital returns are driven by continued earnings growth, and illustrate the power of capital markets.

Sources: Bloomberg LP, MSCI, Ibbotson, Duff & Phelps, FTSE NAREIT

REIT Commentary

In 2019, the MSCI US REIT Index (Bloomberg: RMSG) produced a total return of +25.8%, beating our initial forecast of +12-17% handily. However, as a result of the “revaluation” of REITs mostly due to the strong economy and falling interest rates, we updated our 2019 forecast to +22-29% on September 1, which ultimately proved timely and accurate. Our projections on the economy proved correct as well, given job and GDP growth only slightly decelerated from 2018, and we did not enter a recession.

What did we get wrong?  Our projection that interest rates would be “range-bound” certainly was a “miss.”  Instead, the 10-year Treasury yield dropped by 77 basis points (or bps), from 2.69% on December 31, 2018 to 1.92% on December 31, 2019. This caused REITs to trade at higher multiples on cash flow than we had anticipated.

2020 REIT Forecast

We believe 2020 has a good chance of achieving double digit total returns again. Wall Street projects FFO growth to be in the +4-5% range, which is acceleration from the expected 3.4% for 2019. Similarly, AFFO growth should be in the +5-6% range, which is almost double the 2019 estimated growth of +2.9%. Combining the cash flow growth with a dividend yield of 4% as of December 31, 2019, we are able to get to a base case of a +9-10% total return for REITs assuming no change in multiples.

We also use NAV growth, change in NAV premium, and dividend yield to forecast REIT total returns. We believe fundamentals are sufficiently strong to support equity REITs trading near or in-line with NAV, which would be consistent with the 30 year average. As of December 31, 2019, REITs were trading at a 3% NAV discount, which leaves room for a 3% increase in premium to get to the historical average.

Assuming slight deceleration of SSNOI growth from +2.50% in 2019 to +2.25% in 2020 (+3.7% using leverage) and free cash flow after dividends and maintenance capital expenditures of 1.3%, we project NAV growth to be +5% assuming no change in cap rates. Combining the +5% change in NAV and an expected -1% to +3% change in NAV premium, we believe REIT prices will finish the year 4-8% higher, and the additional 4% in dividend yield helps to arrive at an overall REIT index forecast range of +8-12%.   

Risks to the REIT Forecast

The biggest risks to our forecast include an abrupt increase in interest rates and a decline in demand commensurate with a slowing economy. Due to the length of the construction cycle, we do not see supply as a major risk to REITs on a blended basis.

A rise in interest rates without a reacceleration in economic growth could cause cap rates to increase, which could decrease REIT prices. As of December 31, 2019, the weighted average REIT implied cap rate was 5.5%, which is below the historical average. However, we feel comfortable with the current valuation given that the 10-year Treasury yield was 1.9% as of the same date, resulting in a spread (difference) between the two of 360 bps. This compares to the historical average of 360 bps, indicating that REIT prices are actually fair.

Similarly, the spread between the dividend yield and the 10-year Treasury yield is more than adequate. In fact, the 200 bps spread as of December 31, 2019 compares to the long term average of 130 bps, which implies a cushion of over 70 bps! We expect REITs to increase dividends another 5% in 2020, which would imply a total return of 8.9% assuming a constant dividend yield, giving further credence to our 2020 total return forecast.

From a demand perspective, we believe the biggest risk is a recession or a major change in job growth. Though possible, we view 2020 as unlikely to surprise to the downside. 2020 is more likely to experience less disruption from tariffs than 2019. This should lead to increased business confidence, investment, and hiring. Current consensus estimates call for job growth to be slightly lower than in 2019, which would bode well for commercial real estate. Providing further protection for REIT investors, any downside surprise would likely drive the 10-year Treasury yield lower again, which could have a positive (or at least relatively positive) effect on REITs.


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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