EUROPEAN REAL ESTATE DEBT: WHERE NEXT?
The European lending landscape has been changing, with more varied sources of capital willing to finance the corporate real estate sector.
June marked a turning point in the U.S. economic reopening and reflation outlook. Market conjecture about the timing of peak U.S. growth and inflation coincided with a change in tone from the Federal Reserve. The U.S. central bank hinted at a potential reduction in its asset purchase program, with a nod to inflation markers—such as commodities and wages—that have weighed on markets since the beginning of the year. At the same time, prices of several key commodities declined from their peaks earlier in the year, helping to somewhat calm inflation fears. U.S. and global equities rallied on the improving sentiment, with many indices closing out the first half of 2021 at or near record highs.
The economic recovery has continued to strengthen as the pandemic’s most serious effects wane, particularly in the United States which has among the highest vaccination rates. Although pre-pandemic activity has begun to resume, labor shortages and higher prices of goods continue to weigh on the pace of recovery. The Federal Reserve’s communications have begun to reflect these concerns and we believe it is likely to taper asset purchases sooner than might have been expected at the start of this year. The 10-year U.S. Treasury yield declined to 1.45% at the end of June from 1.74% at the end of March, reflecting changing expectations surrounding a sustainable rate of U.S. GDP growth.
Fiscal stimulus has peaked and is expected to decline as extended state unemployment benefits expire at the end of September. This should help ease labor shortages that have persisted despite higher wages. There remains a revenue windfall from the U.S. Treasury that will be awarded at the discretion of state governments to non-entitlement areas—that is, local counties and cities—that will flow over the balance of 2021. As such, we expect the U.S. public sector to be an unusually strong source of demand and spending over the medium term.
Investors spent much of the first half of 2021 attempting to bisect the equity landscape along themes of growth versus value and economic reopening versus remote work. However, stock price fluctuations over the past two quarters suggest this is a simplistic approach to forecasting the course of equity markets.
In our view, corporate profit growth and economic recovery have been constant factors throughout the year, despite changing expectations about their rates of improvement. Corporate profit growth was strong throughout the second quarter, highlighting the expanding recovery across industries and boosting business confidence to its highest level since before the pandemic. Although U.S. consumer spending remained elevated, the pace began to moderate following reductions in direct payments from the federal government and extended state unemployment benefits. We believe these fundamental markers provide more nuanced insight into the longer-term path of markets and individual beneficiaries.
The pandemic is by no means over and the Delta variant’s spread is affecting the economic reopening outside the United States. We believe that lingering ambiguity surrounding the growth outlook points to continued market volatility ahead, with a positive bias from ongoing upward earnings revisions. Our fundamental research continues to focus on companies with secular growth opportunities that we expect will extend well beyond the pandemic. These durable opportunities have been a source of strong growth this year, and we believe they are poised to offer improving rates of relative growth as the effects of fiscal and monetary stimulus diminish through the back half of 2021 and into 2022.
First quarter earnings results for the S&P 500 improved over last quarter with more companies beating or meeting expectations. Large cap growth stocks resumed their market leadership in the second quarter coming in just ahead of mid-cap growth. In the small cap market segment, value narrowly outperformed growth. From a sector perspective, real estate was the best performing sector in the quarter, followed by information technology, energy, and communication services.
In 2021’s second quarter, the health care sector of the S&P 500 Index rose 8.3%, which was in line with the overall Index, which advanced 8.4%. We believe the pandemic could have a permanent and salutary impact on the health care sector. The past several quarters have highlighted inefficiencies within the system and the serious implications of administrative mismanagement. At the same time, there has been incredible speed of discovery and multiple modalities available within the biotechnology, life sciences, and health care technology industries to address unmet medical needs. As a result, many companies may be able to penetrate their total addressable markets at accelerated rates.
The market saw broader sector participation in the second quarter and financials finished with a return of 8.2% which was in-line with the 8.4% return for the S&P 500 Index. The vaccine rollout and subsequent decrease in U.S. COVID cases, continued strength in the economic recovery coinciding with the reopening, better credit conditions, higher interest rates, and the lingering effects of the second stimulus continued to be tailwinds for the sector during 2Q21. The Fed has signaled that interest rates will remain at depressed levels at least through 2022, and there is still no certainty around whether a higher nominal environment can be sustained. As such, the sustainability of the rally in the sector is uncertain.
Midstream and MLP stocks generated positive returns over the second quarter, with the Alerian MLP Index gaining 21.23%, while the Alerian Midstream Energy Index, which includes not just MLPs but a broader group of midstream infrastructure companies, advanced 16.39%. Improved fundamentals are finally starting to be reflected in stock prices, but may give investors pause given uncertainty in the exact timing of a full reopening of the U.S. and global economies. As economic activity continues to slowly ramp up, stocks should begin to price in not only the short-term economic recovery bounce, but also the long-term positive benefits from the significant transformational corporate reform that has occurred over the past few years. With the Biden Administration unlikely to make permitting easier for new pipeline projects, we believe the value of existing infrastructure could also increase as a result, and we would not be surprised to see M&A and industry consolidation occur over the next 12 to18 months.
Underperformance for the utility sector persisted in 2Q21, as market sentiment continued to favor economically-sensitive sectors expected to benefit from a global economic reopening and rebound in economic activity. The second half of the quarter also saw a rebound in growth-oriented sectors. The combination of these left the defensive sectors, like utilities, trailing the strong performance of the overall market. We continue to find the sector attractive given the still lower-than-average interest rate environment, the sector’s predictable fundamentals, and its ability to provide stable dividends amidst macro uncertainty. We believe it should also provide earnings growth above its historical 3-5% EPS growth, given the potential growth opportunities from renewable energy investments.
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