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.
QMA remains positive on risky asset classes and continues to overweight stocks and commodities relative to cash. We are also overweight real estate relative to fixed income. Our pro-risk view is driven by the continued strong economic and earnings recovery after the pandemic, the accommodative stance of global central banks, and widespread fiscal support, which has left consumers with excess savings at a time of significant pent-up demand from a year of COVID-19 restrictions. We expect upside growth and inflation surprises could continue through the summer months as we reach peak reopening.
Earnings and GDP growth in the United States should peak in the second quarter of this year with S&P 500 earnings per share expected to grow 65% and U.S. real GDP expected to rise 13%—both year-over-year.1 We think equities and commodities should continue to perform strongly and interest rates should rise as investors stay focused on reflation and reopening. We view the latest decline in interest rates as a temporary consolidation/countertrend move before the next leg up. However, we think the magnitude of any interest rate rise will be limited, given central bank bond buying.
U.S. stocks have been the relative outperformer so far this year because of the U.S.’s supercharged economic rebound, which has been driven by standout performance on vaccine distribution and tremendous fiscal and monetary stimulus. However, U.S. stocks should typically lag during a strong global upturn, given the U.S. equity market’s higher quality and less cyclical market composition. We think non-U.S. equities are likely to take the leadership baton from here on given their cheaper valuation, more cyclical market exposures, and the narrowing of the gap on vaccine distribution between the U.S. and the rest of the world. We think the rotation within the equity markets is intact and sustainable and value/cyclical sectors should continue beating growth/defensive sectors.
Even with big questions hanging over the future of the office sector in the post-pandemic world, REITs were the strongest performers in the second quarter and year-to-date. REITs were a significant laggard last year relative to broader equities and are benefiting from some mean reversion. Meanwhile, beaten-down sectors, such as lodging and hospitality, are bouncing back strongly due to the economy reopening. Finally, with inflation rising, property is benefiting from its status as a “real asset” as investors reallocate exposure away from fixed income.
Within fixed income we stay “risk on,” as well, emphasizing spread sectors such as high yield bonds and emerging market debt over core bonds (Bloomberg Barclays Aggregate Index) given the strength of the global recovery. We think TIPS should continue outperforming nominal bonds, as they have so far year-to-date.
The biggest risk to investors looking forward is that policymakers (both fiscal and monetary) stay too profligate and allow inflation to rise above what investors consider to be benign levels for too long, thereby making the environment prone to the risk of a wage-price spiral. The Fed has shifted to average inflation targeting, assuring investors that it will be patient and reactive in responding to higher inflation that is not transitory, i.e., only when it becomes visible in the data and is persistent. This is positive for stocks in the near term, but it raises the risk that the Fed falls behind the curve and has to tighten much more aggressively down the road. This would be a negative for stocks as aggressive Fed tightening would undermine lofty equity market multiples, putting stock markets at risk of large drawdowns.
In the past, we have discussed the possibility that the pandemic has ushered in a new regime of higher inflation on a trend basis. Further, we are less sanguine about the inflation risks in the short to medium term than what we are hearing from the major central banks. We note that real assets are winners compared to traditional assets in a higher-inflation environment. Commodities and real estate in particular see dramatically improved performance compared to the low (0-2%) inflation period that has reigned over the past decade. Equities have experienced higher returns in the 2-3% inflation environment than when inflation was in the 0-2% range, but lower returns in higher inflation periods. Equities also have a negative beta to inflation surprises, especially in higher inflation periods.
Our research shows that real assets are an effective inflation hedge, as they are likely to outperform nominal assets, such as stocks and bonds, in a period of rising inflation levels and upside inflation surprises, without sacrificing exposure to economic growth. Further, real assets are effective diversifiers to traditional stocks and bonds—the diversified real assets portfolio has a correlation coefficient of 0.6 relative to the 60/40 portfolio over the time period examined.
We are bullish on the outlook for real assets such as natural resources stocks, master limited partnerships (MLPs), and commodities due to strong economic growth prospects, supply constraints, and the increasing possibility of inflation rising and remaining elevated for longer than expected. Oil and other commodities have historically performed well during episodes of rising inflation expectations. Despite structural headwinds from decarbonization, oil prices are likely to remain firm as OPEC’s supply response to the strong oil demand recovery has been fairly restrained. In the case of commodities, such as industrial metals, the supply response, in the form of new mines and expanded production, inherently takes time. While oil prices have rebounded sharply from the lows in 2020, energy stocks, which have just erased their pandemic losses, have not fully discounted the rebound in oil prices. In addition, energy stocks remain relatively depressed compared to the broader market despite their gains in the past year, suggesting that the rally in energy stocks has more room to run.
Midstream energy infrastructure—including MLPs—offers another avenue among real assets to benefit from the rising inflation environment. MLPs rank highly in our models using carry, momentum and valuation factors. Midstream energy sports attractive yields: the yield on the Alerian MLP Index is currently 7.3%, while the yield on the broader Alerian Midstream Energy index is 5.9%—the latter includes C-Corps and generally higher-quality companies.2 Meanwhile, MLP valuations are very attractive relative to history, roughly near the top 10th percentile in terms of attractiveness. Moreover, the momentum score in our models for MLPs has just started picking up in the past few months, suggesting that the positive streak for MLPs could just be starting.
1 Source: FactSet as of 7/1/2021.
2 As of 6/18/2021.
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