Risk assets clipped by higher rates

Market index returns

Week to date since October 02, 2024 as of October 09, 2024

Index definitions: Global Real Estate = FTSE EPRA/NAREIT Developed Index; Global Infrastructure = Dow Jones Brookfield Global Infrastructure Index; Natural Resource Equities = S&P Global Natural Resources Index; Commodity Futures = Bloomberg Commodity Index; TIPS = Barclays US TIPS Index; Global Equities = MSCI World Index; Real Assets Index = 30% FTSE EPRA/NAREIT Developed Index, 30% Dow Jones Brookfield Global Infrastructure Index; 15% S&P Global Natural Resources Index; 15% Bloomberg Commodity Index, 10% Barclays TIPS Index. Source: Bloomberg, DWS. Past performance is not indicative of future results. It is not possible to invest directly in an index.

Market commentary

Global equities rose slightly higher during our review period, but it was far from a linear path. The East Coast port strike ended as quickly as it started, and a blowout jobs report helped put markets in good spirits. Then, higher interest rates, falling expectations of another 50 basis point (bps) cut from the U.S. Federal Reserve (Fed), withering optimism on China’s announced stimulus, and a second major hurricane (in as many weeks) to make landfall in the U.S. dampened market sentiment. Still, broader markets managed to grind higher, but market volatility (per the VIX Index) also moved higher. Crude oil prices and U.S. dollar strength picked up too, with tensions high between Israel and Iran. Israel is launching almost daily strikes into Lebanon with Hezbollah reciprocating in kind, while the world holds its collective breath to see what sort of response Israel will have for the October 1st missile attack from Iran.^[1]

All Real Assets classes saw negative returns during our review period. Treasury Inflation-Protected securities (TIPS) declined the least and were closely followed by Global Infrastructure securities, which saw the Americas Midstream Energy segment provide some resiliency. Natural Resource equities had slightly larger losses, and Commodities fell even more; both were helped by rising crude oil prices, but those gains were eclipsed by declines in industrial metals and the related mining names. Global Real Estate securities were the laggards, with Asia ex Japan property stocks, Canadian Real Estate Investment Trusts (REITs), and U.S. Industrial REITs dragging the asset class down.^[1]

Why it matters: While things seemed pretty rosy in the latter half of August, the first week and a half of October was a tougher slog. Economic indicators on employment have been mixed, and inflation might be creeping higher, giving the Fed reason to pause on further rate cuts. What perhaps worries us the most is the situation in the Middle East, where Israel has yet to retaliate for the recent Iranian missile strike. Will Israel’s response be a slap on the wrist, or will they strike energy infrastructure and possibly even nuclear sites in Iran? And then what will Iran do in return? We also edge closer to the U.S. Presidential Election, where a clear favorite to win remains unknown, but the outcome could shape foreign and domestic policy for years to come. And then there’s the weather, which cannot be controlled nor reliably predicted, but yet has the power to cripple ports, ravish agricultural crops, and create wild volatility in the energy markets, especially for natural gas.

Macro Dive: We’ll first look at the minutes from the Fed’s September meeting that maybe weren’t as dovish as expected. Next, we’ll review the latest inflation indicators in the U.S. and what they mean for the calculus of the Fed’s November meeting. Then, we’ll give a quick recap of what’s going on in the bond market.

Wait a minute: Minutes from the Federal Open Market Committee (FOMC) meeting on September 17 & 18 were released and showed that some members had reservations about providing a 50 bps cut to the Federal Funds target rate, preferring a more measured 25 bps cut instead. All participants agreed it was time to ease rates, but it appeared there was a healthy debate on the size of the cut to be enacted, with some favoring a more gradual path towards normalization. While the committee discussed that elevated inflation in the first quarter was “a temporary interruption of progress,” almost all members felt inflation was on its way towards a 2% level. We would also note, this clause from the minutes: “Almost all participants saw upside risks to the inflation outlook as having diminished, while downside risks to employment were seen as having increased,” which should not come as a surprise given the fewer jobs created in both July’s and August’s non-farm payroll data, which were 89k and 142k respectively at the time of the meeting. We will have to wait and see if that view still holds given the more robust 254k jobs created in September, the declining unemployment level, and more recent inflation data (some of which is reviewed below).^[2]
Some Like It Hot: But probably not the Fed when it comes to inflation. Consumer Price Index (CPI) and Producer Price Index (PPI) data in the U.S. was released this week, and both tilted towards the higher-than-expected category. Headline CPI for September was 0.2% month-on-month and 0.3% for core (excluding food & energy); both were the same as August but both 10 bps above expectations. The headline year-on-year print of 2.4% was 10 bps below August but again 10 bps above estimates, while core CPI year-on-year was 3.3%, 10 bps above August and expectations. PPI month-on-month data for September was tame (flat for headline, 0.2% core) landing inline or better than estimates and the prior month, but the year-on-year numbers gave some concern. To start, August’s headline and core prints were revised higher by 20 bps to 1.9% and 2.6%, respectively, and September’s core PPI was higher yet at 2.8%. Personal Consumption Expenditures (PCE) might be a better gauge for the Fed, which they’ll get one more read of before their next meeting. As initial jobless claims popped to 258k last week and continuing claims rose to 1,861k (both higher than estimated and the prior week), clearly the Fed will have some thinking to do. However, investors (per Fed Funds futures) have ruled out another 50 bps cut and are giving a ~15% chance of no cut in November.^[3]
Bonds throw a curve ball: U.S. Treasury yields have been rising lately on both the short end and long end of the curve, which could be one factor weighing on Global Real Estate securities. As we write, the 10-year Treasury yield is on the cusp of breaking through 4.1% (which hasn’t been seen since July) after almost falling below 3.6% in mid-September. The 2-year Treasury breached 4.0% this week (although it is just below that level now) after almost falling to 3.5% in September. Of note, the 2s-to-10s curve has been positive since early September (currently at 13bps) after spending over two years inverted starting in July 2022. The cause for the rise in Treasury yields is almost evenly split between inflation expectations and real rates. Inspecting the recent ~50 bps rise in the 10-year Treasury yield, exactly 25 bps of the increase can be seen in the 10-year inflation breakeven. The 5-year breakeven has risen even more during the same time, up 33 bps to 2.29%. One final item we’re watching closely is credit spreads, which have contracted during this time, with BBB spreads down 14 bps to 1.13% and high yield spreads down 32 bps to 3.19%, indicating corporate borrowers are not feeling the full brunt of rising Treasury yileds.^[3]

Real Assets, Real Insights: First, we’ll survey the changing field of direct real estate ownership in Europe. Then we’ll look at how Hurricane Milton is impacting infrastructure assets. Finally, we’ll review a trade war that has China calling “sour grapes”.

The Times They Are a-Changin’ (Real Estate): And real estate is changing too. The DWS Real Estate team released a paper titled “The Changing World of Real Estate” this week, which highlights the shift in European property types in core institutional direct real estate ownership. This is a trend we have witnessed and illustrated in the U.S. listed real estate space for a while. For instance, office and retail properties are a lesser proportion of major listed real estate indices than they were 10 or 20 years ago, while industrial and residential have grown their share. Newer and once niche property types, such as self storage, healthcare, and data centers, have become more mainstream and are now widely accepted in both the listed and direct real estate markets. The paper goes even further and highlights some of the secular trends that should drive further growth in these “newer” property types. For your enjoyment, the full research paper can be found here.^[4]
Rock You Like a Hurricane (Infrastructure): Reports of the damage from Hurricane Milton are still coming in, but we thought it worthwhile to address how it affects the infrastructure space. At the highest level, Tampa avoided a direct hit and a worst-case scenario, but early estimates indicate as much as $75B in damage. Within the electric utilities, as of Thursday morning, Florida Power & Light Company, owned by NextEra Energy, Inc. (NEE), stated they had ~1.2M customers without power and expected that number to rise, while Tampa Electric, owned by Emera, Inc. (EMA), stated more than 840k customers were without power, and Duke Energy (DUK) indicated ~850k customers without power. While the utilities will incur expenses to restore power, to the extent there is considerable utility infrastructure damage, Florida is considered the gold standard for recovering restoration costs in a timely manner. Within Transports, we counted at least 10 international and regional airports closed, including Southwest Florida International, Orlando International, and Tampa International. Over 10,000 flights will have been cancelled or delayed by the time normal operations are resumed. Port Tampa Bay and Sarasota Port were closed on October 8th, while Port Canaveral was closed on October 9th, affecting cruise lines, shipping lanes, and cargo operations; all remained closed at the time of writing. The energy segment was largely unaffected as there weren’t any significant offshore rigs or platforms in the path, although some pipeline systems and terminals in the Tampa area where briefly shut down.^[5]
China sees the grapes of wrath (Commodities): In what could have profound implications for industrial metals (especially those used in batteries) and agricultural commodities, a trade war is brewing between China and the European Union (EU). The recent spat started when the EU voted on October 4th to impose tariffs as high as 45% on Chinese electric vehicles (EVs) for the next five years. China responded this week with tariffs up to 39% on European brandy, which is really aimed at French Cognac and Armagnac, as France was a big supporter of the duties on Chinese EVs (Germany voted against it). China is also conducting investigations to determine if European pork and dairy products are being unfairly dumped in China, but no decision on new tariffs for pork or dairy has been made yet. Should new tariffs be placed on European pork and dairy, it could level the playing field for U.S. farmers, where China already has a 25% tariff on U.S. pork and duties as high as 45% on U.S. dairy. It’s too early to say if the brandy tariff on the EU will benefit U.S. grape growers and distillers, but we surmise it could.^[6]

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