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- Markets tick down, volatility picks up
Market index returns
Week to date since September 20, 2023 as of September 27, 2023
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:
In the wake of the U.S. Federal Reserve’s (Fed’s) hawkish pause and “higher for longer” comments, which were echoed by other major central banks, most risk assets priced lower this week. Broader equity markets declined, falling deeper into negative territory on a month-to-date basis, while volatility (per the VIX Index) briefly topped 19.6, its highest level since May. All Real Assets classes also ended the week lower. Commodities (buoyed by the energy complex), TIPS, and Natural Resource Equities fared better than broader equity markets, while Global Infrastructure securities and Global Real Estate securities had steeper losses, dragged down by European infrastructure and residential names as well as the U.S. office REITs.
Why it matters: The narrow tech-driven rally that began earlier this year appears to be losing steam, and investors have turned their attention back to fundamentals and macroeconomic data. Global economic growth is slowing while inflation isn’t slowing fast enough, leaving central banks at an unfortunately familiar crossroads. Turn one way and additional rate hikes may impede already anemic economic growth, particularly as debt-to-GDP ratios across developed markets have ballooned while debt servicing costs are becoming increasingly painful, limiting the potential for fiscal intervention in the event of a recession. In the other direction, a premature end to the tightening cycle risks reaccelerating inflation, particularly given tightening energy market dynamics, which are already driving fuel prices (and thus input costs) higher. Meanwhile, geopolitical risks loom, including an impending U.S. government shutdown. Against this challenging backdrop, we continue to advocate for a professionally managed, holistic allocation to Liquid Real Assets, which can offer diversification benefits (through low correlations to other assets), defensive posturing (by exposure to necessity-based assets), and inflation mitigation (from commodities and equities with inflation-linked contracts) in a liquid and transparent wrapper.
Digging deeper: Below we review interest rates and the sudden surge at the long end of the curve. We then ruminate on two hot economic topics: 1) the final print of U.S. 2Q GDP growth – what might have inflated it and where it could be headed – and 2) fresh-off-the-press PCE inflation data in the U.S. Finally, we cover recent price action for crude oil and the broader energy market and some of its main drivers.
Why it matters: The narrow tech-driven rally that began earlier this year appears to be losing steam, and investors have turned their attention back to fundamentals and macroeconomic data. Global economic growth is slowing while inflation isn’t slowing fast enough, leaving central banks at an unfortunately familiar crossroads. Turn one way and additional rate hikes may impede already anemic economic growth, particularly as debt-to-GDP ratios across developed markets have ballooned while debt servicing costs are becoming increasingly painful, limiting the potential for fiscal intervention in the event of a recession. In the other direction, a premature end to the tightening cycle risks reaccelerating inflation, particularly given tightening energy market dynamics, which are already driving fuel prices (and thus input costs) higher. Meanwhile, geopolitical risks loom, including an impending U.S. government shutdown. Against this challenging backdrop, we continue to advocate for a professionally managed, holistic allocation to Liquid Real Assets, which can offer diversification benefits (through low correlations to other assets), defensive posturing (by exposure to necessity-based assets), and inflation mitigation (from commodities and equities with inflation-linked contracts) in a liquid and transparent wrapper.
Digging deeper: Below we review interest rates and the sudden surge at the long end of the curve. We then ruminate on two hot economic topics: 1) the final print of U.S. 2Q GDP growth – what might have inflated it and where it could be headed – and 2) fresh-off-the-press PCE inflation data in the U.S. Finally, we cover recent price action for crude oil and the broader energy market and some of its main drivers.
- What’s “UP” with interest rates?: Likely a result of the Fed’s “higher for longer” messaging, longer-term treasury yields have continued to rise, with the U.S. 10-year hitting 4.68% just after our review period (though it has settled down as we write). That’s 57 bps higher from the start of the month, and some prognosticators (such as Larry Fink of BlackRock) are expecting the 10-year to top 5% in the near future. As inflation expectations have been steadier (the 10-year break-even is only up 11 bps MTD), it’s the real rate that has been driving yields higher. The 10-year real rate reached 2.26% as the nominal rate peaked, its highest level since 2008 and a swift ascent from the 1.05% seen back in April. Intuitively, higher real rates can be a burden on borrowers, but they can also shift investors’ preferences among asset classes. For example, investors may prefer cash or T-bills, with higher real yields, over Gold which has no yield (and dropped $55 to $1,875 oz this week), though preferences could shift again quickly if a recession materializes.
- An “iconic” moment for GDP: U.S. 2Q GDP’s third (and final) release of 2.1% was unchanged from the prior but 10 bps lower than estimates. We would note some unique occurrences that likely helped prop up GDP in the 2nd quarter (special thanks to Taylor Swift, Barbie, and Oppenheimer), which could carry over into the 3rd quarter but are nonetheless running out of steam. While we won’t get an advance read for the 3rd quarter until the end of October, the Federal Reserve Bank of Atlanta has a GDPNow forecast of 4.9% for Q3 indicating stronger growth than most expect. In any event, handicapping in either direction may be harder to calculate during a government shutdown as data collection could become delayed and/or publications be disrupted due to a lack of funding for statistics bureaus.
- Between the [head] lines: So, was inflation up or down with the most recent Personal Consumption Expenditures (PCE) release from the Bureau of Economic Analysis (BEA)? Headline PCE Deflator prints for August of 0.4% month-on-month and 3.5% year-on-year were both up 20 bps from July. Yet, the Fed might see it differently as the committee prefers the PCE Core Deflator (ex-volatile food & energy), which registered a teentsy 0.1% month-on-month increase (the slowest since November 2020) while the year-on-year print of 3.9% slowed by 30 bps from July. While energy prices were a clear driver of the headline increase, the core annualized print remains well above the Fed’s 2% target. Nonetheless, odds of a rate hike at the Fed’s November meeting have been trending down and are currently below 19% (as measured by the Fed Fund Futures markets), while odds of any additional hikes this cycle sit around 38%.
- Barrel-ing towards $100?: Crude oil prices continue to climb, with WTI Crude Oil’s front-month contract price briefly topping $95/bbl (just after our review period), while Brent Crude came within a hair of $98/bbl. Inventories remain tight, with stockpiles in Cushing, OK (a major oil trading, storage, and transportation hub) hitting seasonal lows not seen since 2014. There are even signs of Russian oil being sold to India at $80/bbl, 33% above the EU/US imposed price cap of $60. OPEC+ is scheduled to meet next week, and we’ll be watching for any signs of increased production or if Saudi Arabia may end its voluntary production cuts early given the stronger prices. We would remind readers that Liquid Real Assets offer several ways to gain exposure to the energy and oil markets, such as managed commodity futures, producers, & refiners (Natural Resource equities), and storage & pipeline owners/operators (Global Infrastructure securities).
What we are watching: First up, we recap three key risks to the U.S. economy ahead of important milestones occurring this weekend. Next, we preview nonfarm payrolls, which could offer a telling sign if U.S. employment trends will remain a point of strength or begin to rollover. After that, we ponder an announcement from the White House on new spending to fortify the country against climate change and how it could affect infrastructure and real estate assets. We wrap up by reviewing a trend in U.S. office REITs, which have had their share of challenges since the COVID pandemic began.
- Rapid-fire risk recap: Here are three risks we’ll be watching carefully in the coming days and weeks:
- A U.S. government shutdown seems likely as intra-party conflict has rendered the House unable to pass even a stopgap funding bill or vote on a bi-partisan Senate proposal.
- United Auto Workers (UAW) strikes may expand further if an agreement isn’t reached soon. The strikes already expanded this week, but the UAW is starting to soften on its 40% pay raise demand.
- Student loan repayments resume on October 1st in the U.S. where ~44 million borrowers have not been required to make payments since March of 2020, but with interest resuming during September and payments required in October, many borrowers could find themselves with less disposable income.
- Juggling jobs reports: While this week saw initial jobless claims at 204k and continuing claims at 1,670k (both a touch higher than the week prior but below estimates and rather benign), next week will bring us the September jobs report. Current estimates call for a pickup of 170k in non-farm payrolls, which would be below August’s print of 187k but ahead of both June and July. Furthermore, the unemployment rate is expected to tick down by 10 bps to 3.7%. However, given when and how the U.S. Bureau of Labor Statistics calculates the unemployment rate, almost the entirety of currently striking UAW members will not be included in this figure (though they will be in the October’s print). Additionally, August’s JOLT report will be released next week, which is expected to show 8.9M job openings – this would top July’s 8.8M, but still fall well below the 12.0M seen in March.
- Who benefits from the climate cash infusion?: $500M in funding to fortify the U.S. from climate-related incidents was unveiled by the White House this week. Included was $168M from the Department of Energy to modernize the electric grid, which should benefit the regulated utilities involved in the transmission and distribution of electricity. Other awards will help mitigate wildfire risks, which should also help electric transmission and distribution utilities. $13M will go to help communities protect themselves from flooding and other climate-related hazards, while $16M will come from the Labor Department to create climate resilience jobs in underserved communities. There are also plans to launch a National Climate Resilience Framework, which we are eager to review as it could include the adoption of new building codes that could have an impact on the listed real estate market.
- Death by a thousand (dividend) cuts: Ok – less than a thousand – but we’ve counted no less than nine U.S. office REITs that have cut their regularly recurring dividend payment since December 2022. A few others cut in the immediate aftermath of the pandemic, and another hasn’t paid a regular dividend since 2014 (though it remains a special case). More broadly, office fundamentals have been in the dumpster, with vacancy hitting a 30-year high (per a recent CBRE report) and utilization rates low at those properties that are leased, but there could be better days ahead. Due to the high availability of space (and lack of financing), new construction remains very low and there have been many instances of conversion to other property types (i.e. residential), reducing aggregate availability. CBRE expects occupancy and rents to bottom in 2024 and then begin to increase, while another office broker, JLL, noted a meaningful pickup in leasing activity during the 2nd quarter and concurs that vacancy should peak in 2024.
