The global economic environment is in the midst of a structural shift as most regional economic cycles are within their troughs. This leads to adjustments in the outlook for factors such as inflation, risk premiums and general asset valuations.
As the economy enters its structural shift, it might be worth revising one's investment framework. Here are my latest thoughts on the outlook for various asset classes.
Bonds
The newly released U.S. inflation report provides a solid foundation for juxtaposition. The U.S. inflation rate for July settled at 3.2%, marginally below the estimate of 3.3%. July's inflation rate landed higher than June's 3%, leaving the trend rate above the Federal Reserve's target of 2%.
Although the U.S.'s inflation rate remains above its desired level, disinflation has commenced and is likely to continue into the latter stages of the year. As such, the bond market might align favorably due to credit instruments' strengthening purchasing power and the anticipation of an interest rate cut in early 2024.
In my opinion, high-quality bonds, such as U.S. sovereign bonds, will outperform emerging market and corporate bonds as recession risk remains rife, which can be substantiated by the inverted yield curve. Additionally, the disinflationary environment might act unfavorably against inflation-linked bonds, giving nominal bonds the upper hand.
Further, credit-linked vehicles such as mortgage-backed securities flash significant risk premiums amid a crunch in the cyclical credit space. As mentioned earlier, inflation risk remains high, lending a baseline to a bullish argument on risky debt.
Source: ST. Louis FED (MBS Spreads)
U.S. domestic equities
Many portfolio managers invest in stocks when factors emerge, such as a steepening yield curve, a positive economic output gap, abating credit spreads and cyclically low inflation.
As discussed before, the yield curve remains inverted and inflation, although on a downward trajectory, is yet to bottom out. These indicators combined imply short-term struggles for pro-cyclical stocks; however, secular growth stocks such as Microsoft Corp. (MSFT, Financial), Apple Inc. (AAPL, Financial), Alphabet Inc. (GOOGL, Financial) and Tesla Inc, (TSLA, Financial) might break through such headwinds and benefit from factors like an improving output gap and lower credit spreads.
Source: World Government Bonds (U.S. CDS Values)
Furthermore, high-quality and non-cyclical stocks such as British American Tobacco PLC (BTI, Financial), Coca-Cola Co. (KO, Financial) and Walmart Inc. (WMT, Financial) might experience market-beating results driven by investors' desire to hedge recession risk while maintaining exposure to equities.
Public real estate
Real estate investment trusts are a mixed bag at the moment. As I will discuss later, real estate prices are softening; however, as publicly traded securities, REITs are priced in advance and not coincidentally like tangible real estate. Moreover, REITs generally hold strong short-term correlations with stocks and most often only correlate to tangible real estate in the long run. As such, analyses of REITs and tangible property are usually independent.
Residential REITs such as Essex Property Trust Inc. (ESS, Financial), Equity Residential (EQR, Financial) and Camden Property Trust (CPT, Financial) might soon experience support from expectations of an early 2024 interest rate cut. In addition, as illustrated below, lower-term premiums might bolster residential REIT valuations. However, I remain concerned about the disinflationary environment and the above-expected jobless claims for the first week of August. If both trends continue, rent escalation might curtail and vacancy rates may rise, leading to lower implied capitalization rates.
Source: St. Louis FED (Term Premium)
On the other side of the playing field, high-quality commercial REITs might outperform the broader market due to their blue-chip tenant exposure and long-life lease agreements. Sure, royalties-based retail REITs might suffer from an expected recession; nevertheless, base rents will likely remain stable due to the reasons mentioned above.
Despite my bullish outlook on retail REITs, the same cannot be said for office REITs. As shown below, office REIT occupancy rates continue to wane as the work-from-home concept continues its momentum. Moreover, many investors might tie a possible recession directly to the office REIT space, concurrently causing a sell-off.
Source: S&P Global
Real assets
Real assets have two distinguishable traits. First, they are generally correlated to inflation. Second, they have inherent value. Even though the scope of real assets is broad, this analysis sticks to commodities and tangible real estate due to their abundant representation within the asset class.
As evident in the diagram below, commodity prices have slumped in the past year. Sure, there have been a few exceptions, such as gold and timber. However, in general, slower global industrial production paired with high interest rates has led to softer inflation. Thus, commodity prices have felt the brunt of the impact.
Source: Bloomberg Commodity Index
Looking ahead, it is highly unlikely that broad-based commodity prices will rebound sharply until interest rates bottom and fiscal policies enter expansionary territory. Although gold experienced robust year-to-date returns, much of it was driven by economic tail risk, which is slowly abating as a "soft recession" seems like the most likely outcome.
Finally, tangible real estate is in a tight spot for the time being. Cash buyers are benefiting from softer prices; however, levered buyouts are falling victim to elevated interest rates. The diagram below shows the average house price in the U.S. has plummeted in the past year; however, the trend will likely flatline in early 2024 if interest rates start tapering.
Source: St. Louis FED (U.S. Housing Prices)
Final word
The U.S.'s July inflation report, combined with other salient economic and market-based risk factors, suggests a shift in asset allocation might be necessary for most investors.
The current disinflationary environment lends an opportunity to bonds and certain stocks; however, fears of a recession suggest that Treasury bonds and non-cyclical stocks are the most prudent. Furthermore, residential and office equity REITs are up against it amid declining home prices and lower office occupancy; nevertheless, high-quality retail assets might receive support from long-life leases and an anticipated interest rate cut in early 2024.
Lastly, most real assets face headwinds as the economy is in a trough and inflation is on a downward trajectory.
Although few and far between, lucrative investment opportunities still exist!
