What’s next for interest rates and Reits?
Where’s the smart money at? Matein Khalid discusses
Janet yellen confirmed the Wall Street consensus that the Federal Reserve will raise its overnight borrowing (Fed Funds) rate at the March FOMC. Wage growth, inflation, crude oil, asset prices, economic data momentum and Trump’s fiscal stimulus all reinforce the dual mandate logic of a rate hike. Only a really awful February non-farm payroll shock (consensus is 200,000 jobs) will avert a rate hike on March 14.
Trump’s election led to a historic selloff in the US Treasury bond market as the yield on the 10-year note rose from 1.75 per cent in October to 2.6 per cent in mid-December though yields have since softened to 2.51 per cent now. Is the $3 trillion bear market in global bonds over as the financial markets brace for political (French elections, North Korea) and economic (the US deficit spending spree time lag on tax cuts) shocks? No. I expect volatility on the US Treasury bond market to rise in 2017.
If Marine Le Pen becomes France’s next president and threatens to pull her country out of the eurozone, all bets are off. The world financial markets would panic. The US dollar index could well soar 20 per cent. The US Treasury bond market will become the world’s safe haven and the yield on Uncle Sam’s 10-year note could plunge to 1.5 per cent or even lower while the yields on French, Greek, Spanish and Portuguese debt would soar as investors dump Club Med debt. Gold could soar to $1,500 an ounce but crude oil could plunge to $35 a barrel, despite the Saudi/Russian output cuts, as the world economy slips into recession.
The smart money in Europe does not discount the awful Madame Le Pen win scenario, though my contacts in Paris assure me she will never live in the Élysée Palace. This is the reason the yield on the German two-year government bond (Bund) fell to minus 0.95 per cent. This is what visceral fear in the capital markets means (or “flight to quality” in the sanitised language of asset management!).
The macroeconomic case for higher US Treasury bond yields in the US becomes more compelling if the French election does not lead to a win for the National Front. Fiscal stimulus at a time of full employment is a formula for inflation risk, as Yellen has warned the Trump White House ad infinitum. Her forecast for three rate hikes in 2017 and 2018 becomes certain if wage growth exceeds 2.5 per cent, the jobless rate falls below 4.5 per cent and US economic growth accelerates to three per cent. The rise in crude oil has led to an uptick in inflation risk across emerging markets. In this scenario, the ten year US Treasury bond yield moves to 2.9 per cent or higher, bank shares begin to soar again and King Dollar becomes King of Kings Dollar!
Real estate investment trusts (Reits) are a classic hedge against inflation risk when global growth and interest rates creep higher. Reits were a licence to print money in the Fed’s easy-money era, generating a total return (dividends plus capital gains) higher than the S&P 500 index. The Reit sector was slammed after Trump’s win as interest rates rose. Yet, unlike Treasury notes or Eurobonds, Reits provide inflation protection as rents rise when economic growth accelerates and the CPI rises. True, aggressive Fed rate hikes in 2017 will lead to panic selling in Reits. Yet stronger economic growth invariably correlates with higher rental growth, higher tenant quality, higher capital values in selected property segments. Please, no shopping malls or department stores!). This is the reason I would accumulate shares of industrial Reit colossus Prologis and prime New York office Reit SL Green Reality (steeper yield curve, global growth and Trump’s pledge to “do a number” on Dodd Frank is nirvana for New York money centre banks). The world is still in the early stages of the e-commerce/digital revolution and demand for distribution centers will explode.
I have zero interest in Reits listed in Dubai as office fundamentals are poor (46 per cent vacancy rate) sponsors charge excessive fees (up to 400 basis points) and yields are hostage to high bank leverage. It is far better to invest in the Vanguard Reit index fund, with $34 billion in assets, 0.1 per cent in fees (40 times less than illiquid Dubai Reits!) and offer a five per cent dividend yield for those who can design option strategies on the Chicago Board Option Exchange. This is a must own product for any investor who needs liquid real estate as an inflation hedge. Once Fed rate hikes happen the Vanguard index fund becomes a must own inflation hedge!