Real Estate

With Treasury yields backing up from extremely depressed levels, many clients are asking if an overweight allocation to the REIT space remains appropriate. While a sharp spike in yields would clearly be problematic in the short run, we have shown that REITs have often outperformed during periods of strong economic growth and Fed tightening cycles. The key is for REITs to generate above-market cash flow. At the moment, our composite REIT rental rate inflation is running comfortably above overall inflation, led by the CPI for homeowner's equivalent rent (top panel). New supply has been coming on stream for years, but so far has been absorbed with little adverse pricing power impact. Vacancy rates are still historically low. Consequently, operating performance should stay robust. Importantly, relative valuations are not overly demanding, and technical conditions are not overbought, and there have been no negative momentum divergences. We continue to recommend an overweight stance. BLBG: S5REITS

Post-Brexit uncertainty will continue for some time. But we were already cautiously positioned, and would not go any more defensive.

Special Report

In this <i>Special Report</i>, we revisit our list of signpost economic indicators introduced two years ago to identify if the U.S. and Euro Area were falling into a "Secular Stagnation".

While the financial sector relief bounce is likely to peter out as the Fed threatens to tighten monetary conditions during a profit recession, the more defensive REIT sub-component should continue to outperform. REITs are still not overvalued, despite the relentless decline in yields on competing assets. While Fed rate hikes could be construed as an impediment if they lift the cost of capital, REITs have not typically run into trouble until policy has tightened by enough to cause a trifecta of headwinds: a cresting in commercial real estate prices, a peak in occupancy rates and by extension, a downturn in the CPI for rental inflation. Once these factors turn bearish, upward pressure on cap rates materializes. None of these concerns currently exist. Keep in mind that with QE and NIRP, there is still a massive search for yield in global financial markets. Roughly $9T of global bonds trade at a negative yield, a massive increase from only two years ago, which should sustain the secular advance in REITs. Moreover, REITs are slated to become a new GICS1 sector on August 31, a new classification that has the potential to augment investor interest. Adding it up, the security, safety and yield appeal of REITs should remain intact regardless of the Fed's near-term zigs and zags, unlike the overall financials sector. Stay overweight and see yesterday's Weekly Report for more details.

Investors have embraced renewed Fed hawkishness as a vote of economic confidence and confirmation of analysts' rosy earnings forecasts, but the bounce in financials looks unsustainable, outside of REITs. Hang on to gold shares.

Special Report

Australia's equities and currency are driven largely by industrial commodities prices, Canada's by the oil price. Given our more positive view on oil, we prefer Canadian assets, though both markets face risk from stretched property prices and household debt.

We focus on 3 stress-points in the economy and markets which segue to several high conviction investment recommendations.

Approaching the referendum on EU membership, what are the prospects for the U.K. economy and financial markets?

While we recently downgraded financials and banks to underweight, this bearish view does not extend to each of the sector's components. REITs are a positive exception. The group is still not overvalued, despite the relentless decline in yields on competing assets. This may reflect an undercurrent of skepticism regarding the sustainability of cash flow growth and low cap rates. However, both appear sustainable. The CPI for homeowner's equivalent rent, a proxy for REIT pricing power that has a good correlation with relative performance, is still accelerating even though it is already well above the overall rate of inflation. Moreover, commercial property price inflation continues to climb. While Fed rate hikes could be construed as an impediment if they lift the cost of capital, REITs have not typically run into trouble until policy has tightened by enough to cause a cresting in commercial real estate prices, a peak in occupancy rates and by extension, a downturn in the CPI for rental inflation. None of these concerns currently exist. Consequently, we recommend maintaining an overweight position. BLBG: S5REITS

Treasuries appear overbought in the near-term, especially given evidence of a rebound in global manufacturing, but we would need to see evidence of a sustained re-synchronization of global growth before advocating a shift to below benchmark duration on a 6-12 month horizon.