Amid expectations of higher inflation and a rising rate environment, equities that are considered safe stocks or “bond proxies” – which have historically offered higher income or lower volatility such as utilities or consumer staples – are likely to suffer, as GSAM pointed out in its 2017 outlook report. The view is also shared by Jupiter.
However, GSAM holds a more constructive look on one bond proxy: REITs.
“REITs could come under pressure, but we expect some offset as rising inflation leads to rising rents, in contrast to the negative effect that inflation could have on consumer staples via rising input costs,” the report noted.
Data from FE Analytics showed that FTSE ST All Share REITs Index has been underperforming key equity indices over the past three years, notably due to a sharp fall since September this year, as shown in the chart below.
However, “we believe investors should remain patient through the current volatility, which could also serve as an attractive entry point or opportunity to top-up existing positions,” the GSAM report said.
Lee, who co-leads the GS Global Real Estate Equity Portfolio, believes REITs offer both higher income and earnings per share (EPS) growth as compared to other defensive sectors such as utilities and consumer staples.
“In a short-term rising rate environment, markets often group these sectors into the same “bond proxy” category. However, over the long term, markets can realize the growth potential for REITs to exceed other defensive sectors,” he said.
A GSAM report cited that during the Federal Reserve tightening cycle in 1999 and 2005, global REITs index dropped at the beginning but rose to new highs afterwards.
He also sees that the asset class is supported by limited new supply and stable demand. “Unlike traditional fixed income, REITs have historically performed well in a rising rate environment because they have the ability to grow distributions over time and provide greater interest rate resiliency,” he said.
Another appeal of REITs is their fair valuations at the moment after the recent market corrections. “Compared to bonds, REITs look very attractive, and following the rally of the S&P 500 over the past quarter, REITs are now trading cheaper relative to equities as well,” Lee noted.
The biggest risk for REITs in the next 6-12 months could be the short-term uncertainty over the 10-year US Treasury yield, he said.
“That said, investors may want to take into consideration that an unusually high 10-year US Treasury yield would not only hurt REITs, but could also potentially dampen the US economy from both a consumer and a national debt perspective,” he contined.
Performance of FTSE ST All Share REITs Index over S&P 500 and MSCI AC World Index in three-year and three-month horizon, respectively: