Argus offers its assessment of real assets, within a two-part series. The first part is focused on the overall environment for real assets, currency sensitivity and real estate. The second part of our series will focus primarily on commodities.
Summarizing our conclusions within a few bullets points, we make the following observations:
· For balanced accounts, we would allocate 5% of investments into real assets, split as follows:
o 1%-2% in real estate
o 3%-4% in commodities and non-equity energy
· We would focus on commercial real estate, based on our view that the professional-investor phase in residential real estate is ending.
· For the intermediate-term, we are encouraged by signs that commodities have come off their lows, despite the negative of the currently strong dollar.
· For the long-term, we believe that commodity demand drivers will remain intact and that a weakening dollar will support commodity prices.
Argus Asset Allocation Strategy
The Argus Asset Allocation Strategy calls for a balanced approach to distributing investments among asset classes. Given our view that stocks remain undervalued based on underlying fundamentals and valuation, we recommend that investors allocate 65% of their investments to equities, with approximately two-thirds in large cap names and one-third in mid-sized and smaller names. We also recommend 25% exposure to fixed income, while being mindful of the risks in that forecast based on the prevailing trend (upward) in interest rates.
For the remaining 10% of investments, we would recommend an even split of 5% each to cash and to real assets. Variously called non-traditional or alternative assets, real assets would include gold and other precious and base metals, industrial and agricultural commodities, non-REIT real estate assets, and non-equity energy assets.
Equity and fixed income investments and allocations are endlessly discussed and dissected. Much less attention is paid to investments in real assets. As a largely equity-focused enterprise, Argus will eschew recommending assets, such as specifically dated futures contracts, in the real assets arena. But we will offer our assessment of the investing backdrop and macro-economic sensitivities that investors should understand before investing in real assets.
Dangers of replicating exposure
We begin our discussion with a brief reminder on the dangers of replicating exposure to hard assets within equity portfolios. Ownership of hard assets such as metals, oil future contracts and agricultural commodities can overlap and potentially replicate positions and exposures within equity asset classes.
This is a particular concern for investors with market-mimicking equity asset allocations or who own S&P index funds. As of the final week of August 2013, energy represented 10.5% of S&P 500 weighting; and materials represented 3.4% of S&P 500 weighting.
We are not suggesting that investors need to hew to a sector allocation exactly in line with the S&P 500 weightings. But we do recommend being aware when ownership of real assets in the metals, energy or other categories effectively creates overweights in the portfolio.
Real Asset Drivers: Balancing Currency and Demand
The first principle of real asset investing is currency awareness. We differentiate between real estate and commodities, however, in their relative currency exposure. U.S. real estate investors in certain markets, particularly the major coastal cities, can see demand patterns become sensitized to movements in the euro or yen. In general, however, real estate investors face much less currency risk than commodities investors who are subject to global forces. Most of our currency discussion is targeted at commodity investing
Most raw and semi-finished commodities are priced in dollars. One exception is display glass, which is priced in yen. The London Metals Exchange prices metals such as copper and aluminum in Sterling. But even metals prices are impacted by dollar trends, given the amount of trade between the U.S. and dollar-sensitive nations in Asia.
When making a bond or stock purchase, international factors can be a consideration, but they are often far down the list of priorities. Real assets, on the other hand, are primarily impacted by global factors even though they are priced in dollars.
Investors in commodities need to be mindful of global trends in interest rates, macro and regional economic trends, and movements in other currencies.
Dollar strength has historically been inversely correlated to commodity prices. However, this relationship can be superseded in periods of extreme commodity demand, such as the "super-cycle" that some investors believe began (approximately) in 2000.
We would be highly aware of dollar trends against the currencies of major trading partners when making intermediate-term trades or taking intermediate-term positions within real assets. For longer-term investors, currency impacts tend to dwindle time, while real demand and supply-demand balance remain the key determinant of returns.
Dollar behavior: historical trends
We use Federal Reserve Bank of St. Louis data (FRED) to examine the trend in movements of the trade-weighted dollar. We have tended to focus on two FRED measures: the Trade-weighted U.S. Dollar Index: Major Currencies, and the Trade-weighted U.S. Dollar Index - Broad. While we previously focused on the Major Currencies index, we would argue that the Majors index has over-weighted the euro and yen through a period in which our trade with Japan and Europe has been superseded by trade with other nations. The Broad index in our view now provides a better gauge on movement of the dollar against the currencies of a more diverse and more representative group of our trading partners.
By either measure, the dollar has lost significant ground against the currencies of our trading partners in recent decades. According to the Major Trading Partners index, the dollar has declined by more than 50% from its peak. Against the Broad index (which has a shorter historical measurement period), the dollar has declined more than 30% from peak levels.
The principal reason for dollar weakness against the trade-weighted basket is that the U.S. has been living beyond its means. Since the recession the U.S. on average has spent approximately $4 for every $3 it brings in tax receipts. When nations resort to the printing press to close their budget gap, their currencies tend to weaken, and that is what has happened to the U.S. dollar. But the U.S. is not alone in its currency profligacy, and the dollar has quietly begun recovering in recent years.
Using the Broad index to track recent performance, we see that the dollar hit an interim low amid the worse months of the 2008 recession. From there, however, the dollar moved steadily lower. The broad index dollar bottomed out in July 2011, amid the bitter partisanship around the debt ceiling showdown. At this time investors and currency traders saw starkly the deep divides on deficit and national debt policy between Republicans, who were emboldened after reclaiming the House of Representatives in the mid-term elections, and Democrats, still committed to deficit spending to resuscitate a weak economy.
Investors reasoned that the compromises wrought by the summer 2011 debt-ceiling imbroglio portended more quantitative easing, given that any actions were pushed out nearly 18 months to year-end 2012. But those compromises - including the end of the Bush-era tax cuts and the imposition of sequestration - also signaled the potential for long-deferred action on closing the deficit.
Argus Dollar Outlook
Between the "debt-ceiling low" of July 2011 and spring 2013, however, the broad dollar index improved 9.8%. Several things have happened to disrupt the multi-year dynamic of a declining dollar. The United States was the first major nation that meaningfully adopted quantitative easing. But many nations have followed, most recently (and most emphatically) Japan. Given the Fed's seeming commitment to taper timing, we may well be the first major QE nation to exit the program.
Equally important has been a shift in the budget-deficit dynamic. The three key factors related to budget deficit - spending, tax receipts and economic activity - have all become more favorable in the past year.
The year-end 2012 tax hikes create more income, including higher income tax rates for the highest earners and higher payroll taxes for every worker. On the cost side, the compromise known as the sequester has helped reduce government spending. While sequestration is seen by some as the main cost-cutting event, in fact government spending and government employment have been in a multi-year decline.
Economic growth, in our view, is the most important of the three factors in restoring balance to the budget. The U.S., in our view, remains in persistent if low-grade recovery. U.S. economic growth has shifted from the industrial sector, dependent on international demand trends, to the consumer sector, more dependent on domestic trends such as employment and consumer spending. Growth in employment in particular is contributing to higher tax revenues
The U.S. has just begun the huge task of closing its deficit, and has much more to do before we can even think about reducing the massive national debt. Still, we are looking like the "cleanest dirty shirt in the closet" compared to many of our global neighbors. Our relative solvency is contributing to relative dollar attractiveness.
Even as U.S. economic and deficit fundamentals have improved, emerging economies have been hit by weaker trends. China has been unsettled as the new administration seeks to tamp down past excesses in the shadow-banking and real estate sectors. The resource economies are hurt by commodity softness. All five major resource-economy stock markets - Brazil, Russia, Canada, Australia and South Africa - are negative for 2013. Among mature economies, Europe is showing preliminary signs of stabilizing, but at very low levels. Japan implemented its own "super-QE" program in autumn 2012 and winter 2013. That has aided its economy by deliberately slamming the yen to better compete with China and Korea.
Against this backdrop, our intermediate-term outlook calls for continued relative outperformance by the dollar. At the same time, we reiterate our long-term forecast of dollar weakness against the trade-weighted basket.
For the long-term, we anticipate still-poor long-term deficit/national debt trends. This reflects the strains on the entitlement programs as aging baby boomers draw on Medicare, Medicaid and Social Security. These onerous entitlement spending trends, coupled with inevitable down cycles, are likely to supersede the current patch-work of deficit solutions.
In summary: we anticipate near-term relative strength in the dollar, but longer-term dollar weakness. On that basis, those taking intermediate-term positions in hard assets such as commodities must be mindful of dollar trends. Those with a longer-term investing horizon should focus more on commodity demand trends and the demand-supply balance.
Investment returns in Real Estate are tough to gauge. Our analysis of real estate returns generated widely different outcomes, with returns deeply affected by real estate niches, regional factors and most notably investment timing. Real estate, like private equity, is illiquid or has low liquidity and has long time horizons on return. The return experience can vary widely even within single neighborhoods.
Investors should also be aware of the potential for duplication. If you own financial sector SPDRs/ETFs, you may already own a position in REITs.
Residential Real Estate
In our view, the U.S. housing economy is still in the early to mid-innings of recovery. Amid uncertainty in the BRIC economies and turmoil in resource-based economies, many U.S. investors have turned inward to consumer-sensitive businesses such as housing and automotive. The sectors offer low Forex sensitivity - U.S. housing sales tend to be dollar-indifferent, with just some moderate currency impacts mainly in coastal cities like New York and L.A.
At the same time, however, professional investor participation in the housing cycle may have peaked. Given cut-rate prices on high-quality housing stock and extremely low interest rates, investment banks and hedge funds piled into the residential housing sector in the years immediately following recession. Housing prices are now rising, prompting these investors to cash out. At the same time, rising interest rates are increasing the cost of carrying these assets and dissuading new entrants from the house-as-investment market.
Despite these trends, the house-as-home market has further to go, in our view, given the enormous housing demand built up over missed cycles between 2006 and 2012. Eventually, rising home prices and mortgage rates will impact demand. For now, rising employment and improving consumer confidence are stoking home demand. Rising prices may also prompt empty nesters toward overdue sales of the family home. That could increase the available stock, prompting prices to flatten and increasing relative value available.
We caution that regional factors still prevail in the residential housing sector. Investors should not assume that the overbuilt Sunbelt, which fell hardest in the housing-sector crash, will be fastest to recover. We would pay attention to regional economic health to determine general areas to invest, and would even explore pricing and demand trends on a neighborhood by neighborhood basis.
In summary, we believe the overall housing recovery has room to run, but would be aware that the professional-investing phase in residential real estate is likely ending. Before investing in this areas, we would be highly aware of regional trends, and more broadly trends in interest rates, while being sensitive to consumer employment levels, spending and sentiment.
Commercial Real Estate:
Unlike the residential sector, where shelter dynamics prevail, secular changes may supersede cyclical trends within the commercial real estate segment. These secular negatives, though well discussed, bear repeating. They include changes in employment practice, including telecommuting, "perennial part-time" workers, growing ranks of contract employees, and the rise of the home office. Even bigger changes have been wrought by online retail and e-commerce, which has impacted development and activity levels in shopping centers and malls and on Main Street in your town.
For the savvy investor, these secular changes also bring some positives. We have seen a rise in warehousing to serve an e-commerce economy. We have also seen a rise in storage facilities utilized by a fluid and mobile workforce. We also see some cyclical positives in commercial real estate. Aging downtown infrastructures are ill-suited to the digital age. The reduced need for on-site employees also contributes to further dispersion of commercial real estate beyond the first outer-city circle.
Brick and mortar retailers are fighting back against show-rooming, helping lure shoppers back to the stores. Office buildings are similarly stepping up amenities as they battle telecommuting. In summary, commercial RE investors must be highly attuned to digital-age secular trends and how these play out on a regional basis. But we also see opportunity in the commercial space for the first time in years.
Real Estate recommendation
· Within 5% (500 bps) alternative investment allocation, we would allocate 100-200 bps primarily to commercial real estate.
(Jim Kelleher, CFA, Director of Research)