In what some observers described as an “upside-down” week in the financial markets, US equities climbed for the third straight week as trade tensions between the US and China appeared to cool ahead of the all-important in-person trade discussions in early October. Another week of solid economic data and a show of strength from the Republican party in a closely-watched set of special elections (especially of interest to the Chinese trade delegation) lifted investor optimism and sent the 10-year yield surging to the biggest weekly gain in six years.
Sector and factor rotation have been key themes over the past several weeks with a sharp reversal in leadership groups. In a sharp move that confounded many investors, the high-flying momentum and high-growth factors have significantly underperformed in recent weeks while the beaten-down value and quality factors have suddenly caught a bid, a theme that we’ve observed play out within the REIT sector as well.
The S&P 500 (SPY) and Dow Jones Industrial Average (DIA) each climbed another 1% this week, pushing the major large-cap benchmarks back to within 1% of all-time record highs. The small-cap Russell 2000 (IWM), which has underperformed for most of this year, surged nearly 5% on the week while on the flip-side of the coin, the high-flying REIT sector took a step back as the broad-based REIT ETFs (VNQ and IYR) dipped more than 2%.
The “upside-down” week was apparent within the REIT sector as the high-flying cell tower sector plunged more than 7% while the struggling mall and hotel sectors saw sizable jumps. Despite mixed retail sales data and the reports of an impending bankruptcy from one of the seemingly better-performing mall-based retailers, Forever 21, the low-productivity mall REITs including CBL & Associates (CBL) and Washington Prime (WPG) each jumped more than 10% on the week.
On an otherwise kooky week in the financial markets, the Hoya Capital US Housing Index, which tracks the GDP-weighted performance of the US Housing Industry, continued its steady march higher. As we’ve discussed for the past several months, strong performance from the US housing industry – underpinned by signs of resurgence in the single-family sector - was perhaps the best counter-evidence to the building “recession” narrative. Highlighting the diversity of the broader housing industry, while the more defensive residential REIT sector dipped 2% on the week, the home furnishings and mortgage lending sectors jumped by 8% and 6%, respectively.
At Home (HOME) and Realogy (RLGY) jumped more than 20% on the week while Restoration Hardware (RH), Wayfair (W), Sleep Number (SNBR), and Regions Financial (RF) each climbed at least 10%. Underperformers on the week included some of the more yield-sensitive senior housing REITs including Welltower (WELL), Ventas (VTR), and HCP (HCP).
After reaching the fastest rate of growth since 2012 in the middle of last year, retail sales growth has generally moderated over the past several months, but data has been relatively strong this summer despite the volatility seen in the financial markets. Continuing a similar trend seen throughout this summer, total retail sales beat estimates last month, but many “brick and mortar” continue to see significant weakness. E-commerce (nonstore retail) sales were again the stand-outs last quarter with the category seeing the largest year-over-year increase in sales in nearly twenty years.
We recently published Mall REITs: Fears of Retail Apocalypse 2.0. Store closings have unexpectedly surged in 2019. For retailers, the more significant issue over the last two years has not been on the demand-side, but rather on the expense-side. Before even considering the margin hit from tariffs and excess inventory, labor costs have risen considerably over the last two years as eighteen states raised their minimum wage in 2018 and many cities (largely in already high-cost markets) have raised minimum wages over the last two years, oftentimes far above market rate, which has begun to result in retail job cuts and store closures. Hourly earnings surged to 5% in early 2019, outpacing the roughly 3% growth in retail sales, while retail job growth has been negative on a year-over-year basis for all of 2019.
While the majority of the store closings (on a square footage basis) over the last five years were concentrated in the anchor and big-box space, more than half of the store closings so far in 2019 have been in the specialty categories, indicating that smaller businesses have been hit especially hard by minimum wage pressures. While hardline and food retailers tend to be somewhat immune from e-commerce related disruption, softline and specialty retail categories are generally more at risk. During the so-called "retail apocalypse" of 2016-2017, these categories were particularly weak but recovered nicely in 2018 before turning lower again over the last two quarters.
While lower oil and food prices continue to put downward pressure on the headline inflation data, core inflation (excluding food and energy) has perked up over the last three months. Core CPI rose 2.38% on a year-over-year basis, which marked the highest rise in core inflation in more than a decade. Earlier in the week, the BLS reported Producer Price Index data, which has exhibited similar underlying trends. Core PPI rose to 2.34% in August, which was the highest since April 2019. The PPI index for all commodities, meanwhile, has declined by 2.0% year-over-year. Core PCE data has continued to show modest inflationary pressure.
There are two primary factors behind this summer's acceleration in core inflation: rising core goods costs (largely related to tariffs) and rising housing costs. Housing (CPI: Shelter) accounts for more than a third of the total CPI weight (42% including housing-related services), and since 2013, housing inflation has been significantly above the overall inflation rate. From 2015 through late 2016, housing inflation was one of the only components keeping Core CPI out of deflationary territory, and since 2013, core inflation excluding housing has averaged roughly than 1%. Housing inflation has reaccelerated over the last several months after moderating slightly in 2018. Consistent with earnings results from the apartment REITs and private-market data showing a reacceleration in rents since late 2018, at 3.4% CPI: Shelter is within 20 basis points of multi-decade highs.
While a leg higher in shelter inflation explains some of the upward pressure in core inflation, the rise in core goods is the bigger culprit. In August, Core goods (excluding food and energy) rose at it's highest year-over-year rate since 2012. Core goods have been in a state of persistent deflation over the last half-decade as the forces of globalization, soft wage growth, and e-commerce have led to reduced prices for consumer goods. While still rising less than 1% on a year-over-year basis, the effects of rising wage growth and tariff-related cost pressures have kicked core goods inflation back into gear.
(Source: Michael Ashton)
Despite this week’s underperformance, with gains of more than 22% so far this year, the broad-based REIT ETFs (VNQ and IYR) continue to outperform the S&P 500, which has climbed roughly 10%. Not all REITs are seeing the windfall, however, exhibited by the 50% performance gap between the best- and worst-performing REIT sectors. The US Housing sector has climbed 27% this year led by the 46% surge in Homebuilders (ITB). At 1.90%, the 10-year yield has retreated by 78 basis points since the start of the year and is roughly 135 basis points below peak levels of 2018 around 3.25%.
This week, we published Industrial REITs: Don't Bite The Hand That Feeds You. Industrial REITs remain the unstoppable force in the real estate sector, delivering another stellar second quarter with particularly strong results from Prologis (PLD). Investors have systematically under-owned this sector, waiting for the pull-back that never came. A concern we raised last quarter, while the sector has benefited more than any from e-commerce, an intensification of retailer bankruptcies would concentrate more power in their largest tenant: Amazon (AMZN).
We also published Student Housing REITs: Spoiled By The Millennials. The millennial generation - the largest cohort in American history - supported the maturity of the student housing industry – including American Campus Communities (ACC) - over the last decade into a mainstream institutional-grade real estate sector. At 23 years old, the youngest of the millennials are now out of college and for the student housing sector, growth has been harder to come by over the last half-decade. Concerns regarding rising tuition costs, however, are overstated by the widening gap between “sticker prices” and net costs.
With equity markets flirting new all-time highs, the Federal Reserve is expected to walk a tight-rope in this week’s upcoming meeting, where the committee is widely expected to cut interest rates by a quarter-point. Expectations of easing monetary policy have been a key factor in the stabilization in key economic sectors this year and have been the driving force behind the reacceleration in the single-family housing markets. Speaking of the housing markets, it’s a huge week for housing data with Homebuilder Sentiment released on Tuesday, Starts and Permits data released on Wednesday, and Existing Home Sales released on Thursday.
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