JULY 2017 Real Assets Outlook
Table of contents VERUSINVESTMENTS.COM SEATTLE 206-622-3700 LOS ANGELES 310-297-1777 SAN FRANCISCO 415-362-3484 Executive summary 3 U.S. economics - Inflation 6 Outlook summary 7 Current conditions and 10 outlooks Appendix 29 2
Executive summary Real Assets Outlook 3 July 2017
The three balanced tenets of our investment philosophy Verus real assets philosophy The three tenets of our investment philosophy: 1. Create a real asset portfolio with a high degree of inflation beta 2. Provide attractive diversification benefits to the overall portfolio 3. Focus on attractive risk-adjusted returns We do not maximize one tenet to the detriment of the other two Client needs will dictate how much we may overweight or underweight specific characteristics. For example, commodities offer a high degree of inflation beta, but a low expected return. We will allocate more or less to commodities depending on the inflation protection the client seeks. Real Assets Outlook 4 July 2017
Maintain real asset exposure with return drivers outside of pure inflation Observations driving our outlook Risk of unexpected inflation shock Our outlook for energy and metal commodity prices look favorable beyond 2-3 years Inflation levels remain moderate in developed markets, though we have seen a recent upward shift in inflation, mostly due to rising energy prices Supply cuts, driven by lower prices, are filtering through to the market. off of last year's lows. The risk of unexpected inflation shock suggests it is For clients comfortable assuming equity risk, investing in natural prudent to maintain real asset allocations with risk exposures outside of resource companies that can generate positive cash flow at current spot inflation. prices should be even more attractive if prices increase in the next 3-5 years. Commodity futures still face return headwinds in the near-term, but could play a role within a portfolio as a hedge against inflation Within real estate, we recommend a conservative approach to shocks. leverage, liquidity, quality and pace of capital deployment Private real estate continues to appear favorable compared to other It is important to distinguish between strategic allocations inflation protecting asset classes, although returns may be moderating to normal levels. Fundamentals have remained strong alongside slow and and intermediate-term valuation differentials steady economic growth without the overbuilding that is typically seen at This report is written primarily with an intermediate-term view (3-5 this stage of the cycle. Real estate debt appears to be offering a favorable years), and is intended to help guide potential tilts within strategic target risk-return tradeoff. allocations and new capital deployment. It is not intended to override long-term portfolio planning. Real Assets Outlook 5 July 2017
U.S. economics – Inflation — Headline CPI was 2.2% in March, down from 2.8% in February, but the general trend has been moving steadily upwards over the last two years and is now above the Fed’s target of 2%. — Much of this jump in inflation can be attributed to the base effect of low oil prices one year ago. The energy component of the CPI basket increased 9.4%. Core inflation remained unchanged at 1.9%. — After rising considerably following the presidential election, market inflation expectations were mostly unchanged during the first quarter and slightly down in March. The 10-year TIPS breakeven inflation rate finished March at 1.9%. The market continues to discount low levels of future inflation relative to history. In comparison, consumers are expecting 2.5% annualized inflation over the next 5-10 years, according to the University of Michigan survey. The Wall Street Journal survey of 60 economists is projecting 2.4% inflation over the next few years. — Our view remains that although the market seems less worried about a rise in inflation, the potential for upside remains. U.S. CPI (YOY) U.S. TIPS BREAKEVEN RATES INFLATION EXPECTATIONS 5 16% 3% 4% Actual 4 12% Forecast Average 3 2% 0% 8% Mar-15 Mar-17 2 4% 1 1% 0 0% -1 0% -4% Jun-68 Jul-76 Sep-84 Oct-92 Dec-00 Jan-09 Mar-17 Nov-09 Feb-11 May-12 Aug-13 Nov-14 Jan-16 Apr-17 -2 06 2009 12 2009 06 2010 12 2010 06 2011 12 2011 06 2012 12 2012 06 2013 12 2013 06 2014 12 2014 06 2015 12 2015 06 2016 12 2016 06 2017 12 2017 06 2018 12 2018 06 2019 12 2019 US Breakeven 2 Year US Breakeven 10 Year US CPI Ex Food & Energy US CPI US Breakeven 5 Year US Breakeven 30 Year Source: FRED, as of 3/31/17 Source: FRED, as of 3/31/17 Source: Wall Street Journal Real Assets Outlook 6 July 2017
Outlook summary Strategy Current Environment Potential Risks Outlook/Implementation View Fundamentals remain strong, however ― New supply could increase ahead of We remain broadly favorable on real estate given valuations are getting expensive, especially current projections and outpace continued strong fundamentals, low new supply for high quality core assets in gateway demand. and favorable interest rate environment. Given markets. ― A sharp rise in interest rates could we are potentially late in the cycle, we would Private Real lead to increased cap rates, hurting recommend remaining cautious with the use of Positive Estate values. leverage, excess illiquidity, lower quality assets or ― A general economic slowdown would strategies that will take a long time horizon to drastically impact demand for real execute such as complex distress or construction. estate. REITs have benefitted from the overall ― Rising interest rates can have a While we are broadly favorable on real estate, strength of the real estate markets, negative effect on REITs and all yield- we remain neutral on REITs given current however REITs have underperformed sensitive assets over short time valuations appear fair. REITs can provide liquid broader equities in 2016 and early 2017. In periods. exposure to real estate with the following REITs Q1 U.S. REITs were hurt by a spike in ― REITs will be sensitive to economic caveats: high sensitivity to equity market Neutral interest rates and increased economic decline and general equity market volatility over shorter holding periods, higher growth expectations led to a rotation away volatility. leverage and higher exposures to non-core from yield-oriented assets. sectors such as hotels, self storage, for-rent residential, etc. Commodities futures have had lackluster ― Key risks would be decreasing Overall, commodities futures curves have been performance over the last decade. An inflation expectations, general flattening, creating a more positive environment. upward sloping futures curve for most of economic weakness (especially in Global inflation expectations have been rising the last decade has created a headwind for emerging markets) or a further moderately. Expected returns over the long run Commodities Neutral the asset class. Contributing factors also overhang in supply. for this asset class remain low and are typically include slowing global GDP growth, low used as an inflation hedge rather than a portfolio global inflation and pockets of oversupply return enhancer. across most commodity complexes. Low nominal interest rates combined with ― Decreasing inflation expectations or While inflation expectations have been trending low to moderate inflation has led to a rising nominal interest rates would modestly upward, low current yields and modest TIPS Negative depressed return environment for TIPS. be a headwind to TIPS. Continued inflation expectations has led to other real assets low rates create a high cost of carry. offering higher total return potential than TIPS. Real Assets Outlook 7 July 2017
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