REITs

While we expect both direct and indirect exposure to generate solid risk-adjusted returns, favor direct given its overall portfolio impact, lower correlation to financial assets and better inflation protection.

REITs have been climbing a wall of worry in recent years, as the group has had to overcome chronic concerns about potential supply growth and low cap rates. To be sure, the group typically experiences a boom/bust cycle. However, outside multifamily dwellings, REIT supply growth has been subdued globally: our proxy for global construction growth has been remarkably subdued since the Great Recession. Low cap rates have been an issue for years, but the proliferation of negative interest rates around the world and persistently high economic uncertainty argues against expecting a sudden reversal. Instead, low interest rates are spurring strong commercial real estate demand (bottom panel), which has propelled commercial property prices to new highs. In the absence of a sudden and unanticipated surge in overall inflation, the forces that have supported the REIT bull market should remain intact. Stay overweight and please see yesterday's Special Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5REITS-SPG, AMT, PSA, CCI, PLD, HCN, EQIX, VTR, AVB, EQR, WY, BXP, HCP, VNO, O, GGP, DLR, ESS, HST, KIM, SLG, FRT, MAC, EXR, VDR, IRM, AIV. REITs Are Still Attractive REITs Are Still Attractive

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 bca.uses_in_2016_07_20_001_c1 bca.uses_in_2016_07_20_001_c1

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

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.

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 bca.uses_in_2016_05_06_001_c1 bca.uses_in_2016_05_06_001_c1

As world central banks increasingly shift toward negative interest rate policies to combat deleveraging and deflation, the search for yield in financial markets is likely to persist. Global bond yields continue to grind lower, which is raising the allure of income producing equities. Indeed, an Insight on February 9, showed that equity market fixed-income proxies surged in the aftermath of the ECB's decision to implement negative deposit rates. More recently, REITs in the euro area and Japan have soared anew, reflecting this powerful undercurrent of demand for stable cash flow producers. As such, we expect sell-offs in the S&P REIT index to prove transitory, and reflective of short-term swings in risk-on vs. risk-off assets rather than a fundamental change in investor appetite or REIT prospects, please see the next Insight. (Part I) REITs Are Re-Rating Around The World... (Part I) REITs Are Re-Rating Around The World...

The previous Insight showed that REITs in other parts of the world are outperforming smartly, but lagging in the U.S. We expect a re-convergence. Already a yawning gap has opened between REITs and Treasury yields (shown inverted). That is not sustainable, especially in view of positive underlying cash flow fundamentals. Our proxy for the REIT occupancy rate is still trending higher (third panel), supporting good growth in REIT pricing power proxies. Importantly, pipeline supply pressures look set to ease, based on the downturn in multifamily home construction. All of this points to decent cash flow growth prospects. Against a backdrop of still attractive value in a world starved for yield, we continue to recommend an overweight portfolio position in the defensive S&P REIT index. (Part II)...But REITs Are Oddly Out Of Favor In The U.S. (Part II)...But REITs Are Oddly Out Of Favor In The U.S.

Our cautious outlook on corporate profits amid ongoing deflation pressures is reason enough to favor non-cyclical equity sectors. But the surprise Bank of Japan move to introduce negative deposit rates adds yet another catalyst for defensive and fixed-income proxies. On the margin, capital is likely to seek out high yielding government bond markets. The U.S. still has comparatively juicy yields compared with other developed countries. In fact, a growing swath of the euro area bond market has negative yields. In addition, the U.S. has a strong currency. That could create a self-reinforcing feedback loop, as the exchange rate will sustain imported deflationary pressures over and above the additional pressure on China and the rest of Asia if the yen weakens. When the ECB announced negative deposit rates in the spring of 2014, the U.S. dollar immediately vaulted higher and Treasury yields declined for the rest of the year (see the vertical line). At the same time, long duration sectors such as health care accelerated, while utilities and REITs caught a bid. We expect these sub-surface equity trends to repeat, and broaden, as telecom services should now fit into the mix, because unlike 2014, overall corporate profits are falling and financial conditions are much more restrictive. The implication is that a defensive portfolio structure remains appropriate. Another Wave Of Deflation Favors Long Duration Sectors Another Wave Of Deflation Favors Long Duration Sectors