Inside Creative House
Last week, August CPI has decisively broken out of the down trend it has been on since September 2022, when it missed expectations and came in at 3.7% year-over-year.
The expectations miss was largely driven by two things. First, a spike in energy prices which increased by 5.6% during the month of August alone due to a double-digit increase in the price of gasoline. And secondly, as a result of the lag in shelter inflation which continues to be reported at 7.3% YoY, despite the fact that rent prices have largely stabilized.
Trading economics, U.S. Bureau of Labor Statistics
While for shelter CPI it’s likely only a question of time before it declines, energy prices are more unpredictable. Russia and Saudi Arabia recently extended their production cuts and the price of oil seems to be in a steady uptrend, pointing to more inflation for gasoline in the following months.
Not only that, but GDP growth remains strong at 2.1% in Q2 2023. And this is problematic for the Fed. Since last year, they have been clear about the fact that a period of below-trend growth will be needed to bring inflation down and so far, we haven’t had that.
U.S. Bureau of Statistics
Earlier this week the Federal Reserve has paused rate hikes, but increased their interest rate forecast for next year from a median of 4.6% to 5.1%. The tone has remained quite hawkish as a result of fear of re-accelerating inflation on the back of strong economic growth and rising energy prices.
Below is the most recent dot plot, which shows interest rate expectations of members of the Fed. For this year, about two thirds predict no more hikes and one third predict one more 25 bps hike. For next year, there isn’t quite as much consensus, but what matters is that the dots have moved higher compared to the last FOMC meeting, indicating higher rates for longer.
Here’s what it all comes down to. The Fed has to talk tough if they want to bring inflation down and they will likely continue to do so until the very last minute when they unexpectedly flip and start to slowly cut rates. The market knows this and has been calling the Fed’s bluff for a while. Every time the Fed has pushed their interest rate cut expectation further, the market priced this in by a sell off. The million dollar question is when will these cuts finally come?
As of right now, the probabilities implied by trading for the end of 2023 are largely in line with the dot plot. There’s a 58% implied probability of no more hikes, 37% probability of 25 bps and 5% probability of 50 bps.
What it really comes down to is next year’s expectations. While the Fed sees median rates at 5.1%, the market is pricing in significant rate cuts.
CME FedWatch Tool
Last time I wrote about the S&P 500 (NYSEARCA:SPY), I highlighted that the index trades at a high P/E multiple which historically translates into subpar 5% annual returns. The article titled Why I Stopped Buying The S&P 500 To Buy REITs Instead also discussed why I believe that REITs provide a good alternative.
Today, I want to expand on the topic, look at multiple possible future scenarios of inflation and interest rates and choose the best sectors to invest in, based on history.
If we zoom out a little and ignore the recent AI trend, the S&P 500 (SPX), as well as the Nasdaq (NDX) and Dow Jones (DJI) have, for the most part, been driven by interest rate expectations. So really, there are two scenarios we need to look at:
Right now, the market expects about 75-100 bps of cuts over the course of 2024. I’d argue that this is only possible if (1) we get a soft landing, or (2) growth slows, unemployment rises and the economy enters a recession.
Both of these are of course possible, but the problem is that the market is already priced for perfection at a high forward P/E multiple of 20x.
What this means is that everyone is already expecting this bullish scenario to play out and as a result, future total returns are likely to be low. In particular, J.P. Morgan estimates that over the next 5 years total return of the S&P 500 will be below 5% per year, which makes for a very bad risk reward.
J.P. Morgan Asset Management
This scenario is quite easy. The risk is not in big losses, but rather the opportunity cost of buying the index and earning sub-par returns.
A potential way of beating the index is buying undervalued companies for which a drop in interest rates will be a major bullish catalyst. I happen to believe that REITs and Financials are those sectors, but before investing, it’s important to also look at the risky scenario.
Rates are high because of high inflation and fear of strong economic growth pushing it even higher. A higher for longer scenario therefore implicitly assumes high inflation and an economy in an OK shape.
This scenario is risky because (1) high inflation tends to put downward pressure on P/E multiple and (2) there is a lot of potential downside from today’s elevated multiples (of the index), if the market is wrong about rate cuts.
A study by Hartford Funds has looked at all sectors of the S&P 500 over the past 50 years and has found that in a high inflation environment, Energy and Equity REITs beat inflation most of the time (75% and 65%, respectively).
Moreover, the outperformance tends to be significant with annual inflation adjusted returns of about 10% for energy and 5% for Equity REITs. Note how badly Mortgage REITs are positioned in the chart below.
I think for most it’s quite intuitive that energy is a good sector in an inflationary environment, because the price increases can easily be passed through and often high energy prices are the cause of high inflation.
For REITs, on the other hand, it’s less intuitive. Of course valuations suffer when interest rates are rising, but once interest rates plateau, REITs can increases their rents quite significantly in some cases and this can often offset interest expense increases for those REIT that have solid balance sheets.
A study by Cohen & Steers has found that REITs have historically delivered double-digit (nominal) returns in high inflation environment. Note that high inflation is defined as inflation over 4.5%.
Cohen & Steers
Moreover, they show that REITs tend to outperform significantly once interest rates plateau, regardless of the level of interest rates. In particular, over the 12 months following peak rates, REITs have returned 21.4% on average, more than double that of the broader stock market.
Cohen & Steers
Of course, some REITs are much better positioned than other, which is exactly what I discussed in my recent article called 3 REITs For A Higher For Longer Scenario.
I don’t know what will happen to interest rates, but I do know that I’m not interested in investing in the index at this time. If rates decrease, the index is unlikely to deliver high returns and if the market is wrong and eventually prices in higher interest rates for longer, the down-side could be significant.
On the other hand, Equity REITs and Financials trade at historically low valuations and will likely outperform the index under scenario #1. Under the higher for longer scenario, Energy and Equity REITs are the top contestants with significant outperformance potential.
I feel good about investing in all three of these sectors.
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This article was written by
David Ksir is an ex-Private Equity investment professional with a strong European real estate background, now focused on active investing in US and EU equities. His goal is generating market beating returns with an emphasis on reliable (growing) dividends. He is primarily invested in REITs, Financials and Renewable Energy.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
I own a diversified portfolio of REITs, Financial and Energy stocks.
Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.