October 16, 2017

John LaForge, Head of Real Asset Strategy

Retail REITs—Not Biting, Yet

Key Takeaways

• Recent retail bankruptcies highlight two negative long-term trends in the retail industry; the “Amazon effect,” and the “gutting” of middle-class income levels and spending.
• Retail real estate investment trusts (REITs) have bounced in recent months, after more than a year of being brutalized.

What it May Mean for Investors

• It is not yet time to bottom-fish retail REITs. Values are good, but we need to see sustainable outperformance versus the average REIT before we would increase exposure to the sector.

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We love a good contrarian buy as much as the next investor. In real assets, the most asked-about contrarian buy is retail-related REITs. In the past 18 months, they have been beaten to a pulp, versus the average REIT. Chart 1 shows the different types of retail REITs, relative to the average REIT. As tempting as it may be to bottom-fish retail REITs today, we’re not biting. But, we are getting closer. Let us explain.

Retail REITs, effectively the landlords of retail companies, have had a tough go of it recently, because some high-profile retail tenants have declared bankruptcy. While the recent bankruptcies are not widespread, they have investors disturbed. The reason is that the bankruptcies spotlight two negative long-term trends in retail; the “Amazon effect,” and the gutting of middle-class income levels and spending in the U.S.

The “Amazon effect” refers to how quickly e-commerce companies have changed the retail landscape. At the start of 2009, e-commerce made up only 3.5 percent of total U.S. retail sales. In the fourth quarter of 2016, e-commerce reached a record 9.5 percent of total U.S. retail sales (according to the U.S. Census Bureau). Tenant bankruptcies and store rationalizations remain concerns across the traditional brick-and-mortar retail complex today—thanks, in large part, to the growth in e-commerce sales.

The “gutting” of middle-class income and spending has been a slow-drip problem for decades. But the recent move to more online shopping has magnified the detrimental impact of middle-class spending changes on brick-and-mortar retailers. It is no coincidence that many of the high-profile retail bankruptcies are prime tenants in middle-class suburban malls. The share of U.S. income held by America’s middle class has slipped from 62 percent in 1970 to 43 percent in 2015. Possibly even more disturbing, 40 percent of the U.S. population has seen inflation-adjusted income decline since 1996; and another 20 percent has seen inflation-adjusted income run flat. Much of this inflation-adjusted income decline has been absorbed by the U.S. middle class. This, in turn, has led to soft spending trends in traditional middle-class retail shopping areas, such as malls.

Of course, not all retail is the same. Some areas are even thriving. Where there is growth, it is typically coming from the low end (for example, dollar stores), the high end (even high-end malls), and specialty areas (such as beauty retailers). This is where it can pay to have professional money management—to weed through the winners and losers for retail-related REITs.

For those of you that are looking to bottom-fish retail REITs as a general group, though, we say—it is too soon. But, we may be close, based on values. Chart 2 highlights that mall REITs now trade at a 32.9 percent discount to their underlying real-estate holdings (known as net asset value (NAV)). The 2008-2009 period is the only time that we have seen better retail REIT values. Many of the retail-related group values look this way—trading at substantial discounts to their underlying real-estate holdings.

If values are this good, why not buy now? For one, notice that the trend in Chart 2 remains down. We do not like to fight trends, especially powerful trends. Retail-related REITs can become cheaper still, and it could be years before we see a meaningful turn. Secondly, we are looking for retail-related REITs to show more sustained outperformance versus the average REIT before we would consider adding exposure. They have shown better performance recently (highlighted in Chart 1), but it is unclear whether we are seeing a dead-cat bounce (small, brief recovery in the price of a declining stock) or a new uptrend. A genuine new uptrend would confirm for us that investment money is ready to return to retail-related REITs.

The bottom line is that, for us to become more bullish on retail-related REITs, we need to see sustainable uptrends in both Chart 1 (relative strength) and Chart 2 (value)—something that we are not seeing today. Our recommendation is to remain on the sidelines for retail-related REITs until sustainable uptrends emerge.

Equities

Stuart Freeman, CFA, Co-Head of Global Equity Strategy

S&P 500 Index Appears Fully Valued—Yet Valuation Is Still More Attractive than Bonds

Large-cap U.S. equity valuations appear near the higher end of their historic ranges. The 20x trailing 12-month price/earnings (P/E) multiple represents a material premium to the long-term median of 16.7x. The forward multiple also represents a premium valuation, and the price-to-sales ratio sits at the top of its long-term range. Yet, we believe that stocks remain modestly more attractive than bonds on a valuation basis.

The chart below plots the interest-rate-adjusted earnings yield for the S&P 500 Index. This is the index’s earnings-to-price ratio (the reverse of the price/earnings ratio) minus the 10-year Treasury yield. When the blue line is above its two-percent average, stocks appear less expensive than bonds. When it is below the average, stocks appear more expensive than bonds. The circle on the left side shows the most expensive valuation period for stocks versus bonds (over the past three decades). That extremely high relative valuation occurred during the late 1990s during the technology bubble. The absolute valuation also was extreme, with a P/E ratio above 30x.

On the chart’s right side, the circle shows the period when stocks were inexpensive versus bonds. The cheapest level was in September 2011, when the index reached +6.7 percent. Since then, the index has declined to the 2.8-percent level (closer to the long-term average). This has occurred as both P/E multiples and Treasury yields have risen. The analysis suggests that stocks are still modestly more attractive than bonds (on a valuation basis), but the indicator no longer leans heavily one way or another. As the U.S. economy continues to grow over the next year, we anticipate that slowly rising Treasury yields will move this indicator to neutral for the first time in eight years.

Key Takeaways

• S&P 500 Index valuations are near the higher levels of historic ranges, but still appear modestly more attractive than those of 10-year Treasury notes.
• We recommend that investors rebalance their portfolios, as they now may be too heavily equity-weighted following the move over the past year.

Fixed Income

Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

U.S. Intermediate Term Taxable Fixed Income

TIPS—Adding Inflation Diversification

One of the risks of owning bonds, especially for investors locked into a longer-term payment stream, is that inflation will be higher than expected—so the stream of payments buys less than it otherwise would have. While we view inflation risk as low, there is the potential that tax cuts could increase the risk in 2018. When everyone in the market has a similar view, the market often finds a way to surprise. Currently, markets and investors have a benign view of future inflation expectations, with few contrary opinions. Granted, we have a similar view, but we see an asymmetric payoff within Treasury Inflation-Protected Securities (TIPS) for fixed-income investors. The cost to take a small contrarian position is very low today. At current valuations, we see minimal downside risk within TIPS; however, an inflation surprise that neither we—nor the market—is expecting could lead to significant TIPS outperformance relative to nominal Treasury performance. Given our favorable valuation view on TIPS, we recommend that investors consider including a modest allocation to TIPS, where appropriate, within a well-diversified fixed-income portfolio.

The benefits of TIPS for investors are fairly straightforward; the real purchasing power of the security (the value of the bond, adjusted for inflation) is expected to keep pace with inflation until maturity. TIPS help to mitigate credit risk, as they are backed by the full faith and credit of the U.S. government. An allocation to TIPS can offer enhanced sector diversification for a portfolio—providing returns that are not highly correlated with other sectors of the fixed-income market. TIPS are subject to interest rate risk especially when real interest rates rise. This can cause the underlying value of the bond to fluctuate more than other fixed income securities. TIPS have special tax consequences, generating phantom income on the “inflation compensation” component of the principal. A holder of TIPS may be required to report this income annually although no income related to “inflation compensation” is received until maturity.

Key Takeaways

• At current valuations, we believe that TIPS offer an affordable hedge against unexpected inflation, with minimal downside risk.
• We recommend that investors include a nominal allocation to the TIPS sector as part of a well-diversified portfolio.

Real Assets

Austin Pickle, CFA , Investment Strategy Analyst

The “Amazon Effect”—Good for Industrial REITs

“Mistakes are a fact of life. It is the response to the error that counts.” --Nikki Giovanni

Brick and mortar retail stores—and their landlords, retail REITs—have had a tough go of it recently. Much of the blame has gone to the growth of e-commerce, also known as the “Amazon effect.” With all of the attention on the detrimental impact of e-commerce on retail REITs, it is easy to overlook the fact that the “Amazon effect” has been a boon for other REITs—mainly industrial REITs.

Industrial REITs own properties such as warehouses and distribution centers—and charge companies rent to use them. Demand for these facilities is poised to grow for years to come, because: 1) e-commerce companies require two to three times more warehouse space than traditional brick and mortar retailers do; and 2) the growth of e-commerce has been tremendous—and this is forecasted to continue. Few REIT sectors have such positive, secular demand drivers.

Industrial REITs are up roughly 20 percent year to date. While we do not expect such high returns to be the norm going forward, we do expect industrial REITs to outperform the average REIT. Increased demand and manageable supply are expected to keep occupancy at, or near, all-time highs, which, in turn, should facilitate higher growth in rent than that of other REIT sectors. Investors are awakening to this sector’s potential and are driving the recent outperformance after years of industrial REIT underperformance (see the chart below—a rising line means that industrial REITs are outperforming the average REIT).

The demand backdrop for industrial REITs is likely to remain intact for years, and the current trend and momentum point higher. We have a favorable view of industrial REITs in the long term, and we would recommend using any market weakness as a buying opportunity.

Key Takeaways

• The “Amazon effect” has been a boon to industrial REITs.
• We have a favorable view of industrial REITs, and we would recommend using any market weakness as a buying opportunity.

Alternative Investments

Ryan McWalter , Investment Research Analyst

The Benefits of Active Management in Commodity Markets

We believe that traditional, long-only commodity exposure can be complemented with alternative investment managers known as commodity trading advisors (CTAs). These managers trade in a variety of markets, including stock, bond and currency markets, but they also may have large commodity-market allocations.

Most CTAs utilize a “systematic” approach to taking long or short futures positions. This means that they potentially can generate positive returns in both bull and bear markets. This can provide valuable diversification and help to smooth out returns through the peaks and troughs of multiple market cycles, particularly in times of extreme market dislocations, such as the 2008-2009 period.

The chart below shows the effect of combining long-only commodity exposure in equal (50/50) allocations—using the S&P GSCI Commodity Index and a CTA allocation represented by the HFRI Macro (Systematic) Index. The purple line shows the S&P GSCI Commodity Index, which measures broad commodity-market performance and includes 24 commodities across the industrial/precious metals, energy, agricultural and livestock sectors. The HFRI Macro (Systematic) Index is composed of approximately 190 Systematic Macro managers (shown in the blue line, which reflects the highest total appreciation over the period). Yet, a 50/50 combination of the two indices (green line) illustrates the historical benefit of utilizing alternative investments to diversify long-only commodity exposure—as it has the potential to reduce volatility and increase return over multiple market cycles. Such an approach highlights the long-term benefits of the diversification that could be gained by adding alternative investments to traditional equity, fixed income and real asset portfolios.

Key Takeaways

• Systematic Macro managers can complement traditional commodity allocations, given their ability to take both long and short positions, potentially generating positive returns in both bull and bear commodity markets.
• Incorporating a Systematic Macro allocation with a long-only commodity allocation has the potential to reduce volatility and increase returns over multiple market cycles.

Risk Considerations

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

Definitions

FTSE NAREIT All Equity REITs Index is designed to track the performance of REITs representing equity interests in (as opposed to mortgages on) properties. It represents all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity criteria.

FTSE NAREIT Equity Industrial Index is a free float adjusted market cap weighted index that includes all tax qualified industrial REITs listed in the NYSE, AMEX, and NASDAQ National Market. Total return accounts for dividends reinvested in the index.

FTSE NAREIT Equity Regional Malls Index is a free float adjusted market cap weighted index that includes all tax qualified regional malls REITs listed in the NYSE, AMEX, and NASDAQ National Market. Total return accounts for dividends reinvested in the index.

FTSE NAREIT Equity Retail Index is a free float adjusted market cap weighted index that includes all tax qualified retail REITs listed in the NYSE, AMEX, and NASDAQ National Market. Total return accounts for dividends reinvested in the index.

FTSE NAREIT Equity Free Standing Index is a free float adjusted market cap weighted index that includes all tax qualified free standing REITs listed in the NYSE, AMEX, and NASDAQ National Market. Total return accounts for dividends reinvested in the index.

FTSE NAREIT Equity Shopping Center Index is a free float adjusted market cap weighted index that includes all tax qualified shopping center REITs listed in the NYSE, AMEX, and NASDAQ National Market. Total return accounts for dividends reinvested in the index.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

An index is unmanaged and not available for direct investment.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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