INSIGHTS

On April 29, 2014

REITs, Utilities & Equity Market Outlook

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(As of 3/31/2014)

REITs

Real Estate Investment Trusts (REITs) outperformed the broader S&P 500 Index in the first quarter of 2014 as the Russell 3000 REIT Index posted a total return of 8.8% versus the S&P 500 Index’s 1.8% gain. The outperformance is in part due to a rebound after the sector sold off during the second half of 2013 on expectations of rising interest rates associated with tapering of the Federal Reserve’s (the Fed) asset purchase program. While Fed guidance is for short-term rates to remain near zero until at least late 2015, long-term rates are facing upward pressure as the Fed pares purchases of 10-year U.S. Treasuries and we expect yields to rise to 3.5% by the end of 2014. As REITs often borrow short-term to fund purchases of long-term investments, a greater spread between the two rates is likely to provide a significant tailwind. We also believe the sector’s outperformance is in part a result of investors seeking relatively higher yielding assets, with REITs generating dividend yield of 4.0%¹.

We expect the modestly positive general trend in fundamental data (economic, employment, and housing data) to continue. In the near-term, this improving macro backdrop, along with a favorable rate environment, high yields, and continued recovery from second-half 2013 levels, combine to create what we believe can be an attractive buying opportunity for REITs. The sector is still subject to headline risk associated with any potential increase in short-term interest rates, which may occur if economic, employment, and housing data come in meaningfully different than expectations.

Utilities

The S&P 500 Utilities Index returned 10% in the first quarter of 2014, outperforming the broader S&P 500 Index’s 1.8% gain. The outperformance is in part due to a rebound after the sector sold off on higher interest rate expectations during the second half of 2013. As many utilities borrow money to finance projects, the expectation of rising interest rates associated with the tapering of the Fed’s asset purchase program contributed heavily to underperformance in the second half of last year. We also believe the sector’s outperformance in the first quarter of 2014 is in part a result of investors seeking relatively higher yielding assets, with utilities generating almost twice the dividend yield of the S&P 500 (3.7% vs. 1.9%²).

While rates have stabilized, we believe utilities will face long-term headwinds due to expectations of rising long-term interest rates. However, we also expect the modestly positive general trend in fundamental economic, employment, and housing data to continue and provide a tailwind. In the near term, we believe the sector’s high yield should remain an attractive investment and expect continued outperformance as long as the current environment features a stagnant broader market.

A risk to these forecasts is that economic, employment, and housing data come in meaningfully different than expectations.

Equities

The equity markets, as measured by the S&P 500 Index, returned a modest 1.8% in the first quarter of 2014. Going into February the market drew down about 5%, but earnings season and economic data showed no major cracks – after accounting for weather – and the markets climbed through the rest of the quarter. Leadership came from revenue-steady utilities (+9.0%) and health care (+5.4%), while consumer discretionary saw the biggest first quarter decline (-3.2%). U.S. equity markets (MSCI All Country World ex-U.S. Index, 0.9%), bonds (Barclays U.S. Treasury 20+ Year Index, +7.7%)³ and gold (+7.5%)⁴.

We find market fundamentals to be relatively healthy and expect modestly improving macro, revenue, and earnings data that should support modest, positive equity returns over the next quarter or so – similar to what we saw in the first quarter. Pockets of froth in internet and biotech stocks are worthy of keeping an eye on, but not so the “equity bubble” talk. A series of small pullbacks would not be alarming to us and would probably be healthy for the market to contain and relieve the pockets of froth. However, a more significant pullback, on the order of 10% or more, is from an historical point of view overdue and not out of the question. Either way, we think these pullbacks are simply a part of the markets’ process of setting a new, more modest, trend versus the +30% trend set in 2013.

The risk to this forecast is that earnings, sales and other fundamental factors come in much better or worse than we expect. Another concern is that rising interest rates could be a headwind to stocks.

 

 

1. Compares dividend yields of Russell 3000 REIT Index vs. S&P 500 Index per FactSet as of March 31, 2014

2. Compares dividend yields of S&P 500 Utilities Index vs. S&P 500 Index per FactSet as of March 31, 2014

3. Source: Barclays Live, as of March 31, 2014

4. Source: U.S. Performance Monitor, Bank of America Merrill Lynch U.S. Quantitative Strategy, April 1, 2014

 

CRN: 042314-4149R

Past performance is no guarantee of future results. An investor cannot invest directly in an index.

The opinions expressed herein constitute the HIMCO’s judgment as of March 31, 2014, and are subject to change without notice based on market, economic or other conditions. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice.

Sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision. All data referenced is from sources deemed to be reliable but cannot be guaranteed as to accuracy or completeness.

Investment Risks: All investments are subject to risk, including the possible loss of principal. REITs are subject to credit and interest rate risk, as well as negative developments in the real estate industry, including high vacancy rates and economic difficulties. Investments in the utilities sector can be significantly affected by supply and/or demand for services or fuel, financing costs, conservation efforts, and government regulation. An issuer of a security may be unwilling or unable to pay income on a security. Common stocks do not assure dividend payments. Investments in small and mid-capitalization companies may involve a higher degree of risk and volatility than investments in larger, more established companies.

 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com