INSIGHTS

On August 17, 2017

Alternative Sources of Income: Second Quarter 2017 Review and Outlook

INVESTMENT REVIEW

Global equity markets made record highs in the second quarter as global economic growth continued at a modest pace, although U.S. data was weaker than expected. Growth in Europe continued to advance, while Japan’s government raised its overall view of the economy, citing stronger private consumption and an improved employment picture. In the United States, the Federal Reserve responded to an improving economy and falling unemployment by raising its benchmark short-term interest rate in June by 0.25%—the third such increase since December 2016. Overall, equity markets were supported by an ultimately benign interest rate backdrop.  

The Russell 1000 Dividend Growth Index returned 2.1%, led by the health care sector, which outperformed in anticipation of relaxed regulations on insurance companies. Information technology, which was a top-performing sector in the first quarter, was relatively unchanged. The energy sector was a notable underperformer, weighed down by weak and volatile oil prices.

Master limited partnerships (MLPs) posted a –6.4% loss in the quarter, as measured by the Alerian MLP Index. Concerns persisted that the recovery in North American production could counteract the Organization of the Petroleum Exporting Countries’ (OPEC) production cuts and push oil prices lower. For MLPs, those concerns were largely misplaced, however, as rising oil volumes are historically beneficial to midstream energy companies, translating into improving cash flows that could be used to strengthen balance sheets and increase cash distributions. In earnings announcements released in the quarter, MLPs generally provided modest guidance for the first half of 2017. However, many companies stated that they expect stronger conditions heading into 2018.

Real estate investment trusts (REITs), as measured by the FTSE NAREIT Equity REIT Index, advanced 1.5% and generally benefited from the prospect of a stronger economy. Late in the quarter, REITs came under pressure as ECB (European Central Bank) president Mario Draghi said that the factors recently dampening inflation in the Eurozone may prove temporary, with the region poised for a strengthening and broadening recovery. Market observers initially inferred that the bank may begin to decrease its quantitative easing programs, which sent sovereign yields higher. However, Draghi reiterated that any policy changes would be gradual, and other ECB officials quickly released comments with a softer tone.

Preferred securities rose 3.5% in the quarter, as measured by the Bank of America Merrill Lynch Core Fixed Rate Preferred Index, and outperformed high-yield and investment-grade bonds but trailed long-dated U.S. Treasuries. For the first time, all 34 participating U.S. bank holding companies passed the Federal Reserve’s annual supervisory bank stress, maintaining adequate common equity Tier 1 capital ratios in the most severe hypothetical stress scenario. The news was favorable for common equity shareholders, as passing the test provides banks with more leeway to return capital to shareholders in the form of increased dividend payouts and share buybacks after years of building capital well in excess of requirements. European bank contingent capital securities produced particularly strong returns, as risk premiums came out of European assets in general following the success of pro-EU (European Union) candidate Emmanuel Macron in the French general election.

Taxable closed-end funds returned 2.8%, based on the Morningstar U.S. Equal Weighted All Equity Closed-End Fund Index. Broad-based equity funds advanced along with the major U.S. and global stock market averages, adding to the funds’ healthy year-to-date gains. Global growth & income and equity tax-advantaged funds were among top performing taxable closed-end funds categories. Positive investor sentiment was also seen in equity fund discounts to NAV (Net Asset Value) narrowing in the quarter from 5.8% to 3.7%, down from 8.2% at the start of the year. This brought equity closed-end fund discounts below their long-term average discount of 5.2%.

INVESTMENT OUTLOOK

We remain optimistic that the economic strength experienced in recent months will continue, even if at a somewhat slower pace. In the United States, uncertainty has replaced some of the enthusiasm that initially greeted the Trump administration’s pro-growth policies, specifically around the timing and likelihood of potential tax cuts and a major infrastructure spending plan. However, we believe regulatory changes could still have positive implications for U.S. infrastructure subsectors such as midstream energy, as the new administration has already made noteworthy moves to speed up federal pipeline approvals. We expect interest rates will rise moderately this year in response to faster growth and an uptick in inflation.

For dividend-paying equities, we continue to target the cyclical upswing through our allocations to the financial services, industrials, materials and energy sectors. Dividend policies will take on more importance as interest rates rise, in our view, as dividend growers generally outperform higher-yielding, lower-growth stocks when rates rise. In this environment, companies with stronger business models and solid cash-flow generation appear to be better able to grow earnings and dividends through market share gains or acquisitions, supporting dividends and dividend growth.

MLPs (Master Limited Partnerships) may benefit if our expectations are met for the global oil market to shift into undersupply later this year and if North America gains market share as a global energy supply source. We believe North American producers have cost advantages over other potential sources of incremental supply. Over time, we believe MLP fundamentals may strengthen as commodity prices rise, volumes grow and the supply/demand dynamic for pipelines improves.

REITs have historically performed well in periods of accelerating growth—even when interest rates and inflation are also rising. We believe commercial real estate may continue to see improving operating fundamentals in most global markets amid solid economic growth, steady job creation and monetary conditions that will remain relatively accommodative as stimulus is gradually withdrawn. Such an operating environment coupled with attractive valuations could draw increasingly favorable attention to an asset class that has widely underperformed global equities over the past year.

Fixed income assets generally continue to be vulnerable to rising yields, although we believe preferred securities remain well positioned relative to other areas of fixed income. Preferreds have characteristics that could help mitigate potential headwinds associated with a rising-rate environment, as their high income rates and wide yield spreads relative to Treasuries and corporate bonds may help cushion the impact of rising rates over time, in our opinion. Additionally, banks and insurance companies—the primary issuers preferred securities—could benefit from higher rates, lighter regulation and potential corporate tax cuts, which can bolster their earnings power, strengthen their credit fundamentals and potentially lead to narrower yield spreads.

In the closed-end market, we anticipate further incremental price discount narrowing relative to the value of funds’ portfolio holdings. We believe the best long-term returns will be found in equity closed-end-fund categories that are selling at the widest discounts to historical averages. We expect 2017 to be the fourth consecutive year of relatively light new issue activity in terms of total volume. However, Fed rate hikes could increase borrowing costs for levered closed-end funds and modestly impact their total income potential.

CRN: 2017-0803-6080 R

Data represents past performance, which is no guarantee of future results.

Opinions in this piece are those of Cohen & Steers and are not necessarily that of AAM. 

Risks of Investing in Equity Securities: The value of common stocks and other equity securities will fluctuate in response to developments concerning the company, political and regulatory circumstances, the stock market and the economy. In the short term, stock prices can fluctuate dramatically in response to these developments. Different parts of the market and different types of equity securities can react differently to these developments. These developments can affect a single company; all companies within the same industry, economic sector or geographic region; or the stock market as a whole. Dividend-paying stocks may be particularly sensitive to changes in market interest rates, and prices may decline as rates rise. Special risks of investing in foreign securities include (i) currency fluctuations, (ii) lower liquidity, (iii) political and economic uncertainties, and (iv) differences in accounting standards. Some international securities may represent small- and medium-sized companies, which may be more susceptible to price volatility and less liquid than larger companies.

Risks of Investing in Real Estate Securities. The risks of investing in real estate securities are similar to those associated with direct investments in real estate, including falling property values due to increasing vacancies or declining rents resulting from economic, legal, political or technological developments, lack of liquidity, limited diversification and sensitivity to certain economic factors such as interest rate changes and market recessions.

Risks of Investing in MLP Securities. An investment in MLPs involves risks that differ from a similar investment in equity securities, such as common stock, of a corporation. Holders of equity securities issued by MLPs have the rights typically afforded to limited partners in a limited partnership. As compared to common shareholders of a corporation, holders of such equity securities have more limited control and limited rights to vote on matters affecting the partnership. There are certain tax risks associated with an investment in equity MLP units. Additionally, conflicts of interest may exist among common unit holders, subordinated unit holders and the general partner or managing member of an MLP; for example, a conflict may arise as a result of incentive distribution payments.

MLPs are subject to significant regulation and may be adversely affected by changes in the regulatory environment, including the risk that an MLP could lose its tax status as a partnership. MLPs may trade less frequently than larger companies due to their smaller capitalizations, which may result in erratic price movement or difficulty in buying or selling. MLPs may have additional expenses, as some MLPs pay incentive distribution fees to their general partners. The value of MLPs depends largely on the MLPs being treated as partnerships for U.S. federal income tax purposes. If MLPs were subject to U.S. federal income taxation, distributions generally would be taxed as dividend income. As a result, after-tax returns could be reduced, which could cause a decline in the value of MLPs. If MLPs are unable to maintain partnership status because of tax law changes, the MLPs would be taxed as corporations and there could be a decrease in the value of the MLP securities.

Risks of Investing in Closed-End Funds. Shares of many closed-end funds frequently trade at a discount from their net asset value. The funds are subject to stock market risk, which is the risk that stock prices overall will decline over short or long periods, adversely affecting the value of an investment in a fund.

Risks of Investing in Preferred Securities. Investing in any market exposes investors to risks. In general, the risks of investing in preferred securities are similar to those of investing in bonds, including credit risk and interest-rate risk. As nearly all preferred securities have issuer call options, call risk and reinvestment risk are also important considerations. In addition, investors face equity-like risks, such as deferral or omission of distributions, subordination to bonds and other more senior debt, and higher corporate governance risks with limited voting rights.

Risks associated with preferred securities differ from risks inherent with other investments. In particular, in the event of bankruptcy, a company’s preferred securities are senior to common stock but subordinated to all other types of corporate debt. Throughout this commentary we will make comparisons of preferred securities to corporate bonds, municipal bonds and 10-Year Treasury bonds. It is important to note that corporate bonds sit higher in the capital structure than preferred securities, and therefore in the event of bankruptcy will be senior to the preferred securities. Municipal bonds are issued and backed by state and local governments and their agencies, and the interest from municipal securities is often free from both state and local income taxes. 10-Year Treasury bonds are issued by the U.S. government and are generally considered the safest of all bonds since they are backed by the full faith and credit of the U.S. government as to timely payment of principal and interest.

Preferred funds may invest in below investment-grade securities and unrated securities judged to be below investment-grade by the Advisor. Below investment-grade securities or equivalent unrated securities generally involve greater volatility of price and risk of loss of income and principal, and may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher grade securities. The benchmarks do not contain below investment-grade securities.