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Cohen & Steers 2018 Review and Outlook


INVESTMENT REVIEW

Following a prolonged period of steady gains, equity and credit markets encountered turbulence in 2018 amid tighter financial conditions, rising global trade tensions and slowing economic growth. Although economic growth remained relatively healthy globally, momentum slowed across most regions. Europe and China particularly showed signs of deceleration.


Inflation remained subdued, but indications that pressures were building, notably in the labor market, prompted the U.S. Federal Reserve to continue to normalize interest rates. The Fed also removed liquidity from the system by slowly unwinding its crisis-era quantitative easing program via portfolio runoff, while the European Central Bank (ECB) stopped increasing the size of its portfolio.


The Russell 1000 Dividend Growth Index returned -3.5% in the year. Health care was the top performing sector as investors sought havens in a market marked by elevated volatility. Utilities also gained, reflecting the defensive nature of the sector’s cash flows and the group’s strong domestic focus. Consumer staples’ defensive characteristics weren’t enough to overcome market turbulence accompanied by rising input costs. Within financials, banks underperformed on concerns about the economy, credit and a flattening yield curve, while life insurance stocks took a hit due to greater leverage, credit fears and their sensitivity to equity markets. Energy was the worst-performing sector as oil prices declined, driven by mounting supply and demand fears.


Master limited partnerships (MLPs) had a total return of -12.4% as measured by the Alerian MLP Index. MLPs experienced a banner year in terms of improving industry fundamentals and operating performance thanks to rising North American energy production volumes, healthy domestic demand for crude oil, natural gas and natural gas liquids, and growing energy exports that led to greater better-than-expected cash flow growth and throughput volumes for assets owned by midstream companies throughout the year. However, these positives were overshadowed by other factors, including regulatory issues, the broad market selloff and the sharp decline in the price of crude oil.


Real estate investment trusts (REITs) had a total return of -4.6%, as measured by the FTSE Nareit Equity REIT Index. After trailing the broad U.S. equity market for much of the year, real estate stocks began to outperform in the fourth quarter as investors’ appetite for risk assets diminished. While REIT prices moved directionally with the broad market, investors generally favored stocks in the asset class for their stable cash flow generation, attractive dividend yields and relative valuations.


Free-standing retail REITs and health care property companies were positive standouts, favored for their relatively stable revenue generation tied to typically long-term leases. Apartment REITs benefited from favorable employment and household formation trends. Hotels, typically considered one of the more economically sensitive sectors, underperformed. Regional mall and shopping center REITs also struggled amid secular concerns over online retailers gaining market share from their tenants. The data center sector was another notable underperformer, following two years of exceptionally strong performance, on concerns of slowing demand and its ties to the technology sector.


Preferred securities returned -3.6%, as measured by the ICE BofAML Core Fixed Rate Preferred Index. Preferreds delivered a negative total return for the first time in a decade amid a lower tolerance for risk due to decelerating economic growth, trade tensions, the ECB winding down its quantitative easing, and rising political disruption in many parts of the world. Conditions became more challenging in the fourth quarter in part due to technical pressures; ETFs (Exchange-Traded Funds) and mutual funds that have sizable allocations to the group saw significant outflows late in the year, which resulted in widespread and often indiscriminate selling of preferred securities. Tax loss-related selling likely contributed to these pressures ahead of year-end.


Taxable equity closed-end funds returned -13.8%, based on an equal weighted average of that universe. Equity and fixed income categories both declined, although fixed income held better than equity funds as a group. Within equities, the energy/resources and MLP sectors both fell more than 20% amid a sharp decline in oil prices in the year. The more defensive health-biotech and utilities sectors outperformed. Within fixed income, emerging market income and preferred funds were among the poorer performers. Multi-sector funds, which have the flexibility to maneuver around the various asset classes within fixed income, outperformed.


The period saw a general widening in closed-end funds’ discounts to their NAVs. Equity closed-end funds average discount went from 3.4% to 6.8% at the end of the year, somewhat wider than the historical average. The average discounts on taxable fixed income and municipal funds also expanded, to 7.9% and 11.5%, compared with long-term averages of 3.1% and 3.8%, respectively.


INVESTMENT OUTLOOK

Notwithstanding recent heightened market volatility in general, we believe the landscape remains favorable for equities and for the global economy as a whole. However, tight labor markets and early signs of wage growth could cause the market to adjust its inflation expectations higher, potentially leading to a faster pace of rate hikes and further market volatility.


Dividend-paying equities: Our outlook on stocks remains generally optimistic, although 2019’s backdrop could be challenged by ongoing trade issues, a global economic slowdown, higher interest rates and a lack of incremental fiscal stimulus. We are keeping an eye on deteriorating credit trends, as well as how companies continue to grapple with the rising costs of wages and other inputs such as health care and logistics. U.S. politics are back at the forefront as the effects of a divided government remain to be seen.


Longer term, dividend-paying equities may 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.


Master Limited Partnerships: Fundamentals for midstream energy companies appear to be strong amid increasing North American production volumes. Notwithstanding oil’s recent pullback, OPEC’s apparent commitment to production discipline gives us confidence that crude oil prices will remain healthy enough to incentivize continued production growth from North American exploration & production companies.


The multi-year weakness in midstream energy stocks has left the sector trading at discounted valuations. In addition to appearing attractively priced on commonly watched industry metrics, midstream companies now compare well relative to the broad market on a price-to-earnings and price-to-book value basis — potentially bolstering the asset class’ appeal to a broader set of investors. Valuations are even more appealing through the lens of MLP closed-end funds, in our opinion. The group’s yield is significantly above its historical average and is one of the highest of the closed-end fund categories. Additionally, the MLP closed-end fund category’s 7% discount to net asset value at year’s end was considerably wide of its average historical premium, offering the potential for price appreciation.


Real Estate Investment Trusts: In our view, REITs are attractively positioned in a late-cycle environment. As the broad equities market adjusts to an environment of peak earnings margins and decelerating growth, REITs with defensive, contractually based growth characteristics are projected to maintain a positive earnings outlook that is largely unchanged. We believe Treasury yields are less likely to move significantly higher, increasing the appeal of REITs’ above-average income as broader growth slows. Furthermore, multiples have contracted for REITs over the past five years, versus multiple expansion for stocks, while many REITs trade at discounts to their NAVs (net asset value).


Preferred securities: Although the world economy appears to be decelerating, we expect continued growth in the United States. Given the tightness in labor markets, should growth continue near its current pace, the Fed may continue to tighten monetary policy. However, we expect the Fed to exercise more caution in the rate hike cycle in the face of weaker capital markets and tightening financial conditions as risk spreads widen. The very flat yield curve should also give the Fed pause. With preferred prices pressured materially lower in recent weeks, we believe they offer attractive yields and spreads; a great deal of risk and uncertainty is priced in. As well, their high yields should help to cushion the impact of price volatility over time, as the income smooths their total returns.


Closed-end funds: The best long-term returns are likely to be found in closed-end-fund categories where the underlying asset class offers relative value and discounts to NAVs are near their historical averages, in our opinion. While rising interest rates may challenge the earnings power for closed-end funds with leverage in their capital structure, we believe rates will remain accommodative relative to long-term historical averages.




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


CRN: 2019-0107-7139R


Opinions in this piece are those of Cohen & Steers and are not necessarily that of Advisors Asset Management (AAM).


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 commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.


The views and opinions in the preceding commentary are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this presentation will be realized. This material should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice, is not intended to predict or depict performance of any investment and does not constitute a recommendation or an offer for a particular security. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment.


All content on this site is presented only as of the date published or indicated and may be superseded by subsequent market events or for other reasons. In addition, you are responsible for setting the cache settings on your browser to ensure you are receiving the most recent data.


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. 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. Foreign securities involve special risks, including currency fluctuations, lower liquidity, political and economic uncertainties, and differences in accounting standards. Some international securities may represent small- and medium-sized companies, which may be more susceptible to price volatility and less liquidity than larger companies.


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 Cohen & Steers. 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.


Contingent capital securities (sometimes referred to as "CoCos") are debt or preferred securities with loss absorption characteristics built into the terms of the security, for example a mandatory conversion into common stock of the issuer under certain circumstances, such as the issuer's capital ratio falling below a certain level. Since the common stock of the issuer may not pay a dividend, investors in these instruments could experience a reduced income rate, potentially to zero, and conversion would deepen the subordination of the investor, hence worsening the investor's standing in a bankruptcy. Some CoCos provide for a reduction in the value or principal amount of the security under such circumstances. In addition, most CoCos are considered to be high yield or "junk" securities and are therefore subject to the risks of investing in below investment-grade securities.


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