“Someone’s sitting in the shade today because someone planted a tree a long time ago.”
~ Warren Buffet
Our Current Key Macro-Economic and Stock Market Assumptions
As per our macro assumptions noted below, earnings growth has turned negative on a year-over-year basis. Market valuations that were stretched thin at the start of Q2 have moved lower since late July with the broader market averages all recently entering correction territory, as defined by closing at more than 10% below their recent highs. As noted in past HITR Flash Reports, US equities have been struggling outside the magnificent seven for a few years now, particularly smaller cap stocks which have reached discounts to larger stocks not seen since the 1980’s. In real terms, the Russell 2000 is now back to price levels first hit in March 2015. Dividends matter as we discussed last quarter and have helped offset some of these losses but given the broad disparity between smaller and larger stocks it is inaccurate to suggest that all US equities have been powering ahead in the last few years. The mega caps have been powering ahead, taking market cap weighted indices with it to a sizeable degree, but scratch beneath the surface and we’re starting to see an ever-lengthening period of non-mega cap stocks going sideways, especially the smaller ones. In real terms, this is a hidden correction and dividends play a key role in providing returns that are lacking absent price appreciation.
The good news is that this hidden correction is making stocks in general cheaper. But an important historical fact to remember is that the S&P 500 went sideways in real price terms for 29 years from 1929 to 1958, 24 years from 1968 to 1992, and 14 years from 2000 to 2014. Dividends were the driver of returns during these periods. So, after prolonged periods of high valuations, especially during sustained high inflation, equities can be range bound for long periods of time.
With a potential recession looming, this certainly sets the stage for ongoing revaluation in many sectors of the market and the economy. That could certainly impact the relative valuation and thus the allocation among and between the HITR segments as listed below.
Although our forward outlook is revised continuously as new data is available, our Current Key Macro-Economic and Stock Market Assumptions are as follows:
1. US economy suffers a mild-modest recession beginning in late 2023 – Loss of -1.0% to -1.5% GDP over 2-3 Qtrs.
2. Unemployment rises slowly to higher levels (4.5%-5.0%) as the economy slows and consumer spending is more subdued.
3. Inflation does decline but remains sticky with core PCE stubbornly around 3.5% by the end of 2023 & the Fed is constrained from reducing the FFR in a meaningful way until well into 2024.
4. UST/Bonds real yields remain positive supporting yield orientated investments. Nominal yields stabilize and the yield curve normalizes.
5. Corporate earnings turn negative on a Y/Y basis – we assume decline in SPX EPS of -5% to -10%. Sales are generally flat/weak; input costs continue to inflate pressuring margins and there are continued FX headwinds.
6. Current elevated stock market valuations (with weak earnings) limit Y/Y market returns despite a potentially brighter prospective economic/earnings outlook later in 2024.
A few observations worth noting:
The last few months have bordered on un-investible. The market environment where macro, micro and geopolitics have all come together to form a toxic milieu for investing. As noted before, although the headline index has suffered, under the surface sector and stock dispersion has been savage and substantial. This provides interesting potential investing opportunities but also increased risk.
We believe the market is now beginning to fully digest the interplay of higher rates and higher for longer, while having a slowing economy, a nervous consumer, a dangerous geopolitical backdrop, and a market still trading rich when factored through the prism of earnings and interest rates. Without providing the equity risk premium those factors demand, it’s likely to be a bumpy ride for investors on a go forward basis.
When, Q3 reporting season began to ramp up in earnest with 35% of companies’ earnings being released. Already, there have been numerous notable profit warnings with misses being punished aggressively by the market. These warnings so far have been concentrated in Consumer Discretionary and Industrials with multiple companies guiding toward an increasing deceleration in demand for 2024.
Tina/Tara/Taba The market has quickly shifted from TINA (there is no alternative) to TARA or TABA (there are real alternatives/there are better alternatives). And there is certainly some truth embedded in the later statements. Receiving ‘risk free’ real cash-on-cash return of 5% or greater is a compelling value proposition in an uncertain world. Markets continue to re-calibrate to a higher for longer world and attempt to put the appropriate multiple on growth while also trying to price a growth slowdown, central bank policy moves, geopolitical uncertainty, and escalation risks.
Debt. Federal debt as a percentage of GDP has risen from $2.4 trillion in 1990 or 41% to $25.7 trillion or 120% in 2022. It is not clear what impact that will have on issuance and the related market valuation of yield alternatives. The looming supply of new debt is substantial and well above anything we’ve seen before. The usual cohort of buyers is also likely going to be different. China and Japan will no longer buy at scale as we witness globalization begin to unwind and some level of de-dollarization begins to emerge in a meaningful way. We see institutions suffering from owning too much lower coupon, longer duration paper causing unrealized mark-to-market losses. For retail investors owning the front-end shorter duration paper seems like a far more attractive proposition than taking duration risk with a flat curve. This stacks up to look like an unpleasant lose-lose of weak demand and/or increasing supply impacting the longer duration world until there is a new and better ‘clearing price’ that normalizes the curve.
Consumer. Student debt relief has begun rolling off with October being the first month of student loan repayments since 2020. There is no precedent in terms of measuring the potential impact of this reinstatement, but it will certainly be a headwind. Rising delinquencies and growing credit card debt in conjunction with weaker household balance sheets due to lower asset prices is also going to weigh on the consumer, particularly those that are in the median income range and below. Recall in 2007 when GDP saw a massive beat in Q3 (+4.9%) before peaking in Q4 only to then see a material fall to its ultimate trough in Q2 2009 as we dealt with the Global Financial Crisis (GFC). My thought here is that the consumer can react at lightning speed to changes in their economic psyche, so despite a print of a 4.9% GDP figure for Q3 2023, things can change quickly and high frequency data (retail traffic, airline ticket sales, corporate guidance) seems to support some material slowing of the consumer.
Capital markets. The past decade has been lived in a world of abundant (perhaps excess?) liquidity with equity and debt being issued in a size and scale heretofore unseen. This unprecedented volume of investments will now need to reprice across a quality curve that is experiencing a regime change in central bank policy on a global scale. Frequently we see potential ‘zombie’ companies that have found themselves in capital structures that are not fit for their business purpose, normally with too much debt, cheap debt advancing toward maturity and a forward earnings profile that provides little or no ability to do much about it. This situation will play out over the next few years and therein will be some new and meaningful opportunities for HITR portfolio investors. We are likely to see the use of structure to subordinate others on the cap stack and to get equity like returns for debt and equity hybrids as a possible solution. It does feel like things are changing and getting more three dimensional as we see increased issuance of convertible securities and richer yields in the preferred space with meaningful call protection. These situations benefit the strong. We recently watched Raytheon borrowing money to announce a $10bn buyback as a positive example of this ability to play across the cap structure. That decision resulted in a 7% gain in for only 3 bps of credit spread widening. We think we are likely to see more of these types of transactions in the future.
Allocation Notes:
The relative value among and between the four sectors of the HITR portfolio have started to change at a faster pace after remaining relatively stable over the past year. Since our last report, the Other Income and Global Infrastructure sectors have both gained some weighting in our top-down model at the expense of the Common Stock and REIT category. This is in part due to a recent sequence of huge downward moves for companies central to energy transition which largely inhabit the Global Infrastructure and Other Income space. The upward shift in interest rates has resulted in a significant impact on their cost of capital, the cost of growth and in some instances their paths to profitability. This has resulted in many widely held renewable companies having suffered dramatic moves lower. The impacts of these rising capital costs have then spilled outward into areas like the Electric Vehicle (EV) sector and its cohorts like lithium and copper mining stocks.
Our current plan is to adjust toward the model weights gradually into the end of Q4 as we have a fresh set of earnings data and guidance to work with after the Q3 reporting season.
As per our macro assumptions noted above, earnings growth has turned negative on a year-over-year basis and market valuations are more stretched than at the start of Q2. With a potential recession looming, this certainly sets the stage for a potential revaluation in some sectors of the market and the economy. That could certainly impact the relative valuation and thus the allocation among and between the HITR segments as listed below.
3Q23 HITR Flash Report Segment Data:
Common Stock
With the stock market rallying for the second consecutive quarter on hopes of a soft economic landing, our Common Stock allocation, at 23.4% of the portfolio, outperformed the S&P 500 in Q3 by 271 bps (and 216 bps as net performance).
Thematically within the common stock segment of the portfolio we have leaned into selected broad-based technology and basic materials themes that would benefit from continued inflation. A secondary theme of financials that benefit from higher yields is also a minor macro thread across the HITR portfolio.
Our top performing Common Stock, Bunge (BG), was up +17.9% in Q3 as they reported better-than-expected earnings on the top and bottom lines, an increase in free cash flow expectations, and benefited from higher grain prices and tighter end markets. Our second-best performer, AbbVie (ABBV), was up +14.3%. They announced an excellent quarter beating consensus estimates by $0.09 and topping revenue expectations by 6%. In addition, the board raised the dividend by 8% which highlighted the rebound in Skyrizi and Rinvoq, two potential successor drugs to Humira, which had underperformed last quarter ahead of Humira’s upcoming patent cliff.
The biggest laggard this quarter, Albemarle (ALB), was down -22.6% on lowered guidance related to production bottlenecks in lithium for EV batteries. Our second-worst performer, lnterDigital (IDCC), fell -16.0% as concerns over slowing growth in the wireless markets pushed the stock lower.
Changes to the Common Equity allocation during the quarter included the sale of Virtu Financial (VIRT), after the firm disclosed additional information regarding an SEC probe into their internal controls and the Co-President selling shares. In addition, we sold our position in Broadcom (AVGO), as it had reached our price target and had grown to the largest single position in the Common Stock segment of the portfolio.
Global Infrastructure
At 25.3% of the portfolio, the Global Infrastructure allocation outperformed the DJ Brookfield Global Infrastructure Index by 835 bps (and 780 bps as net performance) as our limited exposure in the alternative energy transition space helped to mitigate some of the negative exposure in the sector.
Thematically, the Global Infrastructure segment is focused on a blend of new energy opportunities and traditional energy infrastructure companies. In addition, newly added themes touch on electric vehicles and airport operators.
Valero Energy (VLO) was our top performer, up +26.5% as natural gas prices rebounded after an extended downtrend and refining spreads which were a challenge last quarter rebounded to more normal levels. Euronav (EURN), our next-best performer, was up +20.7%. Clearway Energy (CWEN), one of our renewable energy holdings, was one of our two worst performers as it fell by -26.1% during the quarter suffering from the repricing of transitional energy assets along with Nextera Energy Partners (NEP) which was down -47% on similar concerns.
Other Income
Accounting for 26.3% of the portfolio, the Other Income allocation with a focus on preferred and convertible preferred securities outperformed in Q3 by 51 bps (and 3 bps as net performance).
Thematically our focus in the Other Income segment has been focused on special situations with a bias toward out of the money convertibles which offer decent current yields and the possibility to capture some upside appreciation as the underlying company appreciates toward the conversion price.
Redwood Trust Preferred (RWT-Pa) was our top performer this quarter in the Other Income segment, up +12.4% as the underwriter of variable rate jumbo mortgages enjoyed an uptick in business activity and rebounded from the general downturn in Financials preferreds stemming from the Silicon Valley Bank failure. Our second-best performer, New Your Mortgage Trust Preferred (NYMTM), was up +5% as the company reported strong earnings and benefitted from the similar shift in demand in the mortgage segment much like RWT-PA. Ellington Financial (EFC) and AT&T preferred (T-PC) were our worst performers, with positions down -7.8% and -7.6% respectively, struggling in the face of rising bond yields on the longer duration segment of the yield curve.
REIT
REITs, representing 25.0% of the portfolio, outperformed the NAREIT All Equity Index by 216 bps (and 163 bps as net performance) as our defensive posture helped in the face of rising rates.
Omega Healthcare (OHI) led our REIT holdings, returning +10.8% in Q3. Omega, an owner and operator of healthcare and senior living properties, continues to redeploy assets with good operators which has allowed them to projectably increase rents and increase free cash flow. Iron Mountain (IRM) was our next-best performer up +6.4% as this REIT transitioned from an industrial storage REIT into a diversified REIT while expanding their ownership of data centers as they sell non-core storage warehouses.
Our main laggard, Crown Castle (CCI), was down -17.9%, while American Tower (AMT) was down -16.3%. Both Crown Castle and American Tower, Telcom Infrastructure REITs, were negatively impacted by a rotation out of the sector among investors who continue to migrate into Data Centers for a purer play on artificial intelligence (AI) amidst continued tech outperformance in equity markets.
Conclusion:
The U.S. economy is facing growing headwinds as signs of an economic slowdown continue to emerge. As noted above, we continue to have a cautious economic and earnings outlook. We expect increasing market volatility as we move through into the end of the year given the upcoming the political and economic calendar. We think it is likely, despite the recent modest easing in the CPI report, that the Federal Reserve will continue to attempt to bring inflation down with a tighter monetary policy. Consumers are faced with the erosion of purchasing power with higher prices for goods, services and in particular, shelter putting a strain on the liquidity of the overall consumer sector. Additionally, we expect corporate earnings to continue to come under pressure and expect both supply chain expense and higher labor costs to remain an ongoing margin challenge. Ultimately, the increasing risk is that demand reduction will land the economy in a modest recession. We also suspect the Fed may need to raise rates higher than the market currently expects and keep them elevated for a longer time than anticipated to ensure that inflation does not rebound due to a sticky price environment. All factors considered, now more than ever we expect active management and defensive income-oriented value opportunities like those in the HITR portfolio to resume their outperformance during the final quarter of 2023, as the era of TINA (There Is No Alternative) is over, FAAMGS leadership subsides, and investors once again have attractive investment alternatives in yield-oriented value names.
Richard Imperiale
Portfolio Manager
October 2023
All data are for the period ended September 30, 2023, unless otherwise noted.
The Uniplan High Income Total Return (HITR) portfolio is focused on providing current income and long-term growth by owning dividend paying equity securities. Within the portfolio these investments are grouped into the categories of Dividend Paying Common Stocks, Global Infrastructure) or their proxies, Real Estate Investment Trusts (REITs) and Other Income Equities (primarily preferred and convertible stocks, ETF’s, and ETN’s). This note revisits some of the thematic qualities of the portfolio within each of the categories and the performance by sector across the overall portfolio.
The views, as of October 2023, may not necessarily reflect the same views on the date this letter is first published or any time thereafter. These views are intended to help clarify the portfolio’s investment methodology and do not constitute investment advice.
Important Information: 1. Uniplan Investment Counsel is a boutique investment firm, with roots dating back to 1984, that manages a variety of portfolios primarily for US clients. 2. The composite was created January 1, 2001. Performance is calculated in US dollars utilizing a time-weighted total rate of return. Total return for the composite is represented by the asset-weighted returns of the portfolios within the composite. Trade-date valuation is used. 3. Performance is net of all transaction costs and net performance is net of transaction costs and (maximum allowable total) investment management fee, but before any custodial fees (that may be incurred separately by the client). 4. The benchmark for the composite is the Russell 1000 Index that measures the performance of the 1,000 largest companies in the Russell 3000 Index. The Russell 3000 Index represents approximately 98% of the investable US equity market. 5. Within the Uniplan High Income Total Return (HITR) portfolio investments are grouped into the categories of Dividend Paying Common Stocks, Global Infrastructure, Real Estate Investment Trusts (REITs), and Other Income Equities (primarily preferred and convertible stocks, ETFs and ETNs). These groups are represented by the following indices respectively. S&P 500 – The S&P 500 or Standard & Poor’s 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. Dow Jones Brookfield Global infrastructure – The DJ Brookfield Global Infrastructure Index is designed to measure the performance of pure-play infrastructure companies domiciled globally. The index covers all sectors of the infrastructure market. NAREIT All Equity – The FTSE NAREIT All Equity REITs Index that represents the tax-qualified REITs listed on the New York Stock Exchange, the American Stock Exchange and the NASDAQ National Market System. Barclays Pfd & Cvt – Barclays Capital Aggregate Bond Index is a market capitalization index made up of US Treasury Securities (non TIPS), government agency bonds, Mortgage-Backed bonds, and corporate bonds, and a small amount of foreign bonds traded in the US. Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. 6. The indices are adjusted to reflect reinvestment of dividends. The index figures do not reflect any deductions for fees, expenses or taxes. It is not possible to invest directly in an index. 7. There are no guarantees that dividend-paying stocks will continue to pay dividends. Dividends are paid only when declared by an issuer’s board of directors, and the amount of any dividend may vary over time. Dividend yield is one component of performance and should not be the only consideration for investment. In addition, dividend-paying stocks may not experience the same capital appreciation potential as non-dividend-paying stocks. Diversification does not assure a profit nor protect against loss. Additionally, International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. The portfolio may own ADRs on occasion, as such international investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. 8. The dispersion of annual returns is measured by the standard deviation of asset-weighted portfolio returns represented within the composite for the full year. The standard deviation of the gross annual returns for the period January 1, 2001 through September 30, 2023 is 15.64% for the composite and 17.96% for the Russell 1000 Index. 9. The composite does not have a minimum size criterion for composite membership. All fee-paying discretionary accounts with similar investment objectives are included. Leverage is not used in this composite as a means to generate higher returns. There may be non-fee paying portfolios in the composite. Individual account holdings may vary depending on numerous factors including the size of an account, cash flows, and account restrictions. 10. There have been no changes in the personnel responsible for the management of this composite. 11. The composite contains both traditional and wrap fee portfolios. Uniplan has a flexible and negotiable fee schedule reflecting the differences in size, composition and servicing needs of clients’ accounts. 12. Uniplan Investment Counsel does not claim GIPS compliance. The performance has been verified by an independent source as of 1/01/2011 – 12/31/2022. A complete description of investment advisory fees is contained in Uniplan’s Form ADV and is available upon request. Individual account performance may vary from the results shown because of differences in inception date, restrictions and other factors. 13. This information is not an offer to buy or sell a security nor does it constitute investment advice or an offer to provide investment advisory or other services. All information is subject to correction or change. Past performance is no guarantee of future results. Investment involves a risk of loss.
All investments carry a certain degree of risk, including possible loss of principal. REITs are subject to illiquidity, credit and interest rate risks, as well as risks associated with small and mid-cap investments. It is important to review your investment objectives; risk tolerance and liquidity needs before choosing an investment style. Value style investing presents the risk that the holdings or securities may never reach their full market value because the market fails to recognize what the portfolio management team considers the true business value or because the portfolio management team has misjudged those values. In addition, value style investing may fall out of favor and underperform growth or other style investing during given periods.
Uniplan Investment Counsel is a registered investment advisor. The views expressed contain certain forward-looking statements which can be speculative in nature. Uniplan Investment Counsel believes these forward-looking statements to be reasonable, although they are forecasts and actual results may be meaningfully different. This material represents an assessment of the market at a particular time and is not a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular security and is subject to change without notice. Past performance does not guarantee future results. Prices, quotes and other statistics have been obtained from sources we believe to be reliable, but Uniplan Investment Counsel cannot guarantee their accuracy or completeness. All expressions of opinion are subject to change without notice. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of this security. A list of securities purchased and sold in the portfolio during the past year, including the purchase or sale price and the current market price, is available upon request by calling 262-534-3000.