October 2021 Outlook — The Calm After the Storm

Photo by Abigail Keenan

TLDR:

·        US real estate appears attractive, and international real estate looks unattractive.

·        The US is still my personal favorite region for equities.

·        I continue to favor growth over value, but they may be converging.

               It’s been a busy past two months in the markets. As seen in the news, one of China’s largest real estate developers, Evergrande, has yet to pay off its liabilities as of this writing, inflation in the United States has persisted so far, and the US government narrowly avoided a shutdown tied to the debt ceiling. The S&P 500 was up roughly 3% in August before falling nearly 5% in September. Surprisingly enough, although emerging market equities underperformed in August, the asset class actually outperformed the S&P 500 in September in spite of the Evergrande situation and ongoing market disruptions caused by the CCP. EAFE was the strongest region for equities; one potential explanation for this could be that the energy and financial sectors both comprise larger weights in the EAFE index than they do in the S&P 500, and these two sectors were among those that fared better. The energy sector, which is heavily tied to the price of oil and natural gas, likely benefitted from a significant increase in prices for those commodities, and rising yields gave the financial sector a boost.

               I’ve developed three new forecasts since my previous writing: US core fixed income, US real estate, and international real estate. I will begin commenting on those forecasts from this post and onwards. In September, US fixed income was the strongest performing asset class of the ones that I monitor, but even it had a negative return for that month. Rising yields improve the income portion of the overall return, but rising yields lead to falling bond prices, which is a negative contributor to the overall return. US real estate fell roughly 5.5%, and international real estate fell a little less than 4%. The biggest country weights in the S&P Global ex-US Property Index belong to Japan, Hong Kong, and Australia, so the Evergrande situation affected the asset class to a lesser extent than one might have originally expected.

               Moving on to the forecasts for six months from now, I continue to favor growth over value within the US, but the return differential I’m forecasting has come down significantly. My research suggests that rising fear in the markets (proxied by the VIX) tends to be correlated with growth outperforming, while the impacts of high, stabilizing inflation are correlated with value outperforming. For now, I maintain my overweight to growth, but I will continue monitoring and providing updates as new data comes in.

               I also hold the view that the international asset classes I monitor – EAFE, EM, and international real estate, will underperform US equities. The main driver for this continues to be the relatively weak US dollar; although the dollar has gained some ground in the past couple months, it is about back to where it was six months ago and lower than it was a year ago. Since my forecasts are all based in USD, if the dollar moves closer to where it was a year ago, the return of international assets in dollars will be lower than the return in local currencies. For the EAFE regions, lower yields and credit spreads also contribute to a lower return forecast.

               Finally, I forecast that US fixed income will slightly underperform US equities and for US real estate to slightly outperform. For fixed income, as discussed previously, rising yields improve income returns but reduce price returns. For now, prospects for US equities look positive enough for equities to continue outperforming. For US real estate, rising rates lead to higher rents collected and higher dividends. In the event of continued inflation, real estate tends to be a strong inflation hedge as well. I don’t make forecasts for individual segments of the real estate sector, but residential prices are still rising across the country, and as more workers return to offices, corporate properties could also see higher returns going forward.