Today’s CIO Weekly Perspectives comes from guest contributors Brian Jones, Anton Kwang, Steve Shigekawa and Gillian Tiltman.
Last week, U.S. Treasury Secretary Janet Yellen mused that interest rates might have to “rise somewhat” to accommodate the government’s fiscal largesse and prevent overheating.
Yellen’s words were ambiguous. Was she talking about Federal Reserve policy, or just long-dated Treasury yields? What does “somewhat” mean? And does she think “overheating” is a real risk? Notwithstanding that lack of clarity, the ripple of volatility sent through the markets revealed just how jittery investors have become about rising inflation and rates.
In this environment, we think investors are likely to seek out real assets. We regard Real Estate Investment Trusts (REITs) and other listed real estate securities as a liquid and efficient way to get this exposure, through property price appreciation and inflation index-linked rental income.
But do the data support the idea of REITs as a haven in times of rising rates and inflation? We decided to take a look.
Positive Real Returns
We found that, over the past two decades, dividends from the FTSE NAREIT All Equity REITs Index of U.S. real estate securities (the REITs Index) have grown much faster than the U.S. Consumer Price Index in every year except 2002, 2005 and 2009. The Index has also delivered positive real returns over time. Even if we start counting in 2007 – 2008, when the REITs Index endured a deep sell-off, it has still doubled in value while inflation has been less than 30%.
As well as outpacing inflation over time, specific periods of higher inflation appear to have benefitted REITs. In the 12 calendar years since 1991 when inflation was less than 2%, the average return of the REITs Index was 7.4%. By contrast, the average return for the 18 calendar years when inflation was above 2% was 16.5%.
REITs also appear to get more of a tailwind from inflation than the broader stock market. Over the past 30 calendar years, the REITs Index outperformed the S&P 500 Index in seven of the 12 years when inflation was lower than 2%, in seven of the 12 years when prices rose between 2% and 3%, but in five of the six years when inflation was 3% or higher. (The one year of underperformance was 2007, when there was specific stress in the real estate sector.)
We find a similar story when we consider trends in interest rates.
We looked at every 12-month period between January 1990 and March 2021 and compared the return to the REITs Index with the change in the 10-year U.S. Treasury yield. The average REITs return when the yield declined was 11.5%, but when the yield rose the average return was 14.4%. Moreover, when the yield declined, there were several 12-month periods when the REITs drawdown was -40% or more. When the yield moved higher, the worst 12-month REITs drawdown was -11% and the best return was more than 100%.
We found an even stronger positive tailwind from a rising two-year Treasury yield, which tends to be more sensitive to monetary policy and inflation expectations. Returns to the REITs Index were positive in 85% of the 12-month periods when the two-year yield rose, and the average return was 15.1%, almost five percentage points higher than when the yield moved lower.
You can see more detail in our recent article, “REITs and Rates.”
So far this year, core government yield curves have steepened as central banks have anchored shorter-dated yields, even as growth and inflation expectations recover. This dynamic is generally considered to be supportive of equity markets and, as our data suggest, it has been positive for REITs in the past.
As last week’s “Yellen sell-off” suggests, investors’ current fear is that central banks might lose control of inflation and be forced to raise policy rates. Our findings on historical REITs returns and the two-year U.S. Treasury yield suggest that this scenario may not be especially harmful for REITs—indeed, it could even be a tailwind.
We believe these historical patterns are likely due to REITs’ inherent inflation sensitivity. When both bonds and the broad equity market appear highly exposed to the risk of higher rates, we think that strengthens the case for a dedicated allocation to this unique asset class.
In Case You Missed It
- ISM Manufacturing Index: -4.0 to 60.7 in April
- ISM Non-Manufacturing Index: -1.0 to 62.7 in April
- U.S. Initial Jobless Claims: +498,000 for the week ending May 1
- U.S. Employment Report: Nonfarm payrolls increased 266,000 and the unemployment rate increased to 6.1% in April
What to Watch For
- Wednesday, May 12:
- U.S. Consumer Price Index
- Thursday, May 13:
- U.S. Initial Jobless Claims
- U.S. Producer Price Index
- Friday, May 14:
- U.S. Retail Sales