US equity investors spent most of Second Quarter wondering if the various indices would revisit the lows made in February. From a top down perspective, they had every reason to worry: (i) an activist FOMC, (ii) trade wars all around and (iii) mega-cap tech companies under regulatory threat; however, the balance or risk did seem more favorable within the US rather than without (political risk in Italy/EU, FX problems/bear markets for a number high profile emerging markets, etc.) and, buoyed by a strong earnings season (and subsequent share buy backs), risk assets saw a rebound in the US with domestically focused stocks (Russell 2000) outperforming companies which derive their revenues from overseas (S&P 500).
The third estimate of First Quarter GDP growth came in at 2.0%, compared to 1.2% for First Quarter 2017; the latest estimate for Second Quarter from the Federal Reserve Bank of Atlanta is 4.5% so 2018 is thus far shaping up to be a banner year for economic growth in the US. According to the Bureau of Labor Statistics, changes in total nonfarm payroll in the past three months were 213,000, 244,000 and 159,000, respectively, an average of 205,333 compared to an average of 193,000 for the 12 months prior. The yield on the 10-Year Treasury Note rose from 2.741% to 2.849%.
The Wilshire US REIT Index (“Index”) was up 9.7% in Second Quarter, besting both the S&P 500 and Russell 2000 Indices which advanced 3.4% and 7.8%, respectively; this is the first quarter of REIT outperformance in eight, a clear reversion to the mean for the group; every constituent of the Index except one produced positive returns.
Interestingly, the Second Quarter charge by the group was led by the previous laggards in the Index; Health Care, Diversified and Retail-Local all rebounded strongly from negative double digit returns for the year prior while Industrial and Manufactured Housing, which delivered 21.6% and 16.9% from 3/31/17 – 3/31/18, both underperformed. Given the continued outflows from REIT funds in the US and in Japan, short covering by hedge funds and bottom fishing by generalist were probably the spark for the Second Quarter rally (the sectors favored by dedicated REIT investors, as surveyed in Citi’s 23rd Annual Global Property CEO Conference in March, all underperformed and vice versa).
Even within the sectors themselves, it was a rally led by the under-owned and the under-appreciated. Segregating the Index into quartiles, it was the stocks with the highest dividend and cash flow yields (B/C quality assets, secondary and tertiary markets, bad balance sheets, etc.) that handedly outperformed in Second Quarter, delivering 16.9% and 16.8%, respectively, compared to the Index. Unfortunately, constituents in those quartiles comprised only 17.2% and 10.1% of the Index so institutional shareholders were probably under-represented and did not derive full benefit from the “junk rally” in REITs.