During their last meeting of 2017 held on December 12-13, the Federal Open Market Committee decided to raise the target range for the federal funds rate another 25 bps. There were two dissenters to the decision, Charles Evans and Neel Kashkari, both citing a rate of inflation well below the Committee’s 2% target. Governor Kashkari also cited concerns about a flattening yield curve which he speculated was “partly due to falling longer-term inflation expectations or a lower neutral real rate of interest.” Counterbalancing those concerns are thoughts and observations that financial conditions are still too accommodative, resulting in elevated asset prices with very little volatility; even the conundrum of the flattening yield curve can be explained by “large holdings of long-term assets by major central banks… and substantial global demand for assets with long duration.”
Classic symptoms of demand-pull inflation are being exhibited, albeit selectively. Benefits of the economic recovery from the Great Financial Crisis are accruing unevenly through society resulting in greater disparity in income and wealth; it should come as no surprise to the members of the FOMC that signs of inflation are not quiescent across broad swatches of America while $450.3 million is being paid for a Leonardo Da Vinci painting (purchased at an estate sale in 2005 for $10,000) or $17.8 million is being paid for Paul Newman’s Rolex Daytona (purchased by Joanne Woodward in 1968 for around $250). Bitcoin anyone?
If someone is willing to pay almost half a billion dollars for what has been described by Jason Farago in The New York Times (November 15, 2017) as “a proficient but not especially distinguished religious picture from the turn-of-the-century Lombardy put through a wringer of restorations,” why don’t investors want to buy well located, high quality commercial real estate buildings with an average dividend yield of 3.7%?
Summarizing the view of the naysayers, the research firm Empirical Research Partners writes (January 16, 2018), “Bond Surrogates are the 10% of the equity market with relative returns most tied to the performance of Treasury bonds. More than 80% of them are drawn from the utility, REIT, consumer staples and health care sectors. We’ve thought that most were overvalued, having been priced off their dividend yield rather than their fundamentals. They’ve sold at multiples like those of growth stocks despite the fact that they grow their dividends about half as fast.” But the yield on the 10-year Treasury Note actually fell from 2.446% to 2.405% in 2017!! During that time, the S&P 500 Index, the Dow Jones Industrial Average and the NASDAQ 100 Stock Index produced total returns of 21.8%. 28.1% and 33.0% compared to the meagre 4.2% produced by the Wilshire REIT Index. As a result, REITs screen cheap to both bonds and equities. According to Green Street Advisors, as of year-end 2017, REITs trade at a 19% discount to Fixed Income and 12% discount to the S&P 500. In a world where excesses in valuation are being exhibited everywhere, doesn’t some cheap commercial real estate make sense?