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Larry Antonatos, portfolio manager, Brookfield Asset Management.
Now that central banks are on pause, the risk of rising interest rates is greatly decreased. One year ago, in April 2018, I was concerned that rising interest rates driven by accelerating economic growth would be a headwind for the performance of real asset equities, as broad equities with more cyclical upside would outperform. The 10-year U.S. Treasury yield did rise about 50 basis points over the following six months and broad equities generally outperformed real asset equities over that period.
However, both economic growth expectations and interest rates reversed sharply in 2018 Q4, driving a significant correction in broad equities and a more moderate correction in real asset equities. With listed real estate equities and infrastructure equities down approximately half as much as broad equities, this limited downside capture of real asset equities is a component of the defensive characteristics of real assets, where cash flows tend to be relatively stable. Real asset cash flows are generally supported by long-term leases. Infrastructure cash flows may benefit from attractive supply, demand and pricing fundamentals. Supply of infrastructure is generally constrained because many infrastructure assets are monopolies or semi-monopolies. Demand for infrastructure services is generally steady because infrastructure generally provides essential services with limited GDP sensitivity, and pricing for infrastructure services is frequently regulated.
Looking ahead we are now likely in a renewed lower-for-longer macroeconomic environment, with growth, inflation and interest rates moving up only modestly. In our opinion this is a strong environment for real asset equities to perform well. While many investors are focused on the risk of an economic slowdown, we believe the defensive characteristics of real assets will shine in that environment. In contrast, a meaningful acceleration in growth may result in cyclical equities outperforming real asset equities.
As we return to this lower-for-longer macroeconomic environment, a lingering concern is the length of the economic recovery we have had since the global financial crisis. In particular, many people are concerned about risks in the real estate market because the recovery in real estate has gone on since the financial crisis.
Now one thing to note is that problems in the real estate market have historically been driven by two factors: either an oversupply of space or declining demand for space. We have very good statistics on construction in the United States. In commercial property since 1970, construction starts as a percent of existing supply, have been approximately 2% per year since 1970. After the financial crisis they hit an all time low of 50 basis points. Since then construction has accelerated—it has actually hit the 2% long-term average—but a great benefit has been that construction has actually declined recently and is now running at approximately 150 basis points of existing supply.
This bodes well for the continued real estate cycle. As supply remains under control, now we can focus on issues of demand: Will the economy continue to grow? Will the economy slow and how will that impact demand? Because the supply side of the equation appears to be very much under control.