Spreads are elevated on CRE debt for several reasons. Roughly 50% of maturing 2024 loans were made by banks, many of which are shrinking loan books. Small- and medium-sized banks, which have the largest CRE exposure as a percentage of overall loans, face concerns over credit quality and pay more for deposits. At the same time, the largest banks, which tend to have smaller exposures, face pressure from new regulatory capital requirements. Meanwhile, falling property prices reduce the amount of equity held by owners and higher interest rates weaken debt servicing metrics, which creates an opportunity for mezzanine and preferred equity investors to help tweak capital structures.

Investors have several options when allocating to this market. Open- and closed-end funds offer a variety of exposures, including originating new loans as well as buying existing securities backed by CRE loans—such as commercial mortgage-backed securities (CMBS) and CRE collateralized loan obligations—in the secondary market. Many of these funds focus on new senior loans, but others will also extend mezzanine loans or buy preferred equity to help offset how property price declines have reduced equity cushions. Some funds employ leverage to boost returns by borrowing at the fund level; others may consolidate pools of new loans into a CMBS transaction and retain the “first loss” or “B-pieces.” Strategies vary across markets (primary versus secondary), seniority (senior versus mezzanine, etc.), sectors, and other dimensions.

Return potential varies according to approach. Managers extending new loans on stabilized buildings in sectors with strong fundamentals may target mid-/high-single-digit unlevered yields; with leverage, potential returns may be in the low double digits. In contrast, funds looking to buy secondary market securities (e.g., CMBS) at distressed prices may target low double-digit returns. Closed-end funds that are originating mezzanine or preferred equity may have even higher return targets, though the share from their cash coupon will be lower.

Real estate lending carries potential risks. Higher interest rates have put upward pressure on cap rates, and the potential for interest rates to remain higher for longer could put pressure on owners that have used floating-rate debt. Reduced transaction volumes in recent quarters reflect uncertainty around rates and raise questions around where property prices will stabilize. Fundamentals like vacancies and rent growth are also in flux for some property types. Many private funds are sitting on significant amounts of dry powder, which, if deployed, could increase competition for new loans and reduce spreads. Preqin estimates private real estate debt funds have around $77 billion of dry powder, and so-called opportunistic funds have another $200 billion+ they may be willing to invest at the right yield.

Still, some risks may be exaggerated, creating an investment opportunity. Excluding categories like office (roughly a quarter of the US CRE lending market), fundamentals look healthier in categories such as industrial and multi-family. Given recent price declines, new lenders are both obtaining more security (lower loan-to-value) and lower valuations. Further, existing dry powder seems small relative to the roughly $5 trillion of outstanding CRE debt. In other words, some opportunistic funds may never deploy if spreads retreat, potentially putting a floor under spreads.

Investors should ask how the real estate debt opportunity compares to other opportunities. CRE debt internal rates of return are likely to be attractive for current vintages, given higher rates and spreads. Whether they outperform CRE equity funds in future years will depend on several factors, including the direction of rates, property prices, and riskiness of the underlying assets. Regardless, debt capital can be put to work more quickly relative to equity. Within private debt or diversifier portfolios, CRE debt provides an opportunity to diversify away from corporate credit exposures, though leverage and area of focus will impact relative performance. For investors considering an allocation, we prefer managers that have experience investing through market cycles and can invest across different parts of the capital stack. We also prefer those that have in-house asset management capabilities, given managers may need to take possession of assets.

Wade O’Brien, Managing Director, Capital Markets Research

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The rallies in both bitcoin and gold since last fall have certainly been noteworthy. Bitcoin fervor has returned, owing to two factors. First, the SEC approved spot bitcoin ETFs in January, making it easier for investors to access and triggering significant investment inflows. Second, the anticipation of bitcoin’s fourth “halving” event, which will decrease the rate of new bitcoins entering circulation, sparked speculation that the fair value of bitcoin exceeds its recent price. The digital currency reached $73,000 by mid-March, surpassing its November 2021 high. It climbed 190% trough-to-peak since its September low, representing the ninth time that bitcoin has seen a price increase of more than 100% without a significant price reversal during the run-up. ¹

Gold’s surge has been driven by geopolitical tensions, an uptick in central bank purchases of gold, and the decline in the US ten-year Treasury yield. On the latter, the US ten-year Treasury yield has declined by roughly 70 basis points to 4.3% since mid-October, which has decreased the opportunity cost of holding gold. As a result, gold gained 10% over that same period and is currently near an all-time high of just under $2,200/troy ounce. This has been a sharp rally by gold’s standards.

But focusing on prior rallies is only half of the story. After each of the prior eight episodes when bitcoin gained more than 100%, it experienced a median drawdown of 30%, which often happened in less than a month. It is also worth noting that bitcoin plummeted 77% in just over one year after reaching its last peak of around $68,000 in 2021. Gold’s drawdowns have been fewer and smaller in magnitude. Still, since 1990, it has seen nine drawdowns with a median of -22%, and these drawdowns occurred after gold had rallied by around 40%.

Still, we view bitcoin and gold as different investments. We see bitcoin as highly speculative, and we believe it will behave like other risk assets in a market downturn. In contrast, gold has a more proven track record as a reliable haven instrument, meaning it may perform well in a risk-off scenario.

All this is to say that these rallies in bitcoin and gold may be overextended when viewed with a historical lens. At the very least, investors choosing to add either asset should size positions modestly, understanding that rapid price swings are likely to persist. Recent price action in bitcoin furthers this point; in the week since it reached its all-time high, it saw a 15% pullback in its price. For those investors thinking of adding gold as a potential source of portfolio protection, we favor long US Treasury securities, which also offer that benefit and include the added bonus of a healthy yield.

Sean Duffin, Senior Investment Director, Capital Markets Research

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

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US REIT Performance Should Rebound in 2024

Sehr Dsani, Investment Director, Capital Markets Research, and Marc Cardillo, Head of Global Real Assets

US REITs have performed poorly since the end of 2021, underperforming US equities by 20 ppts. Increases in bond yields were a significant headwind, diminishing the relative attractiveness of REIT dividend yields and raising concerns over the value of underlying assets. Following the weak performance, valuations have fallen to an attractive level. This reality—combined with the fact that REITs are well positioned to take advantage of acquisition opportunities from overlevered private property owners—positions the sector for a rebound in 2024.

Recent poor performance has improved the attractiveness of valuation metrics. First, the sector’s price-to–funds from operations (P/FFO) multiple relative to a similar measure for the broader US market is at the 35th percentile of observations since 1990. Second, REITs are trading at a 17% discount to net asset value, which is lower than the 20-year average of a 0.9% discount. Taken together, these metrics suggest the market has already adjusted price levels to reflect difficult conditions in 2024. Historically, REITs have outperformed as a new business cycle emerges. We expect investors will increasingly get clarity on the next business cycle as 2024 evolves.

Despite concerns that the real estate sector must refinance a material volume of debt, REIT balance sheets are generally sound. This is in part because REITs delevered since the GFC. The sector’s debt/equity leverage ratio is 35% versus the sector’s 50% level during the GFC and 60%+ for many private counterparts today. Around 90% of REIT debt is fixed rate, maturities are reasonably staggered, and the low leverage rate relative to the private sector is due in part to REITs’ low office exposure (4.6%). In addition, many REITs have the advantage of being able to access the unsecured debt market. These dynamics position REITs favorably relative to their private peers and should allow them to address upcoming refinancings and have the necessary capital to make strategic acquisitions in this environment.

Infrastructure Performance Should Rebound in 2024

Wade O’Brien, Managing Director, Capital Markets Research 

Public infrastructure equities underperformed broader benchmarks in 2023, weighed down by rising interest rates, policy uncertainty, and recent profit warnings in some sectors. Improved valuations, a supportive policy backdrop, and an ability to grow earnings during inflationary environments mean the sector should boost investor portfolios in 2024.

Infrastructure assets include those in areas such as transportation, communications, and power generation. An increase in benchmark bond yields, as well as profit warnings from some large renewable energy players, caused listed infrastructure assets to underperform, with US and global ex US infrastructure stocks returning -4.5% and 2.4%, respectively, year-to-date through November 30.

Improved valuations should mean better relative and absolute performance in 2024. P/E ratios for global ex US and US infrastructure indexes have fallen by around 40% and 25%, respectively, since their mid-2021 peaks. Despite weaker earnings guidance from some companies, profitability in both regions remains in line with long-term averages and is protected by long-term contracts that include the ability to pass on higher costs to users. These dynamics help explain why utility sector earnings forecasts have predicted higher growth than most others in 2023, as well as why listed infrastructure assets historically have outperformed during periods of elevated inflation.

Infrastructure assets also have tailwinds from recent policy developments. Legislation like the US Inflation Reduction Act and the European Commission’s REPowerEU plan will boost demand for clean energy infrastructure and underlying profit margins. Ambiguity around yet-to-be finalized language in the US legislation has been one factor recently weighing on stock performance, but this should be cleared up in the months ahead.

While public infrastructure equity performance is likely to improve in 2024, investors willing to lock up liquidity for several years may also benefit by allocating to private funds. While approaches and operational risks can vary (i.e., greenfield versus brownfield assets), the best of these funds can offer exposure to skilled operators capitalizing on secular themes such as the energy transition and burgeoning data center demand. Despite near-term economic uncertainty, these trends continue to accelerate, which we expect will generate rewards for investors.

Nuclear Should Emerge as a Budding Investment Opportunity in 2024

Michael Brand, Managing Director, Real Assets 

Technological advancement, moderating public perception, improved safety, and new challenges in the drive for net zero have created a foundation for nuclear energy’s next chapter. Renewable energy’s adoption as a key replacement for dirty coal and other fossil fuel–oriented power has created large challenges in maintaining reliable baseload power capacity, which underpins the keystone of energy transition—electrification. Even as the memory of past disasters lingers and the issue of waste storage endures, new technologies and the urgency to bridge the new challenge of intermittency has helped nuclear re-emerge as an option for clean, reliable, and scalable baseload electricity. Policymakers have also provided a boost, with countries such as France pledging in 2022 to further build out its nuclear fleet, and even the United States implementing substantial subsidies to keep its existing fleet operational as part of the recent Inflation Reduction Act—a sharp about-face from a policy standpoint. We believe nuclear will emerge as an energy transition investment opportunity in 2024, given the need for clean, reliable baseload electricity, recent government policy changes, and technological advancements.

The opportunity is not exclusive to just reactors, where it is unclear whether the future is modular or traditional, large-scale. Complementing the reactor fleet is a fragmented ecosystem of services and technology companies, which both construct new reactors and keep existing ones running. The landscape features an abundance of small, entrepreneur-run businesses that fly under the market radar and transact at significant discounts to the broader opportunity set. These companies seek to add value by helping businesses professionalize, consolidate, and harness new technologies. There are also opportunities associated with AI, software platforms, and plant-management technology, all of which should continue to make the sector safer and more efficient.

Hurdles certainly exist in the form of public perception, political jockeying, and even securing a steady stream of fuel, as the mining sector remains constrained. However, energy transition’s demands have created an ideal environment for the sector’s next chapter. With power-hungry 21st century initiatives, such as digitization and electrification, the sector should continue to enjoy increased investor attention as the opportunity emerges.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

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In this edition of VantagePoint, we look at the progress in the energy transition to date and consider means for investors to both profit from and accelerate the transition across the risk/reward spectrum through investments in private equity (PE), venture capital (VC), infrastructure, public equities, and green metals. Investors looking to maximize impact should invest in strategies that lean into recent policy initiatives and specialized climate tech funds seeking to solve difficult challenges such as decarbonizing industry. Those looking for more stable returns will find an abundance of opportunity in infrastructure funds given soaring demand for renewable energy. ²

Pockets of Momentum With More Innovation, Derisking, and Scaling Required

Spending on the energy transition totaled $1.1 trillion in 2022; a 31% increase over the prior year, but still well short of the scale required to meet net zero greenhouse gas (GHG) emissions targets by 2050. Investment amounts have been far smaller, as spending figures include sales of items, like electric vehicles (EVs) and heat pumps, as well as government investments. For example, China—where the government is a key player—accounts for roughly half of total spending ($546 billion), compared to just $141 billion and $180 billion in the United States and EU, respectively.

Nearly 90% of spending in 2022 was directed to renewable energy ($495 billion) and electrification of transportation ($466 billion, 83% of which is spending on passenger EVs). These segments have seen prices fall to levels competitive with some fossil fuel–heavy options, which has pushed up demand. Policy initiatives, such as the United States’ Inflation Reduction Act (IRA) and Europe’s Fit for 55 and Green Deal Industrial Plan, further improve economics for many energy transition technologies.

As economics have improved, corporate and consumer demand for lower-carbon products and services has increased, accelerating the transition in a virtuous cycle. Lazard estimates that before subsidies, the levelized costs of energy for utility-scale solar and onshore wind have decreased 83% and 63%, respectively, since 2009. As a result, renewables are taking market share over fossil fuels, as demand is broadening to include corporations—such as Amazon—that are increasingly purchasing clean power. With nearly 50% of new annual global electricity capacity coming from renewables, installed capacity is now roughly 40% renewable, driven by growth in utility-scale solar and onshore wind over the last decade.

Similarly, electric cars are becoming increasingly cost competitive with internal combustion vehicles. Although the sticker price for a comparable auto is higher for EVs, lower fuel and maintenance costs and potential subsidies make prices more comparable over time, while improved battery performance and growth in charging stations also boosts demand. It will take time to turn over the stock of vehicles, given EVs account for less than 2% of cars on the road globally. Still, EV sales are growing rapidly, with global EV market share increasing from less than 5% of new passenger vehicle sales in 2020 to 14% in 2022.

While meaningful progress has been made in critical areas, the pace of the transition has lagged ambitious objectives. For example, venture capitalist John Doerr keeps track of progress against a six-point plan for reducing emissions that he outlined in his book, Speed & Scale. ³ Outside of autos and renewables, progress has fallen short of ambitious targets. Investments in hardware technology to solve the biggest problems—such as power storage, difficult-to-abate industries (e.g., steel and cement production), and commercial transportation (e.g., trucking and shipping)—remain in the development phase. Investment in hydrogen fuel cells, the source of much hope for greening transportation and industry, totaled less than 0.2% of energy transition spending last year, while areas like energy storage and carbon capture also attracted relatively few dollars.

Further advances must address numerous challenges and constraints. Key among them is access to metals needed for the green transition and bottlenecks in expanding the electrical grid globally. Decarbonizing the grid and electrifying as much heating, transportation, and industry as possible are central to a low-carbon future. While renewables are more competitive, further progress must overcome some hurdles. The electrical grid is already congested, interconnections face multiyear delays (averaging three to four years for US solar and ten years for UK onshore wind), and significant grid expansion is needed to meet swelling demand. Grid expansion requires planning for future electricity needs, allocating costs, and permitting, all of which present challenges. Interconnections to the grid are the most pressing issue in the near term. For example, in the United States, there is more energy capacity (2,020 gigawatts, mostly renewable) in the queue to be connected to the grid than is installed (1,250 gigawatts of power capacity, mostly non-renewable). These challenges also create opportunities for companies that can operate around or mitigate such constraints.

Opportunities for Investors

Investors can play the energy transition across private and public markets and have a variety of options in terms of fund return targets and liquidity. On the private side, climate tech VC funds target mid/high double-digit returns by focusing on early-stage companies in areas such as software, battery/storage technology (including recycling, management, etc.), commercial transportation, renewable fuels, and solutions for complex industrial challenges (e.g., cement and steel production). PE strategies with similar return targets will overlap in some of these areas but tend to focus on scalable, cash-generative businesses in areas such as renewable developers, grid enhancement (storage, efficiency/metering, etc.), and transportation plays (e.g., EV charging). Private infrastructure funds will sometimes overlap. For example, some smaller infra funds will invest in areas like scaling solar developers and EV infrastructure, given double-digit return targets, while larger funds with lower return targets may focus on acquiring contracted power assets (and related storage plays). Public opportunities are varied and include managers that focus on a range of companies across the industrial, tech, utility, and mining sectors. There are also opportunities across both private and public markets to invest in the supply chain resilience of green metals—a critical component to the energy transition—with investments in recycling and new mining processes being examples.

We focus our discussion on the largest investment opportunity sets: private equity and venture capital (PE/VC), private infrastructure, and public equities, and highlight key investment considerations and opportunities.

PE/VC Investment Opportunities Will Continue to Scale, but Higher Global Rates Are a Near-Term Headwind

Close to $200 billion of climate-related private investments were made in 2022, roughly 2.5x the level three years prior and representing 12% of all private-market equity investments made in the year. Investment opportunities include both software and hardware, which tend to have different risk/return profiles. Software companies (e.g., building energy management, smart grid analytics, carbon accounting) have similar risk profiles to their non-climate tech peers and a quicker path to market. These strategies are more investable for generalist VC, growth equity, and buyout strategies, and therefore more competitive, often offering lower returns. In contrast, hardware climate technologies require dedicated expertise in the fields of technology, engineering, manufacturing, and project finance, but offer higher scalability and potential payoffs. De-risked sectors focused on the scaling of energy transition technologies (e.g., power generation, transmission, and transportation) continue to attract the bulk of the capital, while earlier-stage hardware targeting sectors that are harder to abate via electrification have seen a lower volume of investments.

Despite their riskier profile, investments into climate tech hardware solutions have increased as the industry has evolved with strengthened technical and operating expertise and a network of climate tech peers that can take nascent technology from seed and early stage to more mature growth phases and deployment. Capital flow has accelerated to areas like battery/storage technologies and solar energy following targeted financial incentives in the United States and Europe and higher conventional energy prices. Investments also flowed to alternative battery chemistry technologies and battery recycling processes to reduce dependency on certain critical metals, such as lithium.

Further, policy incentives have improved the commercial viability and attractiveness of nascent and more expensive technologies—such as green hydrogen—leading to a rise in such investments. Green hydrogen start-ups are looking to produce lower-cost hydrogen at scale for multiple potential applications, including decarbonizing hard to abate industrial sectors (e.g., steel and cement production) and to provide long-duration energy storage to resolve renewable energy intermittency. The capital-intensive nature of many climate tech hardware solutions imply room for private capital ranging from VC to infrastructure, albeit requiring higher risk tolerance and patience for potentially longer holding periods.

Climate tech PE/VC is facing similar headwinds as the broad market in terms of slowing deal activity and exits, given the higher rates environment. Globally, first half 2023 VC climate tech–invested capital and deal count fell 31% and 38%, respectively, from first half 2022 levels, albeit less than the declines seen in broad VC over the same period (50% and 40%, respectively). Public market exits for climate tech companies in 2022 also fell alongside their peers, with the decline more marked for exits via special purpose acquisition companies (SPACs), which had been a preferred option for high revenue growth but negative earning tech companies. Another metric to monitor is valuations, which have diverged from their peers over the past two years. Valuation-to-revenue multiples for climate tech PE/VC deals stood at 9x and 22x, respectively, in 2022, versus 3x and 15x, respectively, for their broad market equivalents.

Higher financing costs and elevated valuations may weigh on future round financings and exits in the near term, particularly for earlier-stage hardware climate tech companies that have a longer runway to profitability. However, overall investment activity should gradually recover as climate tech PE/VC funds look to deploy a significant amount of dry powder, estimated to total $37 billion as of the end of 2022. The opportunity set for climate tech PE/VC is also likely to broaden further, given tailwinds from positive policy shifts and demand/cost trends. More importantly, the manager landscape and performance of climate tech PE/VC funds today has improved meaningfully from the CleanTech 1.0 wave. Recent vintages have delivered comparable returns to their traditional PE/VC peers as managers’ technical knowledge and investment discipline strengthened, allowing for the generation of more sustainable and competitive returns to add value to investor portfolios.

Infrastructure Is the Largest Sandbox but Beware Crowding in Some Corners

Energy transition–focused infrastructure funds offer investors a large opportunity set with varying expected returns that depend on factors such as capital intensity, development stage, and valuations.

Large funds often focus on existing renewable power assets with long-term revenue contracts in place, though some seek higher returns via greenfield projects. Returns for existing assets can be enhanced via scale and financial optimization. In comparison, smaller funds might take more operational or technology risk by investing in local developers or emerging areas like green hydrogen and battery storage, although others are focusing on existing technologies in carbon capture and sequestration that will benefit from increased IRA tax credits. Some managers focus on specific geographies and assets (e.g., solar), while others take a generalist infrastructure approach and blend exposure to energy transition assets with assets in digital infrastructure and transport. Finally, the definition of energy transition–related assets also varies, with some managers mixing in what are viewed as “transitional” assets in areas such as natural gas transportation and generation plays with renewable assets like wind and solar.

Infrastructure funds benefit from the investment scale needed to meet net zero goals, but face headwinds including rising competition for assets, higher financing costs, and difficulties with everything from supply chains (e.g., IRA requirements) to delays in grid connections. One result is that even some large infrastructure funds have broadened their focus from renewable power project development and operation to related plays like utility-scale storage and residential installation and financing. Investors looking at managers allocating in these markets should consider skill sets (including technical, regulatory, and financial), sourcing abilities, and public market trends, as some energy transition plays have struggled to perform (in part due to initial public offerings executed at high valuations).

Investors selecting among energy transition managers should also consider the potential risk/return of their targeted investments. The opportunity set for large funds investing in renewable power is considerable, given this market represents nearly $500 billion in annual spending versus biofuel investments, which are 1%–2% this amount. The flipside is that acquiring contracted renewable assets likely will generate more predictable returns but less potential upside than investments made by smaller infrastructure funds taking technology risk in areas like biofuels or carbon capture. Investors can improve their odds by identifying manager edges—such as technical and regulatory expertise—and flatten J-curves by looking for pipelines of approved projects with guaranteed grid access. Managers with experienced teams and diversified portfolios that invest across several areas may see smoother returns than those targeting areas with more technological risk like battery science or decarbonizing industry. Investors can also tap infrastructure investments via certain publicly traded plays but should take into consideration valuations and higher potential for volatility.

Public Equities Offer a Broad and Diverse Opportunity Set for Active Managers, but Watch the Valuations

Public equity managers focused on the energy transition typically cover a broad array of securities in businesses ranging from renewable utilities and renewable equipment to energy efficiency, advanced materials, software, agriculture, and the circular economy. The companies themselves may participate in a mix of activities but tend to meet some threshold of green revenues. Managers may also incorporate other environmental, social, and governance (ESG) considerations into their strategy.

Significant up-front capex costs for many clean technologies require scale to spread fixed costs over a wide swath of customers. Indeed, we are seeing consolidation in categories such as renewable manufacturers and infrastructure companies. At the same time, smaller companies have potential to be more innovative and may also be worth holding for high risk/high reward opportunities like battery storage. However, managers must consider the global competitive landscape as customers may view larger companies as steadier hands, often benefiting from diversified revenue streams, particularly when related to riskier technologies. Overall, we see room for winners and losers from this disruptive transition—a facet that can be exploited by talented active managers, including long/short strategies.

Another consideration when investing in public securities is that much of the industrial sector will need to adapt their business models over time to a low-carbon future. Managers that engage with portfolio companies to understand, support, and hold them accountable for realistic climate reduction strategies should unlock value in portfolio holdings over time. Further, equity strategies focused on industrial transformation (i.e., suppliers, enablers, or decarbonizing firms) have more of a value/cyclical orientation beneficial to style diversification in portfolios with high ESG requirements that tend to lean toward quality/growth exposure.

Like PE, performance in public equities addressing the energy transition has been volatile, with some indexes dramatically underperforming the broad market for a decade through 2020 before experiencing a year or two (depending on the index used) of explosive relative and absolute performance. Valuations for renewables remain elevated relative to utilities and the broad market, while more tech-oriented indexes (e.g., the Wilderhill Clean Energy Index) have negative aggregate earnings reflecting the risk of owning such securities, especially if the cost of capital remains elevated.

Green Metals: Tailwinds for Companies Invested in Supply Chain Resilience

The energy transition will be accompanied by a structural increase in demand for certain critical metals, considering the intensity of their usage in renewable energy infrastructure and in the electrification of transport. Copper will see the highest growth in absolute volume, given its application across the value chain, from wind turbines and electricity grids to EVs, but lithium will see one of the sharpest rises in demand relative to current levels due to the dominance of lithium-ion batteries. Without new discoveries, BloombergNEF forecasts that the supply of many of these metals would fall short of the projected increase in demand, thereby increasing input costs to clean infrastructure and constraining newbuild projects.

While the heavy reliance on these green metals poses a risk to the energy transition, it also creates opportunities for investors. There are arguments already in place that the energy transition could drive a new commodities supercycle. However, there are several risks to consider to directly investing in these metals (either via commodity futures or natural resources equities) near term. Many of the transition metals are still predominantly used for industrial purposes and are sensitive to global economic cycles. For instance, prices of copper and nickel surged during the post-pandemic recovery phase and have moderated since, but not yet to cheap enough levels relative to history (in real terms) to mitigate further downside risks from slowing global growth. Demand for industrial metals may soften if China sees a secular shift from an industrial-led to a services-driven economy, while secondary supplies may increase with further investments into metals and battery recycling. The substitution effect would also spur innovations—such as alternative battery technologies—to reduce critical mineral dependency, as seen with Tesla and other major automakers’ switch to lithium iron phosphate batteries to mitigate high nickel and cobalt prices.

Another way to address the green metals theme is through investing in battery recycling and battery technologies, although these are earlier stage in nature and will require careful manager selection to identify potential industry winners. The response to price mechanics should also incentivize both start-ups and existing industry players to rethink traditional mining processes to reduce lead times and/or costs. We are seeing evidence of this today in the lithium market, where higher prices have encouraged investments into technologies such as direct lithium extraction from brine to boost production. An active strategy approach, either within private or public markets, could better help investors to identify sustainable green metals opportunities and add alpha over the broad market.

Conclusion

The energy transition involves a complex and dynamic set of changes in the way we do just about everything from activities as mundane as manufacturing steel and cement to heating buildings and transportation. While significant progress has been made in some quarters, considerable capital will be needed to fund the massive investment required over coming decades. The investment opportunities and the disruptive forces this evolution brings will create plenty of winners and losers that require investor focus. We expect investors with a deliberate and thoughtful plan to invest in the transition across the risk/reward spectrum will be rewarded.

Celia Dallas, Chief Investment Strategist
Wade O’Brien, Managing Director, Capital Markets Research
Vivian Gan, Associate Investment Director, Capital Markets Research

David Kautter and Kristin Roesch also contributed to this publication.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. We use renewables and renewable energy interchangeably to reference technology to decarbonize the electrical grid.
3. See https://speedandscale.com/tracker/ for annual updates on progress.

The post VantagePoint: Investing in a Low-Carbon Future appeared first on Cambridge Associates.

Furthermore, we do not think that the current environment presents a structural problem with CRE, which is not immune from recessionary pressures, but typically performs well during the early recovery phase of the cycle. Indeed, US real estate investment trusts (REITs) have outperformed broader US equities more than 80% of the time since 1975 during the early recovery phase. Thus, we think cyclical pressures will likely create opportunities in sectors we prefer and advise investors to selectively invest in these areas to benefit from a rebound during the recovery.

It is difficult not to be alarmed about CRE, given recent headlines. However, these are often referring to the office sector, which is both cyclically and secularly challenged by changes in consumer and business behavior. Disruption in the sector due to oversupply can create attractive distressed opportunities, but investors should look beyond a deep discount at acquisition and focus on the long-term outlook for the building (vintage, amenities, tenant mix, and the ability to lease up and to [re]finance the asset).

In this note, we will explain why valuations lag in the private sector, highlight the impact of current economic conditions on CRE thus far, outline why we do not think this is a repeat of the Global Financial Crisis (GFC), and share more detail on our sector views.

Private CRE Beginning to Show Cracks

Without making any statistical adjustments to the data, one of the attractive attributes of investing in private CRE is that it is generally less volatile than its publicly traded counterpart—REITs. In fact, in 2022, private core real estate funds returned 7.5%, according to the NCREIF Fund Index – Open End Diversified Core Equity (NFI-ODCE), while US REITs returned -25%, according to the FTSE® NAREIT All-Equity REITs Index. This lower volatility meant the private NFI-ODCE Index has only had negative returns recently, returning -5.0% in fourth quarter 2022 and -3.0% in first quarter 2023.

Transaction volumes have also slowed considerably since the Fed began raising interest rates. Historically, this has often been a precursor to value declines. Transaction volumes contracted by more than 35% in 2022, and year-over-year first quarter 2023 decreased 62%—reflecting ongoing price discovery and uncertainty about markets (Figure 1). Other indicators of CRE health, such as rent, net operating income (NOI) growth, and cap rates (the yield an investor expects to earn on an investment property), have also softened. Based on conversations with multiple industry participants, the overall consensus is that cap rates have expanded (meaning a decline in underlying asset values) by 100 basis points (bps) to 150 bps across all real estate sectors and may expand 25 bps to 50 bps more in 2023.

REITs are liquid and allow investors to swiftly express their sentiment of the asset class. However, while these movements may be directionally accurate, reflecting weakening fundamentals, they can be prone to overcorrections in times of investor panic, leading to higher volatility in public than private markets. On the other hand, private real estate valuations are slower to reflect change, as they rely heavily on healthy transaction volume to establish fair market values. Thus, as transactions become infrequent, private markets exhibit a lag in reflecting current market sentiment (Figure 2). We anticipate private asset values will continue to come under pressure as the economy slows, even if the average decline does not surpass what REITs’ valuations are currently implying.

Select CRE Opportunities During the Economic Slowdown

The CRE sector is diverse, with each segment driven by distinct factors, such as demographics, consumer preferences, and GDP. As such, opportunities may arise during a recession, which investors should be prepared to act on.

We remain optimistic on the industrial segment, where strong secular tailwinds remain. The segment has benefited from the growth in e-commerce and evolving consumer preferences, together with the supply chain disruptions and onshoring trends stemming from the COVID-19 pandemic. We think these supportive trends will sustain over the long term, but may soften during times of economic downturn and as new supply comes to market. Analysts at Green Street project industrial rents to generate an attractive 6.0% annual growth rate over the next five years, coming down from double-digit growth in recent years, but above long-term trends. Occupancy is also expected to remain heathy, at above 96%.

Another segment that we think will continue to demonstrate resilience is multifamily rental housing. The segment has begun to show some weakness as economic conditions soften and a massive wave of new supply comes to market in 2023 and 2024. Although rent growth is still above the long-term average, it slowed to 5% at the end of 2022 from double-digit highs in 2021. On the supply-side, the pullback in lending will result in a decline in new apartment starts, so any period of oversupply will likely be short lived as there is still a deficit in US housing. With the ongoing shortage of housing in the United States, especially as mortgage rates approach high single-digits, making home ownership less affordable, we think the long-term outlook for the segment remains attractive.

Niche segments, such as self-storage and industrial outdoor storage, are also attractive for institutional investors. These segments share common characteristics of operating in fragmented markets, with a high share of small private owners, and have visibility to a runway of operational enhancements, improving profitability and asset quality.

However, one segment of CRE where we think the problem goes beyond cyclical softening, and is secular in nature, is office. Vacancy rates have climbed as businesses allow employees to work-from-home, resulting in empty office buildings and foot traffic to business centers cut in half from pre-pandemic levels. Indeed, the office segment had been softening prior to the pandemic, due to its high-capital expenditure requirements, evolving tenant preferences for newer, more exciting, amenity-rich spaces, and softening NOI growth. Slowing demand has already changed behavior, with construction beginning to slow. This year will see less than 38 million square feet of new office space coming to market, which is 27% lower than the five-year average.

“Bifurcation” best describes the segment today, with varying levels of headwinds. Class-A and newer, more modern properties will likely see modest depreciation in value as demand remains strong, while owners of older buildings or in cities with excess supply likely have little to no negotiating power. Indeed, industry chatter suggests that some properties from the latter cohort trade for just land value. Similarly, performance in public REITs implies that private property values in office could fall by 30%–40%.

Interestingly, geographic disparity has been stark. Markets hit hardest by the slowdown in the technology sector have seen harsh drops in office values, with price per square foot in San Francisco more than 30% lower in February 2023 than its peak levels of more than $1,200 per square foot in December 2020. Miami, on the other hand, has seen the price of offices go up 1.5x since February 2020, as many businesses have chosen to move offices there.

The structural disruption in office is not unique. Retail serves as a good case study for office on how a sector is disrupted when consumer behavior changes drastically, creating unique opportunities. Grocery-anchored and street retail demonstrated resilience, while suburban shopping malls of older vintages continued to struggle. Successful retailers adapted to new shopping behaviors by reformatting and upgrading their tenant mix to prioritize services. Similarly, office owners will need to upgrade or repurpose their assets to their highest and best use. However, we recognize that in the near term, access to financing these projects is challenging.

During the pandemic, vacancy rates deteriorated for both sectors. However, conditions improved considerably in 2022 for retail, while office lagged. It may take some time before we see a meaningful reversal in office vacancy rates, especially since “actual” vacancy rates are higher, when you consider the increased space available for sub-lease (Figure 3).

Selective Investors Will Be Rewarded

With record fundraising and decreased transaction volumes, we estimate that more than $280 billion of uninvested capital has accumulated in funds, which is 3x more than 2013 levels (Figure 4). As defaults increase, this dry powder will likely jumpstart transactions, helping to minimize the decline in valuations across the CRE sector.

We advise investors to keep the pace of commitments consistent with their policies. In a diversified strategy, we favor managers with flexibility to invest across the capital stack. In the current environment, with limited liquidity, debt can offer downside protection and generate equity-like returns.

Conclusion

Commercial real estate is not immune to economic cyclicality, and we think the sector will be challenged through an economic downturn. Property write-downs, slowing rent growth, and difficulty in accessing funding will depress returns in the near term. However, we do not think these issues will last beyond a recession—except for the office sector, where secular headwinds will likely take longer to abate. As such, we expect most CRE to recover alongside an economic expansion. Investors with the ability to conduct in-depth due diligence will benefit during this time of uncertainty and should be rewarded over the long term.

Maria Surina, Senior Investment Director, Real Assets
Sehr Dsani, Investment Director, Capital Markets Research
Patrick Michaud, Investment Associate, Real Assets

Graham Landrith and Ilona Vdovina also contributed to this publication.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. We use renewables and renewable energy interchangeably to reference technology to decarbonize the electrical grid.
3. See https://speedandscale.com/tracker/ for annual updates on progress.
4. Large banks are defined as holding more than $250 billion in assets.
5. Please see Keith Friend, Harry Glenos, and Joseph Nichols, “An Analysis of the Impact of the Commercial Real Estate Concentration Guidance,” Federal Reserve, April 2013.

The post US Real Estate Faces Challenges, But Opportunities Exist appeared first on Cambridge Associates.

Aaron Costello, Regional Head for Asia, and Vivian Gan, Associate Investment Director, Capital Markets Research

The path of global central bank tightening remains a top-of-mind question for investors after the recent stress in the US and European banking sectors. While financial contagion seems contained for now and has yet to spread to Asia, the current environment of higher rates and the risk of slowing global growth pose challenges for Asian markets. Furthermore, China’s reopening has boosted the outlook for the region as a whole, but heightened US-China geopolitical tensions remain a risk. In this edition of Asia Insights, we highlight areas we continue to find opportunities in, despite the current environment of higher rates and market uncertainty.

• Public Equities: After receiving muted interest from international investors over the past decade, Japanese equities deserve more investor attention, given higher relative earnings growth momentum, low starting valuations, and strong corporate balance sheets that are attractive qualities in the current environment. Over the longer horizon, regulatory changes and increased activist engagement will help improve the return profile of Japanese equities.
• Private Investments: Global fundraising and deal activity slowed in 2022, and Asia private equity and venture markets were not spared. Capital availability and deal activity in Asia may remain tight in the near term, as international investors seek to reduce geopolitical and emerging markets risk. However, this presents an opportunity for high-quality managers that face lesser capital constraints.
• Real Assets: Rising interest rates across major Asian economies have eroded the attractiveness of Asian real estate and led to a meaningful decline in recent investment activity. Within the current environment, however, Japan opportunistic real estate strategies can still offer investors a higher return profile, given lower borrowing costs arising from the divergence in the Bank of Japan’s monetary policy from other Asian central banks.
• Hedge Funds: Asia equity long/short strategies have successfully generated alpha in recent years, although they have underperformed their global counterparts given the relative weakness in Asian equity markets. However, we view that the tide is turning for Asia long/short strategies, as the current environment of higher rates and volatility, together with China’s reopening, present a positive backdrop for managers that can generate alpha on both the long and short side of their portfolios.

Public Equities: The Stars Are Aligning for Japanese Equities

Wilson Chen, Managing Director, Public Equities

Investor interest in Japan has been muted, as flat valuation multiples and the yen’s weakness saw Japanese equities underperform their developed markets (DM) counterparts. Over a trailing ten-year period, Japanese equities returned 9.1% ⁶ and 5.4% in local currency and US dollar terms, respectively, versus 10.5% and 9.8% for DM ex Japan equities. Looking forward, we view that there are short- and long-term tailwinds for Japan that warrant closer investor attention.

In the near horizon, Japan still stands to benefit from the reopening of its domestic economy and China’s alike in the form of renewed tourism spending. Corporate earnings growth in Japan – which has been stronger than its DM peers over the past decade – is likely to sustain its positive momentum because of the divergence in monetary and fiscal policy in Japan versus other developed economies. Furthermore, Japanese companies tend to have strong cash balances and balances sheets, allowing them to remain more resilient amid higher market volatility and slowing global growth.

Current valuations for both Japanese equities and the currency remain undemanding. While Japan trades close to fair value in absolute terms, valuations relative to DM ex Japan are low at the 25th percentile of historical observations. Real exchange rate valuations for the yen versus the US dollar are also near all-time lows, reducing downside risks from further yen weakness, especially if the Federal Reserve pauses its rate hike cycle later in the year.

There are positive signs that inflation in Japan is ticking up. While some of this was due to higher import costs, we are seeing evidence today of wage growth and companies increasing prices after years of holding back. A transition from a deflationary to an inflationary environment would induce a paradigm shift, as attitudes toward domestic consumption and investment change. Over the longer term, policy changes emphasising increased governance and shareholder returns – including the unwinding of cross shareholding and the increasing of share buybacks – coupled with a rise in activist engagement, will further enhance the return profile and attractiveness of Japanese equities.

Private Investments: Capital Availability and Deal Activity Likely to Remain Muted for Now

Vish Ramaswami, Managing Director, Private Equity

2022 saw a dramatic fall in dollars raised and deployed by Asia private equity and venture capital (PE/VC) funds. Asian venture markets were hit by the global crash in technology and biotechnology valuations. Returns of mature funds were impacted, dampening the outlook for new fundraising. Meanwhile, companies faced difficulties raising new equity rounds, given flat valuations, and new company formation slowed. Growth and buyout deals have also seen weaker operating metrics over the past two to three years, which affected portfolio marks and dragged down returns. The denominator effect ⁷ has forced limited partners (LPs) to cull managers. Availability of capital fell, while cost went up.

This downward trend mirrors that of other regions. However, in an environment of uncertainty, illiquid commitments suffered additionally in less-proven markets fraught with political or currency risks, such as Asia-Pacific. The impact is particularly pronounced in China, which has absorbed and invested the vast majority of VC raised in Asia but is in a unique geopolitical standoff with the United States. The latter is where most LPs are based and is integral to VC activity, from idea generation to public markets for exit. Beyond VC, we also see a general pullback from China by managers with regional or global mandates.

Meanwhile, ex-China country-focused and regional funds have also seen fundraising slow, reflecting the cautious mood toward Asia-Pacific more broadly. This general muted sentiment is likely to persist over 2023, and coupled with tighter capital availability, means that deals are taking longer to close. PE deals are re-pricing, favouring overcautious buyers, and VC may see flat or even down rounds as the prospect of public market exits becomes more distant.

Amid all this, high-quality managers have raised healthy sums and are optimistic that the situation presents a good investing environment for those with capital. LPs with dry powder face an opportune moment where hitherto access-constrained managers are now open to new capital. The additional silver lining is that the collapse of Silicon Valley Bank (SVB) has had little impact on Asia-Pacific, given few portfolio companies in the region banked with SVB and venture debt, in any case, is a very small portion of overall venture activity.

Real Assets: Japan Remains a Bright Spot Within Asian Real Estate

Johnny Adji, Senior Investment Director, Real Assets and Private Credit

Asia commercial real estate activity saw a marked decline in 2022, and the outlook for the market remains muted in the near term. Rising interest rates across major Asian economies have increased the cost of new acquisitions financing. At the same time, elevated inflationary pressures and cooling global growth have placed a drag on the income return to Asian real estate, particularly for non-residential, commercial sectors.

Across developed Asia markets – including Australia, Hong Kong, Singapore, and South Korea – traditional real estate investments appear even less attractive considering the negative carry yields arising from higher borrowing costs in tandem with lower capitalisation rates. With transaction volume and valuations remaining under pressure, we expect capitalisation rates for these segments to edge upward – potentially expanding by 75 basis points (bps) to 100 bps in the next six to 12 months – following a similar recent trend in the United States and Europe. Alternative real estate strategies (e.g., schools and data centres) in these markets are slightly more attractive as they offer higher yields, although elevated interest rates are still weighing on the overall return profiles. While the same picture looks to hold for Asia emerging markets such as China and India, the outlook there is somewhat more positive, as a result of the countries’ higher economic growth and potential real estate rental growth.

Against this backdrop, we view that Japan continues to be a bright spot for real estate strategies. In contrast to its Asian peers, borrowing costs in Japan remain relatively low, driven by the country’s lower levels of inflation and the Bank of Japan’s commitment to its ultra-loose monetary policy to stimulate economic growth. Capitalisation rates in Japan also remain stable, ranging from 3.8% for traditional real estate to up to 7.5% for alternative sectors. Furthermore, low interest rates in Japan imply that USD-based investors can pick up carry yield from hedging back to the US dollar (while also removing currency risks). As a result, managers investing in Japan real estate are more likely able to achieve their target returns without having to either underwrite capitalisation rate compressions or aggressive rental growth rates.

Hedge Funds: The Tide Is Turning for Asia Equity Long/Short

Benjamin Low, Senior Investment Director, Hedge Funds

Investor sentiments toward Asia equity long/short (L/S) strategies have been dampened by the ongoing volatility in China, as well as the broader weakness of Asian equities relative to their global peers. Indeed, since mid-2021, the performance of Asia L/S funds has trailed that of their global counterparts, although they still managed to add value over the broad Asia market.

Going forward, we view that the outlook for Asia L/S strategies is turning more positive, driven by increased alpha opportunities arising from current market conditions. Higher funding costs and market volatility have led to a wider dispersion between fundamentally strong and weak companies, allowing for alpha creation on both long and short portfolio allocations. Short rebate has turned positive with the rise in global interest rates, providing a boost to returns for funds that have a meaningful short allocation. The continued reopening of China’s economy will also lead to a re-rating in China and other Asian markets as investment capital returns to the region. Managers with proprietary fundamental research capabilities will be better poised to benefit from China’s rebound, particularly in emerging themes such as advanced manufacturing and clean energy where there are no clear winners yet.

Fund managers that can generate consistent short alpha in the current environment will gain traction from investors. However, managing fund capacity will be critical, as a rapid growth in assets under management could necessitate investments into less inefficient segments of the market and erode alpha. Furthermore, while current financial conditions bode well for equity L/S managers, elevated inflation and rates are still headwinds for equities in general. Most Asia L/S fund managers are less versed in navigating through a high inflation environment, increasing the odds of more fund closures in the horizon. However, as manager crowding lessens, the competitive landscape and overall performance of Asia L/S is likely to improve as a result over time.

Drew Boyer and Derek Yam also contributed to this publication.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. We use renewables and renewable energy interchangeably to reference technology to decarbonize the electrical grid.
3. See https://speedandscale.com/tracker/ for annual updates on progress.
4. Large banks are defined as holding more than $250 billion in assets.
5. Please see Keith Friend, Harry Glenos, and Joseph Nichols, “An Analysis of the Impact of the Commercial Real Estate Concentration Guidance,” Federal Reserve, April 2013.
6. Data reflect annualized returns. Japanese equity performance is based on the MSCI Japan Index and DM ex Japan equity performance is based on the MSCI World ex Japan Index.
7. The denominator effect refers to a rise in the proportion of private investments in investor portfolios resulting from public market declines.

The post Asia Insights: Navigating Higher Rates and Volatility appeared first on Cambridge Associates.

Energy Equities at Benchmark Weights Will Benefit Investors in 2023

Wade O’Brien, Managing Director, Capital Markets Research

Energy equities have massively outperformed in 2022, with the MSCI World Energy Index beating the broader MSCI World Index by around 70 percentage points through the end of November. Energy sector profits have rebounded as underlying commodity prices were boosted by the tragic events in Ukraine and related supply disruptions. Given this strong performance, investors may be tempted to underweight the sector, assuming weak growth or the long-term decarbonization and net-zero efforts of the global economy will trigger underperformance. But, in the short-term, we recommend benchmark weights, as energy equities remain inexpensively priced and could again surprise in 2023 under several scenarios.

Depressed valuations suggest energy equities are almost universally unloved, despite rebounding profits and strengthening balance sheets. Forward earnings multiples for European and US energy stocks of 5.5x and 9.8x, respectively, are both in the bottom decile of historical observations. Volatile earnings are a consideration and sector earnings are expected to decline 11% next year (versus a 4% increase for the broad index). Risks are likely skewed to the downside if a recession occurs.

Still, there is a more constructive case for energy equities. The sector has been disciplined with capex in recent years and instead paid down debt, reducing the likelihood of a supply gut if global growth continues to slow. Energy companies also should continue to generate robust, if slightly reduced, free cash flow, offering ample cushion for dividends and buybacks. Even with reduced earnings in 2023, large US energy companies will generate enough cash flow to cover their expected dividend more than three times. Finally, there is a sad possibility that the war in Ukraine will escalate, likely putting a floor under commodity prices even amid a global slowdown.

Many questions hang over energy equities heading into 2023. The slowly unfolding energy transition presents both a long-term threat and competing opportunity set, which investors should also be pursuing. However, with valuations depressed and cash flow generation high, investors should maintain neutral positions to public energy companies in the near term. Those doing so should consider active managers that are engaged with corporate management teams and working to accelerate the transition to a low carbon economy.

The Office Sector Will Finally Present Attractive Investment Opportunities in 2023

Marc Cardillo, Global Head of Real Assets

Although it has been nearly three years since the pandemic began, considerable uncertainty remains regarding the future of the office sector. Performance has severely lagged other property types. MetLife estimates that remote work has contributed 400 basis points to the current elevated 16.8% US vacancy rate, although the impact on office cash flows has been limited, given the sector’s long-term lease structures. However, this dynamic has begun to evolve as leases executed prior to COVID-19 begin to expire. Many office owners with looming debt maturities will be faced with the challenge of trying to refinance properties with declining cash flows in a higher interest rate and more restrictive lending environment. These pressures should lead to rising loan defaults and create opportunities for discerning investors to acquire high-quality office properties at attractive valuations.

However, investors will need to be highly selective, as value traps abound. The quality of physical space and a property’s amenities have grown in importance as tenants have more choices available to them and companies need to give their employees a compelling reason to come to the office. The building attributes with the greatest demand include flexible open space, shared meeting areas, sustainable building features, onsite food options, outdoor amenities, and even concierge services. Many of these requirements are best met by modern office properties. As a result, the office sector has become increasingly bifurcated into a world of “haves” and “have nots,” with the newest, best amenitized properties garnering the lion’s share of leasing activity relative to older, class B products. JLL estimates that over the past two years, the office sector has experienced over 153 million square feet of negative net absorption. However, properties built after 2014 experienced positive net absorption of over 61 million square feet.

The growing emphasis on sustainability will only accelerate the bifurcation in office markets. Opportunities will emerge to renovate and transform certain office buildings to meet the various green certification standards that tenants increasingly seek, particularly in several European cities, which have more aggressive carbon reduction goals.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. We use renewables and renewable energy interchangeably to reference technology to decarbonize the electrical grid.
3. See https://speedandscale.com/tracker/ for annual updates on progress.
4. Large banks are defined as holding more than $250 billion in assets.
5. Please see Keith Friend, Harry Glenos, and Joseph Nichols, “An Analysis of the Impact of the Commercial Real Estate Concentration Guidance,” Federal Reserve, April 2013.
6. Data reflect annualized returns. Japanese equity performance is based on the MSCI Japan Index and DM ex Japan equity performance is based on the MSCI World ex Japan Index.
7. The denominator effect refers to a rise in the proportion of private investments in investor portfolios resulting from public market declines.

The post 2023 Outlook: Real Assets appeared first on Cambridge Associates.

1. Will the US Fed pivot away from aggressive tightening?
2. Will China move away from its zero-COVID policy?
3. Will Europe successfully manage its transition away from Russian energy imports?

We conclude that the Fed is more likely to pause than pivot, but significant tightening is priced in to justify neutral bond duration relative to policy. Beijing may take some time before it is willing to significantly relax zero-COVID policy, but once they do, Chinese equities are poised for a meaningful rebound. Finally, Europe’s transition away from Russian energy will be both challenging and costly, yet markets are discounting enough pessimism for us to be neutral on European equities.

1. Will the US Fed Pivot Away From Aggressive Tightening?

We see a pause as more likely than a pivot. The Fed has indicated they will “keep at it” until the policy rate is restrictive and they feel confident that inflation is on a path back to their 2% target, even if this results in recession. Indeed, the Fed projects that unemployment will increase to 4.4% next year as they tighten. Such an increase in unemployment has never transpired without a recession. Historically, the Fed typically would then ease, but we see this as unlikely without a concurrent sharp decline in inflation. We suspect inflation will be slow to decline, causing a prolonged pause before a pivot.

Inflation is starting to decelerate in some segments of the economy as shown in the table below. However, less-cyclical services, housing, and household-related goods continue to accelerate. The key factors for inflation are wages—the main driver of inflation for much of the service sector—and the health of the housing market, as housing makes up nearly a third of the Consumer Price Index (CPI).

Wages are supported by persistent labor market strength and will only ease as the economy softens, a change that the Fed is trying to orchestrate. The latest labor report showed unemployment fell back to recent lows of 3.5% amid lower, but still robust, job growth and elevated quit rates. Wages continue to increase, even as the pace over the last two months has slowed to an annual rate of 3.6%—a level consistent with a 2% inflation target. Real wages are obviously in decline with headline inflation clocking in at 8.2% in September. Encouragingly, the number of job openings fell by 10% in August, so the labor market has softened some, but it remains unmistakably tight.

As for the housing market, the sharp increase in rates this year has seen 30-year mortgage rates more than double, and home sales have plunged. Inventories are elevated and home prices are starting to fall. In July, the S&P CoreLogic Case-Shiller National Home Price Index fell for the first time since January 2019, declining 0.5% and then again in August by 1.1%. The CPI measure of inflation will likely continue to rise before it starts to fall, as it tends to lag home prices, but this sizeable segment of inflation will probably start declining next year.

As of late-October, the market is pricing in that the Fed will stop tightening in May 2023 with a terminal rate of 4.9%, at which point it will begin easing. This would imply a relatively typical tightening cycle based on the average tightening since 1965 and may understate necessary tightening, given inflation is well above what is typical for most of this period. Should the Fed keep conditions tighter than priced in for longer, equity and fixed income markets will experience more losses before eventually recovering as the Fed ultimately pivots. However, a significant degree of tightening is priced in and ten-year Treasury yields at roughly 4% offer reasonable value. Further, markets are pricing in a long pause, with the Fed funds rate remaining above 4.5% until January 2024. For investors that have been underweight duration, we would seek to move to more neutral positioning relative to investment policy.

While not our base case, a faster Fed pivot would require extreme circumstances—either economic growth slows more sharply than anticipated or “something breaks.” An extreme circumstance could arise due to the rapid pace of conventional tightening along with quantitative tightening. On average, tightening cycles have lasted 22 months. Thus far, the Fed has tightened by 300 basis points (bps) over just six months. Add in the 190 bps of additional tightening priced into the market, and that would mean 490 bps over 14 months. Another possibility is that an extreme circumstance develops in connection to the lengthy period of exceptionally low rates. This likely supported excessive speculation and proliferation of risk-management systems that fail to adequately account for the risk of rising interest rates. While it is unknown how sharp a rate increase is required to ignite these risks in the United States, we do know most investors will not be able to time the bottom, and those who do might just be lucky.

2. Will China Move Away From Its Zero-COVID Policy?

The Chinese government has already pivoted on two aggressive regulatory initiatives, and we believe an easing of China’s zero-COVID policy is next. However, the timing is not likely until after first quarter 2023. The Chinese economy and equity markets have been pummeled over the past two years largely due to self-inflicted policy actions, starting with the regulatory crackdown on the technology sector, a deliberate tightening of credit to the real estate sector, and the ongoing zero-COVID policy and related frequent lockdowns. Since its peak in February 2021, the MSCI China All Shares Index is down more than 50%, underperforming global equities by a wide margin. At the same time, Chinese real GDP grew only 0.4% year-over-year in second quarter 2022 and rebounded to only 3.9% in third quarter 2022, still far below the 5.5% government growth target for the year.

Given the challenging economic backdrop, the recently concluded Party Congress in October has disappointed markets by failing to signal any meaningful change in government policies or priorities. As expected, the Party Congress has confirmed Xi Jinping’s third term as the leader of the Party (and thereby China) and has unveiled the other members of the Politburo, which is now composed almost entirely of Xi loyalists and further cements his political power.

Xi Jinping’s opening speech of the Party Congress focused on the themes of strengthening national security, technology self-sufficiency, and economic development amid a challenging geopolitical backdrop. While Xi’s speech did not deliver any surprises or fundamental changes in existing policies, the conclusion of the Party Congress should help alleviate the current political and policy inertia in China, given lower-level officials (and business leaders) now have more clarity on power dynamics and priorities.

Indeed, we think that some changes are already afoot. First, the regulatory crackdown has effectively ended as China, over the past year, has provided clarity on a slew of regulations facing the technology sector, including overseas IPOs, VIE structures, and foreign audits. Although China has not rolled back the anti-monopoly regulations put in place in 2021, Chinese tech companies have acknowledged the new regulations and changed previous practices to better align with the government’s “Common Prosperity” theme. While investor skepticism remains, for now the regulatory crackdown is over. Indeed, the Common Prosperity theme was somewhat downplayed during Xi Jinping’s speech.

China has also eased monetary policy and lifted restrictions to help support the real estate sector. China has been trying to reduce leverage in the real estate sector for some time, and, by late 2021, the policy and general monetary tightening caused a larger-than-anticipated slowdown in real estate activity. The government has since clearly pivoted to a stance of general monetary easing and lifting of restrictions on the property sector, including the establishment a $150 billion funding plan to help healthy developers take over uncompleted projects of stressed developers. While analysts argue that more support is needed to deal with the issues, government policy is now focused on containing any systemic fallout from the property developer crisis. However, it is also clear that the government does not want to trigger a debt-driven rise in construction activity and property prices. Thus, any rebound in the real estate sector will be modest and alone will not revive China’s economy.

This leaves zero-COVID as the last major policy pivot for China. China has been effective at containing the spread of the virus and limiting COVID-related deaths, but the economic costs are mounting. Consumer confidence has collapsed to record lows, and urban youth unemployment is at a record high of 20%. Frequent lockdowns, even if short in duration, create a sense of uncertainty for households and businesses that hold back spending and investment, including property investment. Thus, it is hard to see a meaningful economic recovery without some form of policy shift on COVID-19.

It remains to be seen when this shift will occur. Xi Jinping’s opening speech of the Party Congress defended China’s zero-COVID policy and did not signal any immediate change in policies. However, behind the scenes small policy changes continue to occur, including the resumption of issuing business and tourist visas to China, increased flight routes, the removal of quarantine for arrivals in Hong Kong, and the potential reduction in quarantine time for Hong Kong–China cross-border travel. Our sense is that continued small policy tweaks following the Party Congress will set the stage for an eventual shift, considering the dire state of the economy. However, meaningful change in policy may not occur until after first quarter 2023, given the required tilt in government rhetoric and because major policies are formally approved and adopted at the National People’s Congress in March. There is also the desire to wait until any winter surge in global COVID-19 cases passes. Other analysts warn that a shift may not take place until China has developed its own mRNA vaccines or other treatment breakthroughs that make the leadership more confident that China’s healthcare system can handle any surge in COVID-related hospitalizations, suggesting a policy shift won’t occur until much later in 2023.

Waiting is the Hardest Part

Due to the current uncertainty, the Chinese economy and equities are like a coiled spring, waiting for the downward pressure to be lifted. The market sell-off following the Party Congress shows that investors have now capitulated on any near-term recovery. Because valuations for Chinese equities are currently depressed, we think investors are compensated for the heightened uncertainty, especially since markets could react quickly and powerfully to any change in zero-COVID policy, making it very difficult for investors to time this pivot.

Furthermore, a 2023 Chinese economy recovery could see Chinese equities outperform global markets amid a monetary policy–induced slowdown in the United States and Europe. China is not facing the same inflation pressures seen globally (headline inflation is running at 2.8%), given the depressed state of the economy. This gives China scope to further increase fiscal and monetary stimulus while the rest of the world grapples with rising interest rates. This divergence in economic cycles adds another layer of optionality and diversification that Chinese equities bring to global portfolios. Yet it is hard to see any sustained market recovery in China without a meaningful easing of COVID-19 policies, which still seems several months away.

3. Will Europe Successfully Manage Its Transition Away From Russian Energy Imports?

Nearly half of the EU’s gas and a quarter of its oil was sourced from Russia in 2021. We expect Europe to ultimately be successful in its move away from Russian energy, but this move will take years and comes with a high price tag that will weigh on economic growth and pressure inflation. Wholesale prices for electricity have risen five to 15 times since the first half of 2021 and gas prices peaked at roughly 20 times their early-2021 lows. European governments are providing relief to shield consumers and corporations from the price shock to varying degrees. However, central banks are seeking to address high inflation by raising interest rates to rein in demand. What is certain is that a meaningful amount of pessimism about economic growth is priced into capital markets, keeping us neutral on European equities.

A Good Start, Especially With a Warm Winter

To offset the elimination of Russian gas, Europe is importing gas from other sources to the degree that its infrastructure allows, building more liquefied natural gas terminals to increase import capacity, accelerating renewables investments, and seeking to reduce consumption to maximize natural gas storage ahead of the high-demand winter season. To complicate matters, the region is suffering a loss of hydro power and nuclear production. In July, the International Monetary Fund reckoned that alternative sources could replace two-thirds of Russian gas over the next year. The EU overall may well squeak by this winter. However, if the winter is unusually cold, resulting in above-average demand, alternative energy supplies and storage may not be enough to meet demand without forced rationing. The situation is more challenging in Germany and Italy, even as both countries appear set to meet their gas storage objectives. Natural gas accounted for about 24% of the EU’s energy mix in 2020, with Germany at 26% and Italy at 41%, nearly all of which was imported.

Most analysts expect that it will take at least two to three years before Europe can adjust to the elimination of Russian energy imports. Looking beyond this winter, Europe will need to source gas and refill storage, likely without any Russian gas, putting continued pressure on gas prices and economic growth.

Economic Growth Will Take a Hit

Corporations have found it challenging to fully pass cost increases on to end customers who are seeing real disposable incomes eroded by high inflation, especially food and energy costs. As a result, the industrial sector has cut production, with the euro area manufacturing output falling nearly 2% since January. A weaker euro could potentially advantage exports; however, its fall has been primarily against the US dollar and currencies of commodity exporters rather than major export markets or export competitors. ⁸

Consensus estimates for GDP growth seem to be accounting for much of this stress. Since March, the consensus 2023 GDP growth forecast for the Eurozone has fallen 250 bps to 0.0%. At the same time, Europe is struggling with higher inflation that has broadened beyond energy in recent months. Central banks are likely to maintain a tightening bias. Meanwhile, governments are engaged in large-scale fiscal interventions aimed at easing the pain of rising energy prices. As we saw in the United Kingdom, such fiscal measures may cause indigestion if they result in concerns over long-term financial stability, although the subsequent announcement by Germany that it will spend €200 billion, or 5.6% of 2021 GDP, to provide aid to businesses and consumers struggling under high energy costs has not met with the same punishment from investors.

Are Equity Markets Pricing in the Stress?

Euro area equities have fallen substantially this year, bringing valuations in line with their historical averages. Relative to US equities, euro area stocks have held up better in local currency terms but have underperformed sharply in US dollar terms. The euro has lost ground to the dollar this year even as interest rates have started to converge. Markets have adjusted to Europe’s narrowing current account surpluses, dragged down by expensive energy imports and relatively low growth expectations, while the US dollar continues to benefit from safe-haven inflows. Indeed, as shown in the chart below, the underperformance of euro area equities relative to the United States has moved in lock step with the increase in European natural gas prices, largely driven by the weakening euro. In other words, the euro has served as a relief valve while valuations have remained flat, although somewhat cheap, compared to global developed markets at about the 25th percentile of the historical distribution.

Consensus earnings expectations for the region have also been downgraded, with euro area earnings expected to grow just 2.8% in 2023. Such estimates are not pricing in steep earnings declines (25%–50%) associated with recessions but are the lowest consensus growth estimates since our data began in December 1987 and are well below the rate of inflation. ⁹

These data suggest that most of the energy distress for the euro area has been priced in, although this is largely reflected in the euro rather than equities. As such, the euro would be the main beneficiary of any positive surprise should Europe manage the energy crisis better than currently anticipated. European equities would also benefit under such circumstances, but perhaps not by more than equities globally as a whole. We would expect a rotation within the equity market away from energy stocks and toward more cyclical sectors and more energy-intensive sectors, like chemicals. Market pricing reflects the outsized risk European equities are facing and we remain neutral on the equity market.

Conclusion

We are certainly living in unprecedented times with high inflation, disrupted supply chains, a war in Ukraine, and an unusual mix of tight monetary and, in some cases, easing fiscal policy. While the range of possibilities for risk assets are wide, we expect more downside and volatility near term as policymakers work through these challenges. Still, valuations have improved, reducing risk and creating opportunities in some market segments. Rather than try to perfectly time the bottom, investors should focus on maintaining adequate diversification, disciplined rebalancing, and taking advantage of attractive opportunities as they develop, recognizing that timing is not going to be perfect and doesn’t need to be if you have an appropriately long time horizon and the fortitude to withstand volatility.

Vivian Gan and Kristin Roesch also contributed to this publication.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. We use renewables and renewable energy interchangeably to reference technology to decarbonize the electrical grid.
3. See https://speedandscale.com/tracker/ for annual updates on progress.
4. Large banks are defined as holding more than $250 billion in assets.
5. Please see Keith Friend, Harry Glenos, and Joseph Nichols, “An Analysis of the Impact of the Commercial Real Estate Concentration Guidance,” Federal Reserve, April 2013.
6. Data reflect annualized returns. Japanese equity performance is based on the MSCI Japan Index and DM ex Japan equity performance is based on the MSCI World ex Japan Index.
7. The denominator effect refers to a rise in the proportion of private investments in investor portfolios resulting from public market declines.
8. On a real effective trade-weighted basis against major currencies, the euro has fallen just 4% year-to-date through August 30.
9. Based on October estimates of the subsequent calendar year earnings growth. The MSCI EMU earnings growth estimate of 2.8% is also the lowest on record based on this methodology.

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