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Macro outlook for 2015
The rising equity markets, rising dollar, oil's 40% slide, possible FED liftoff, and central bank divergence are all hot topics for 2015. Find out what our panel of experts think will happen as we look towards the new year.
Jay Kaplan - Portfolio Manager, Principal at The Royce Funds
Alan Kosan - SVP and Head of Alpha Investment Research at Segal Rogerscasey
Peter Hayes - Managing Director and Global Head of Investment Research at Prudential Real Estate Investors
Duration:
00:51:30
Transcript:
Courtney: [00:00:11] Welcome to Asset TV’s 2015 Outlook Master Class. Stocks have tripled since the lows of 2009 and strategists expect the SMP to rise 10% in 2015. Operating profit margins are predicted to widen and PE multiples to expand. We’ll be speaking with three industry experts about what’s in store for 2015, the markets, rising dollar, oil’s 40% slide, possible Fed liftoff, central bank divergence and the nuances of our experts respective sectors in their 2015 macro outlook. Joining me today are: Jay Kaplan, Portfolio Manager and Principal, the Royce Funds; Alan Kosan, Senior Vice President, Head of Alpha Investment Research, Segal Rogerscasey; Peter Hayes, Managing Director and Global Head of Investment Research at Prudential Real Estate Investors. Gentlemen, welcome. Today’s bull market is the fourth longest in history starting in March 2009. We’re nearly six years in, where do you see this coming out in 2015, Jay?
Jay: [00:01:11] Well, I think to think about it in the context of small cap stocks which is where I focus. It’s good to start at the top and there are two issues to think about, one is interest rates, one is economic growth. The world seems to think that interest rates will go up some time in 2015. That may be true, we’ll have to see, now that oil prices have come down and inflation expectations may get dampened a little bit, we’ll see how that goes. The economy is okay, earnings are okay. But the consumer is getting a big tax cut from oil prices coming down in America; it’s a consumer economy, that should certainly help us. Input costs are coming down for the industrial economy, that should help us. So all those things are pretty good, there’s free money, cheap money, and an economy that’s growing. But in the small cap market it’s really been a good six year almost bull run, multiples have gone up a lot faster than earnings have, so we’ve had some multiple expansion. So the question is what happens if rates do go up, will there be pressure on multiples? Will that push stocks down or how strong is the economy and can companies withstand that? We think they can but that remains to be seen. So we think that as earnings grow, stock prices can grow in lockstep without a lot of multiple expansions, so we could have a muted but positive year in 2015.
Courtney: [00:02:29] Alan?
Alan: [00:02:29] Yeah, I tend to concur. The big themes that we’re looking at right now is where interest rates are going and also the price of energy. The other element here is the role of the central banks and what their behavior might be next year as is indicated. So we see a divergence. We see United States with a better growth trajectory and possibly a rise in rates in Europe and developed markets abroad as maybe declining interest rates and slower growth. So in looking at the prospective going forward we see more of the same in 2015, i.e. more volatility and real question marks on the price of energy. If your prospective is that the oil price change is due to slackening demand then you’ll have a prospective that’s more bearish. That the world is slowing down and that the assumptions of growth are overstated, if you think that it’s due to a supply problem, or a supply issue then you’ll be more, you know, sanguine and more steady and therefore will continue the program going forward.
Courtney: [00:03:19] Peter?
Peter: [00:03:20] You know, in that private space, outside the public market space we are very bullish for 2015. We see the position of the US and Europe leading that sort of global return story we’re seeing in real estate. And that really comes down to that sort of Goldilocks scenario of low interest rates and growth. And those are both important ingredients for real estate returns. The developed market story of Europe and US also translates to Asia. We’re very bullish on Japan for instance. We like Australia. And as a whole we tend to see that lack of supply, that lack of [unclear 00:03:51] activity to be a real boom for real estate returns. Investors are still very, very nervous. They’re really chasing for income. And as a result we’re seeing that sort of movements of capital away from developing markets where there’s a supply side issue and weaker growth environment. So on balance it’s a bit of a mixed picture on where you focus in the world. We do see the US leading, it’s a developed versus developing story at the moment, translating for 2015, interest rates rising, yes, that’s in line with growth. So we tend to expect to see that. In the same way you’d expect to see returns going with falling unemployment, in the same way you’d see interest rates rising with falling unemployment. So as a whole, we are very optimistic for 2015.
Alan: [00:04:26] I think, Courtney, one other thing you need to look at is also relevant valuations, so you look at different markets. And the US has been basically considered to be slightly overpriced at some level, depending on what cap space you’re in or what peer group. But Europe is I feel is underpriced, maybe fairly priced and then Asia, emerging market, there’s a lot going on in the emerging markets and they could be a real good value player there down the line.
Courtney: [00:04:49] And I want to come back to what you all mentioned which is the potential liftoff from The Fed in 2015. How do you see that affecting your respective portfolios and industries?
Jay: [00:05:01] Well, let me start with small cap. So when rates go up the very first time the small cap market probably has a small jilt and probably comes right back pretty quickly. A small increase in rates is a very small increase from a very low spot so the absolute level of rates will still be pretty darn low. If we get a few, and I’m not sure we’ll get a few in 2015, but we get a few, then we have to look for the compression of multiples in some of the high risk more speculative areas, things like biotech stocks or internet stocks for example.
Alan: [00:05:35] Yeah, I think that’s a great question. I think it’s a question of velocity and the increase itself that’s going to be experienced. So The Fed has … they’re meeting this week I believe and they’re going to be discussing whether their key phrase, ‘keeping rates low for a core considerable time’ will remain intact, whether they’ll go to a different nomenclature like patience. So the market will read those statements, obviously sensitivity towards increased rates is going to affect the fixed income market more dramatically, particularly on the short end. In terms of stocks the point that was made is that it depends on how far and how fast the interest rates go up, apparently from zero to five percent increase, it’s from zero percent interest rate to five percent, it’s not going to be that dramatic. It’s going to be a sign of maybe growth, if it gets too high, past an inflection point it could start to hurt stocks. So we’ll have to watch and see how fast and how far it goes. But everything that we read from The Fed is they’re very much focused on employment and even though the employment rate has dipped below six percent, they’re also seeing let’s say less inflationary pressure from the low price of oil. And they have this conflicting issue to deal with right now and improving economy which we’d say time to raise rates but some let’s say dampening on inflation through lower oil and energy prices, so maybe not so fast.
Courtney: [00:06:40] Peter?
Peter: [00:06:40] Yes, it’s a very tough call for central banks at the moment, I mean not least the oil price story about the deflationary pressures and a lot of deflationary concerns in the Euro Zone for instance, in Europe. In the US you know, a lot of the employment growth has perhaps been more the lower value add jobs, which haven’t really led through to wages growth. And The Fed has a real communication issue at its hands. And in many ways investor pricing interest rate hike, they set that in line with GDP growth, which is all part of that return story. In real estate you’re looking at the returns versus where you get alternative investments like bond yields and bond yields are very, very low at spread, it’s still very, very pronounced. So as a whole we actually have no problem with interest rates rising, we see that as part of the cycle. But what we are a little bit worried about is the volatility that might come about through the central bank communication. It’s still not really clear, and this is the meeting with The Fed this week, how are they going to communicate some change of the language, by the interest rate expectations? And of course you never want to kill off a recovery. So there is a concern, what is going on in the markets? Can it absorb an interest rate high? I’d say in real estate again, you know, the big story for the US in particular but also Europe, that lack of development is a key issue, we’re seeing … obviously seeing some development activity in some of the energy markets for instance. There’s a whole … it doesn’t take a lot of employment to get rental growth to give you the returns. So rising interest rates we don’t see as a challenge at the moment for the market.
Alan: [00:07:56] We’d like to see that the market, maybe as [unclear 00:07:58] and some expectation of rising rates we’ve been talking about so much. The Taper Tantrum, we had so many different incidences. And everyone’s talking about June 2015 as a time when the rates might rise. So if the market expects it maybe there won’t be this dramatic reaction to sell off [unclear 00:08:12] if in fact they announce a rate increase.
Jay: [00:08:15] Although we have to, I think, take a look at what’s going on in the junk bond market now. There’s some interesting action there with oil prices. And there’s a lot of energy companies that are in the junk bond market, could be a lot of stress. So that could sort of place some havoc on the fixed income market. And when you have that in the face of all the other noise about changes in rates, you know, credit crisis, no more call for a credit crisis, but disruptions in credit often lead to disruptions in equity markets.
Alan: [00:08:39] Yeah. There has been a flow of capital out of the high yield marketplace, no question. But the question is, a six percent yield roughly, high yield still, well maybe not as appropriately priced for the risk is still on a relative [unclear 00:08:51] base is still a good yield. So it’s really a question of how much risk you’re willing to take.
Peter: [00:08:56] I actually won’t give … you’ve reminded me of an issue because one of the key themes we have with rising interest rates in the US is of course capital outflows from the rest of the world. There is that concern about emerging market, developing markets, investment activity with risk return tradeoff looking more favorable in the US. And they might see capital outflows, more interesting evidence of transactions volume being lower in Asia Pacific in that private real estate space, reflecting some of the economics that’s taking place there. So there is that kind of global story as well that rising interest rates in the US actually has a bit of a global theme to it in terms of capital flows.
Alan: [00:09:28] Yeah, they pull money out of the emerging markets which their biggest concern is. And on interest rates while we’re on the subject in Europe, the role of the European central bank is pretty pivotal here. Draghi has said he’ll do, “Anything to save the Euro Zone.” But what people don’t realize is the ECB’s charter doesn’t necessarily allow them to go out and do a quantitative easing program. They really were set up to fight inflation.
Courtney: [00:09:48] But do you think they will do a QE this year?
Alan: [00:09:49] Well, that really makes this thing interesting which is what would some of the sovereign countries there think of the role of the ECB. Here you have let’s say they want to be active ECB and they’re going to say, “But we’d like the power to buy sovereign debt and large asset purchases.” And then you’ve got countries like Germany say, “Wait a second, I’m not sure we want a fairly activist central bank, we want to raise, at least stimulate the economy through a deficit reduction and austerity.” And Italy and France are stating, they’re saying, “No, we need to spend.” So it’s a kind of an interesting combination of issues going on right now, no consensus. But I do believe that at the end of the day, they’ll probably give the central bank some authority to manage interest rates and to also put money into the economy by buying these instruments so they can get liquidity and get capital flowing. Because remember, Europe right now is in an inflation rate of .5, their long term target is 2. So they’ve got to reflate the economy somehow and all they do is put capital onto distribution.
Jay [00:10:41] You know, with all that said it’s made the US the best house in a bad neighborhood for a while. But conversely, so with the current [unclear 00:10:49] US dollar being strong and overseas economies being relatively weak, there’s pressure on the earnings of big multinational US companies. So that’s one more thing to put into the hopper about the outlook for next year. But large cap stocks, the big ones have that earnings growth pressure from currency and from overseas repatriation of earnings. And we’ll see, and that could bode well for small cap stocks actually, I think.
Courtney: [00:11:15] And how do you see tying this all together, how do you see the divergence among the central banks playing out, BOJ included?
Peter: [00:11:21] I would say that, you know, for me the ECB will move into sovereigns. When the ECB … it’s almost like a track event, it’s seen the US run ahead with the QE, it’s seen the Bank of England run ahead with QE, this is where you feed the returns of real estate. It’s seen Japan suddenly dash off and the ECB’s kind of still there at the starters blocks watching these countries run away thinking, this is what we have to do. The challenge the ECB has apart from the obvious politics about sovereigns is, you know, Europe’s really lacking a growth engine; it’s really lacking a growth driver. You’ve got household indebtness, you’ve got government fiscal problems, you’ve got corporates with profits worried about the outlook. It’s really an export story. So what are the interesting issues you have with this interest rate divergence with the ECB trying to keep rates low for deflation as well as for financing reasons, is the fact that it needs a lower exchange rate. So you’ve got the Bank of Japan going down this lower exchange rate route. You’ve got Europe trying to lower the exchange rate route. You know, there’s some interesting dynamics which again comes back to a theme that we’re looking at which is increased volatility. You know, a bit more uncertainty in the market next year. And I think that’s going to be one of the overriding features we’ll see for 2015.
Jay: [00:12:27] Well, from where we sit at the Royce Funds thinking about US stocks, in particularly small ones, I think all of this swirling on the one hand is really good for the US consumer and US industrial companies. As the things that we all buy and our companies here buy get cheaper and that should give some lift to the economy which should help the stock market offset some of these other negatives that could happen here in the States. So everybody else’s problem to some degree, I think is a positive for us.
Alan: [00:12:58] Yeah, the strength of the dollar will certainly help quality of life here, but it also makes our exports more expensive.
Jay: [00:13:02] It does.
Alan: [00:13:03] And so therefore that imbalance is something that we’re also concerned about the trade imbalance as well.
Jay: [00:13:07] It does, it’s true.
Courtney: [00:13:10] 2014 saw an oil slide, over 40%, how do you see that playing out in the next year?
Jay: [00:13:16] That’s tricky, that’s a crystal ball to start to predict. I bet you if you asked us six months ago where we thought oil prices might be, maybe we’d be hard pressed to give you the number that shows where we are today. I think, you know, part of it is the supply and demand issue, and we talked about this earlier, where does that shake out? But the other part is in terms of how we’re trading in the markets, I’ve met with some energy service companies lately and the executives there talk about how the price in the commodity is a falling knife for now and they’re afraid to step in. And it’s very hard for them to plan their businesses. So when the folks who are working with oil every day don’t really understand where that bottom might be, I think it’s hard for me to try and make a judgment about that as well.
Alan: [00:14:00] I think, as I said, mentioned that there’s a supply or demand driven issue. What’s made this very interesting is that some of the cheap suppliers, so OPEC countries, they’ve kept … particularly Saudi Arabia have kept their production up even in the face of declining prices. Why? They want to maintain market share. They may want to squeeze competitors out of the market. They look at the US rising energy independence and a lot of the interesting thing about oil affects geopolitical issues and national security and there are a lot of issues that relate to the fluctuation of oil. So here you have the US gaining independence and now at some point the price per barrel will hit an inflection where they break even to produce, you know, explore and produce are going to be negative. So at some point there’s going to be retraction of new development. That could create two situations. It could be a slowdown of our independence. It could actually then in the private market or private energy market provide some opportunities as some assets may be, you know, repriced and able to be bought by the more well to do, you know, funds could pick up, you know, reserves and other opportunities. So I think there’s going to be opportunity on the private energy market as this price changes for a while. But I think in the commodity area as well as in the overall consumer spending area, it’s certainly going to have an impact.
Peter: [00:15:12] Yeah, I’d probably catch up on a couple of points there. I mean I think you know, that oil price story obviously will run, I think it has a lot of political issues around it. And I think you’re back in to trying to figure out, you know, what other political events might take place in 2015, you know, who would have known back at the beginning of 2014 about the Russia Ukraine crisis, about the breakout of Ebola for instance, the developments in Middle East. You know, these are all kind of unknowns to some extent. So there’s an element where the oil price story adds another sort of uncertainty. You know, in terms of a house view, you know, what we’re more concerned about is what it means for the energy markets in terms of demand and supply imbalances. You know, obviously we’re a little bit nervous about sort of down in Texas about some development on the real estate side, you know, versus the demand for space. So we’re kind of very watchful about, you know, keeping … if oil prices stay around about 70-80 dollars a barrel that’s fine, below that you are sort seeing a bit of a breakout in the oil markets. But the other theme to catch on is that of course, it’s typically very good. There’s a net of advantage for the global markets, I mean certainly, you’ve got less capital perhaps flowing out of the oil exporters. But the oil importers, they’re benefitting from almost a boost of disposable income, you know, sort of take home pay. And that’s good for retail, that’s good for paying down debt. So it’s a net positive and to that extent it’s relatively good news for the real estate space. And we don’t see oil prices spiking any time soon. So I think we’ll see this lower price a feature of 2015.
Alan: [00:16:42] At now about $59 a barrel, is below 60 for the first time in a while really. And we do think there’s going to be some additional growth, more return of some pricing. So whether it’s 70 or 75, 80, it’s certainly going to come back at some level. And as we just discussed there, it’s not a zero sum game, like there’s not, you know, but there are going to be winners and there are going to be losers in this experience. So again we agree that the net effect is a positive one, more positive than it is negative. Those countries that are exporters and that depend heavily on oil revenues to maintain their economies will have some fiscal pressures, there’s no question, Venezuela and other countries like that, Iran, and countries like Russia. The ruble’s off by 38/40% so the currencies are very imminently involved in the oil fortune. So we think there’s going to be some instability in some parts of the world. But I do think to the developed economies, particularly Europe and Japan, that are big net importers, it’s going to be a net positive.
Courtney: [00:17:32] And how do you see the different components of the consumer food chain being affected by the strong dollar rising inflation and the very low oil prices?
Alan: [00:17:41] I think that the consumer … I’ll take a first shot.
Peter: [00:17:45] It’s a tax cut.
Jay: [00:17:46] Well, that’s right, it is a tax cut.
Alan: [00:17:48] The consumer sentiment index from the University of Michigan was up in November pretty well. So consumers in the United States at least are feeling well about their present. They may be a little bit more iffy about the future, but right now, I mean just filling the car at the pump is basically a really better experience. So that sort of sense of feeling of there’s more cash, that will lead to more spending. Household spending as a percentage … I’m sorry, debt as a percentage of household income has come down. So Americans have to some degree re-levered a little bit. But I think the benefits of low oil prices, I feel that the economy is in decent shape, it’s going to spur consumer spending. We’ll see how the Christmas retail season goes. But overall net positive I think in terms of energy, in terms of consumer confidence, not wildly optimistic but feeling better than they have in the past.
Courtney: [00:18:34] Jay?
Jay: [00:18:35] The early signs were that sales for Christmas were okay so far, while traffic’s not great, but sales seem to be okay.
Alan: [00:18:41] e-commerce is going well.
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Jay: [00:18:42] e-commerce is going very, very well, so net, net, people I think are spending. People are working although we talked earlier, wages aren’t great but people are working. So they’re working and they’re spending in the US, we are a very consumer driven economy. So I think all this is pretty good for the US consumer and therefore for the US economy.
Peter: [00:19:00] The retail sector, you mentioned e-commerce, that is a very challenging market at the moment for investors, trying to figure out where the best performing assets are going to be and what parts of the US will stand out. And a lot of it’s linked to the housing market and so there is a recovery in house prices or multifamily apartment market. So as a positive, the retail sector will benefit. What it means for the type of retail assets that investors are interested in, that’s still a bigger no, and it’s probably the one question I get asked the most by investors globally, and it’s a global theme, you know, “What is the outlook for the retail sector in terms of bricks and mortar versus the online, the e-commerce thread?” But you know, again, you know, giving people more income helps them pay down debt, which is an issue in Europe for instance, which obviously will help the slow recovery that we’re looking for. We still need the housing market to pick up to really get traction. We need stronger employment and wages growth. But on balance, you know, I think policymakers as a whole are pretty happy about this oil price fall.
Courtney: [00:19:59] And now, Peter, how worrisome is it for the consumer that with rising interest rates there could be a potential secondary effect on the value of home prices?
Peter: [00:20:08] Well, that’s always a very good question about to what extent the debt levels are tied to fixed versus floating interest rates. I think again this is really all part of how, certainly in the US, The Fed has to be very, very careful about how it actually manages the expectations around interest rates and debt payoff. It is obviously a risk, you know, we’ve seen this before in other countries where they see signs of recovery, Japan’s a good example recently, but also in the 1990s, they put tax up, suddenly the recovery falls back. And this actually feeds into another theme, I think the interest rate story, certainly from our thinking is going to lag sort of where interest rates should be because the policymakers are very nervous about putting off householders or hitting retail spending. You know, hitting nervousness about retailers and consumers as a whole. So I think policymakers will be very, very careful about how they manage this interest rate. We don’t see a material impact on house prices going forward, we tend to price these things quite early. But it is a risk and it’s obviously one that The Fed presumably is going to be focused on.
Alan: [00:21:08] I mean housing prices have … you tell me if I’m wrong … has slowed a little bit, there’s still housing prices are a positive change but it’s slowed, the rate has slowed. There’s been some value recovery in certain markets that are at the lower end of the spectrum, okay. So housing is still going to be a very dynamic area, it’ll have a lot of different elements to it but we are seeing recovery. Interest rates rising, I mean it depends on household formation, depends on, you know, who’s renting and who’s not, apartments are for the very first time, which have been going gangbusters had basically seen some vacancy creep up, not a lot but a little bit, due to maybe more oversupply but when you hit that equilibrium point where the cost of renting is not superior to the cost of owning there might be, you know, home ownership gets supported. So I don’t think, we think in our firm that there’s going to be a dramatic selloff in homes. But there’s still going to be some general growth.
Jay [00:21:54] You know, on the cusp of again, having down payment requirements go headed down here in the US which I’m not sure is necessarily a good thing because we’ve seen this movie before and it didn’t end well. But to the extent that the government wants folks to buy homes and keep the housing market going, if we get down to three percent down payments again that should keep things going for a little while, at least on the entry level certainly.
Peter: [00:22:17] You know, globally that housing market story is one that policymakers are very nervous about, and you can talk about residential price in London, you can talk about them in Singapore and Hong Kong, I mean obviously the residential market in China’s been growing more headlines. But even places like Sweden as well, and Australia, and this is where governments and central banks have been working to try and figure out ways that when you’re in a low interest rate environment which is the US is in, how do you try and stop asset prices from running away to the point where they become almost a macroeconomic risk? This is kind of the macro of Prudential, the idea of actually putting some sort of impositions on minimum deposits or maximum loan to value borrowing. And as a result that’s kind of another interesting development I think, that we’ll be seeing over 2015. Now, how do you get that balance between getting growth in a low interest rate environment but also trying to avoid some of the asset pricing booms that we’ve seen in the past from recurring?
Courtney: [00:23:09] I want to picot over to small cap stocks, Jay, what is your outlook?
Jay: [00:23:12] The outlook I think is okay, it’s interesting, if you look at 2014, there’s been a big divergence between the performance of large caps and small caps, it’s very, very wide. And as a small cap investor, a little bit unhappy. But that’s okay, but as we look forward, I think there’s some headwinds on large cap stocks and usually when you have this kind of gap, the gap often closes. So I’m actually relatively constructive on small caps. I think we can have an okay year, like we talked about earlier, consumerism is very good for the economy and for small cap. Small cap stocks tend to be more skewed domestically when we’re more internally focused and with the currency problems and global weakness, that’s probably pretty good as well. There have been some pockets of overvaluation, things like biotechs, internet stocks and those may not work terribly well. The small cap market has not been discriminating through this bull run between high quality companies and low quality companies that Royce were looking for, companies with great balance sheets, high returns on capital, those companies have not been rewarded because in a zero rate interest environment every zombie company that may have failed in a different kind of economy, that had a terrible balance sheet, everyone who had to fix their problems could fix their problems. And the market, because money’s free hasn’t really differentiated between the good and the bad, they’ve all gone up. So we sort of feel like we’re at a point in the economy now where with rates going up we can actually do pretty well owning really high quality small cap companies.
Courtney: [00:24:41] And what sectors in particular within the small cap space, what sectors look most attractive right now?
Jay: [00:24:47] Well, I’ve got a lot of investments in retail. We’ve talked about consumer over the last few minutes. Those haven’t worked in the last couple of years, they’re starting to work now, they look really, really interesting. We like companies that are in the industrial economy, we think their input costs are coming down. And we think America’s still going to grow, margins are better, costs are in line, a little bit of revenue growth would go a long way toward leveraging the P&Ls on some of those. And we think there are lots of technology companies, not new technology, no earnings companies but some traditional technology companies where the fundamentals are good and the valuations are extraordinary. So I think there’s a lot of opportunities selectively in the small cap market.
Courtney: [00:25:26] Alan, what’s your outlook for alternatives?
Alan: [00:25:28] Broadly speaking we look at alternatives as hedge funds, private equity and real asset, also hard assets, including timber and farmland. Our view is very bullish right now. It’s not without some cautionary views like on infrastructure for example. But really just to sum it up, on hedge funds which has struggled against the more broader capital market indices over the time, and it’s still trying to find its way in some investors portfolios, we still think that the variety of strategies available in terms of being able to participate in market upside and yet have alpha generating opportunities on the short side is very positive, tend to be less correlated broadly with other asset classes. And allows you to play idiosyncratic trades as well as, you know, take advantage of some beta themes as well. So we like hedge funds. We also like what hedge funds can do when added to a long only portfolio. If you take equity long short, you add it to an equity portfolio at some measure and you take let’s say credit relative value to fixed income, the sharp ratios and the enhanced returns and the overall risk profile can be enhanced, both historically are looking forward in terms of capital market assumptions. On private equity, valuations are up but it’s a very healthy market, right now valuations are 10 times EBITDA in that range on average, which is like 2007 pre crisis levels. But what’s happening right now is astute buyers can find value and by reconstructing their operations can get a net effective EBITDA multiple below 10.
We like private equity, particularly in certain midmarket small cap, you know, buyout spaces. Venture capital, we always like venture capital because of the innovation it brings and the chance for upside growth and real upside value. But it’s tricky, the valuation in the late stage area and very frothy right now, hedge funds have moved into that space and really have increased valuations. We like the early and the mid stage and then we like special situations. Those folks who can go in, look at a misprice restructuring opportunity, get very idiosyncratic, but we think brings restructuring expertise in there, very positive. So again, not without some cautionary signals with regard to, you know, debt multiples being where they are and in terms of valuations but we like private capital. And last thing on real estate, we’re very positive on real estate, less so on core real estate in the United States, gains have been mostly through cap rate compression, you can only get so far with that. Cap rates are around six percent on average, a little below, still a nice positive spread, the 10 year treasuries, but still you’re not going to get a lot of upside. So we tend to favor more value add, opportunistic, repositioning, underpriced assets in secondary markets. And then we really like those very much. And we like Europe, the stress sales in Europe can be very promising, the UK office market and residential market is a little pricey, but we think there are pockets in Germany, Italy, France as well to go for that.
So real estate very positive on and subsectors of that, still like timber, still like farmland, the one area I’ll just mention about, a little more cautionary about is infrastructure. The IMF came out and said, “The way to get the economy going globally is for government to spend more on infrastructure.” We like that, we think infrastructure is a nice long duration asset to match the liabilities of portfolio, good income, but on the other hand, a lot of capital has been raised, transactions have been slower. So a lot of what we call dry powder, meaning capital raised but unallocated. So that’s going to put some dampening on returns for a while but for the long term we like infrastructure. So, overall, alternatives for us is very healthy allocations.
Courtney: [00:28:32] Well, we’ve had trends, last month hedge funds returned nearly 1¼ but they still trailed the overall stock market, how much of that do you attribute to the macro themes that we were discussing earlier?
Alan: [00:28:44] I think, you know, what you’re going to find is hedge fund returns are going to lag in a very bull market, the beta – the beta play for a lot of different reasons. They were shorts, there were other ways that they invest. So I think that it will play out that while the bull market is really running, the equity long short folks will benefit by that, the macro guys will benefit by that when they can recognize trends. The things to remember is that in an era of central bank activity, when they dominate and they stimulate, what they’re going to do is that the correlations of the market will tend to lower. And that does not advantage stock pickers. So when you have equity long short fundamental stock pickers, they’re going to be lagging because they’re just not going to be able to make the same plays when the market is playing at that level. So overall to your question I think that there are going to be some lag over the short term. But if you look back at the seven year period, going back from June, back seven years, the spread between the SMP and the Russell were less to the hedge fund indices than they are today. But they’ve got to look at a little bit of time period.
Courtney: [00:29:38] Peter, what’s your outlook for the global property market?
Peter: [00:29:41] Well, you know, it really is a case about low interest rates and growth. And the lack of developments means higher returns. It’s interesting to note, around the world where we see the opportunities. We still might call real estate a major gateway market, we recognize that there’s early recovery markets, parts of the US, parts of North Europe. And we think taking on more risk, taking a bit more location risk may be moving into downtown markets, suburban markets, taking on a bit more property risk. And this is where the value add opportunities I think are very, very strong, you can get very high returns, and move into that valuation space, value add space. The late recovery markets, the housing boom bust markets along the sunbelt or in the Euro Zone periphery, they’re very interesting markets as well. I think again the core space is very interesting and maybe that’s the place to be. And then you’ve got the structural opportunities linked to logistics and trade and retail. And we think retail’s a very, very attractive play. It’s a very management intensive play. So there’s a lot you can do and this is a theme globally that you’re seeing sort of growth in food and beverage, the sort of repositioning of retail malls and outlet centers, [unclear 00:30:45] entertainment centre.
And we see that retail space probably a bit more advanced when looking at Asia and places like Latin America, we’re very optimistic on Mexico industrial and retail even though the markets there are slowing down a little bit linked to some of the oversupply concerns they’ve had, [unclear 00:31:00] small office than it is retail industrial. So as a whole we’re very optimistic. We’re still looking for growth. The chances are we’ll start off the year very optimistic with growth and then as the year develops we’ll become less optimistic with growth and as for the IMF and the OECD and the European Union, everyone’s GDP growth forecast will come down a bit. For us though it’s still really about income, I mean you know, we’ve seen interest rates staying very, very low, that’s very attractive for the returns you get on property, the lack of development is also an opportunity for investors. And we think that’s a really interesting play for the developed market, we’re seeing that in Tokyo at the moment. So we’re very, very optimistic. It’s a slow recovery and that means you have a lot more investment opportunities. I would say that the really interesting twist is that diversification play you get with global property markets. You’ve got Asia in a period of consolidation. You’ve got the US ahead of the rest of the world in terms of that return story. So I think as a whole, I think global portfolio managers would find markets very, very attractive at the moment around the world.
Alan: [00:31:59] I think in talking about property if I might, US will look at the macroeconomic landscape absolutely. So, the [unclear 00:32:05] wage growth and unemployment starts to come down there’s going to definitely be a high demand for office space. So when you look at each sector, it’s going to be linked to some macroeconomic theme.
Courtney: [00:32:15] And Jay, active managers have struggled over a number of years, what’s the outlook for active versus passive in small cap?
Jay: [00:32:22] I think it’s actually constructive. When I think about active managers versus the Russell 2000, I think that people maybe don’t know or forget that probably 25% or so of the Russell 2000 is in companies that don’t make a nickel of profit. And in a bull market those companies have been rewarded, if the market, you know, gets to any kind of normalized level with slow growth, there could be a lot of pressure on the multiples of those non-earning companies, and that will make it very tough for the Russell 2000 as an index to perform well. And I think in that kind of environment it’s pretty constructive for active managers in small cap. But we’ll, you know, we’ll see.
Courtney: [00:33:05] And, Peter, besides the broader macro themes that we mentioned, are there any other factors that you would consider when formulating your outlook?
Peter: [00:33:12] Oh, there’s many, many factors. I mean the great thing about real estate it becomes such a building specific, location specific story. I mean some of the very obvious ones are things like retreat of bank lending, for instance, through the regulatory framework, that lends itself to a lot of debt investment opportunities which is very attractive. That regulatory framework also feeds through to planning and into infrastructure, you know the changing evolution of cities, urbanization is also an ongoing theme. In fact we’ve seen more and more of kind of demand for downtown apartments, downtown office which seems to be a trend we’re seeing globally, whether it’s in Sydney CBD, whether it’s Berlin or whether it’s, you know, across the US. It’s sort of demand for infill space, apartment dwelling in town centers. So these sort of themes of demographics, age profiles, you know, we love the 18-35 year olds, they love retail malls, that’s an important story, access to credit markets is also an evolutionary story. So there’s a whole lot of socio demographic factors that you kind of have as an overlay, sort of the megatrends that you look to, which also, you know, influence the way you think about how real estate returns play out. Still very linked to macroeconomics, you know, you look at productivity growth, you look at GDP growth, you look at property returns, they’re very, very closely aligned with each other over a long enough time period. But you still have to look at that population story.
Courtney: [00:34:32] And looking to Latin America and Asia Pacific, where are you seeing opportunities to capitalize on the structural shifts that are happening there?
Peter: [00:34:39] Well, you know, Latin America is very interesting because you have got that Mexican story tied in with the US. So we see that demand by international occupiers for modern retail space, for modern industrial space. So we do very much like that market. We see that the growth there with the US economy. Brazil’s very interesting, it’s a large country, so there’s lots of potential there. We’re seeing elements of oversupply that we think will work through the system. We’re optimistic on the new government. There seems to be a push now to develop more economic policy, try and control inflation. But outside of those two, I think we’re a little bit obviously a bit wary about what’s going on with Argentina and Chile we like but that’s obviously slowing down given the sort of slowdown in the global commodity boom. So Mexico, we love, Brazil, I think a bit more late cyclical. If you go to Asia, well, it’s a big place to start. We know that places like Japan are very, very interesting investors, increasingly investors are looking to the secondary cities there. Again there’s a value add reposition in play. We’ve seen a lot of international retailers go there as they are with Australia. But as a whole the developing markets of Asia, there is a slower growth story. It’s all strong growth, there’s a lot of supply. So we’re kind of looking a bit more selective, we like suburban retail for instance in Singapore, we think there might be some distressed opportunities in China with the slowdown.
We like retail as a whole in Asia, about modernization, urbanization. We’re also conscious that that economic growth slowdown there is taking place. So I think as a whole, e-commerce industrial is about the strongest play we do in Asia Pacific at the moment. But we can see the evolution with residential and retail over the shorter term.
Courtney: [00:36:16] And, Jay, what areas are you emphasizing and what areas are you avoiding?
Jay: [00:36:20] Well, again we’ve talked about consumer as being an emphasis and industrial as being an emphasis and there are two main areas we’re avoiding. The first area would be the so called bond proxies, if you remember back in 2013 when we got the first whiff of tapering, the bond proxy stocks did not do well at all. So those are the REITs, the MLPs, the utilities, all the vehicles that are highly leveraged, spread businesses that really depend on those low interest rates. And we tell investors, “Use them as income proxies.” And the [unclear 00:36:56] are pretty low now. So when interest rates go up those will feel some pressures. We’ve avoided those. And on the other hand we’re avoiding those companies that don’t earn a return on capital. Again, because we think that if rates go up and there’s some pressure on market multiples, the non-earners won’t do well so those again are the things like biotechs and social media stocks and internet stocks. There’s been a pretty strong IPO market over the last 18-24 months. And there are lots of companies that have really lofty valuations. And if we get a little bit of a hiccup from rates going up and multiples coming down those stocks just won’t do well.
Alan: [00:37:29] I was going to ask if, you know, REITs have done okay?
Jay: [00:37:31] Yeah, they’ve done more than, okay, they’ve done great. But they’ve done great because interest rates have been really low and property is [unclear 00:37:36] strong, right. And it’s a good spread but as stock vehicles when you saw the last time with a little whiff of interest rates, those stocks sold off really hard. So if we get a couple of those we might see that again.
Alan: [00:37:52] Yeah. I mean our view is not, you know, to be cautionary in some respects but we tend to favor … we like the global real estate, the global securities market. So we would tend to say that, “Well, they’re interest rate sensitive” absolutely. We like the fact that they still resemble … they reflect some of the fundamentals going on in the property market.
Jay: [00:38:08] The cap rates are … there’s no bargain in those cap rates.
Alan: [00:38:11] There’s no bargain.
Jay: [00:38:12] So if you think about it as a spread business and you look at alternatives for capital you can justify the yields that you get. But if you think about the return you get on your capital as an equity owner given the cap rate, if I can buy industrial companies at a much better cap rate, maybe I should do that. And again, you know, the REIT structure, it’s an investment banking structure, right. You have to raise capital because all the capital comes out. And if we get into any kind of capital market trouble, those vehicles as stock market entities tend not to do great. But they’ve been wonderful in the cycle. It’s been a great cycle for REITs, no question.
Alan: [00:38:50] And MLPs which again is a smaller universe but they have been doing okay, well, you know, to the year to date until the recent selloff. So as the energy stocks got sold a lot of the energy infrastructure would get sold off as well. But they’ve had a very nice return as well. So we would not … we would probably look long term to these assets, we probably might trim a little bit. But we’d probably keep it in the portfolio.
Courtney: [00:39:10] And what other areas are you emphasizing and avoiding?
Alan: [00:39:14] Okay. I think we’re still positive on the US, I think the large cap has been doing … small caps have struggled but we like small caps for the thesis that they represent. So I think we would still be … our positive views is on US equities, slightly overvalued, but we like the long term growth, the growth of the economy. And we think the factors that we discussed earlier today will apply. We are less favorable on non-US developed. But we want to keep our eye on that, there still might be some buy opportunities there selectively. And we think EM with all the turbulence and turmoil there and the susceptibility of a flight of capital with interest rates still present long term growth positives. So like EM for the long term, a little cautionary on Europe right now, particularly peripheral Europe because in peripheral Europe you look at Greece and Italy, Greece is having an election. And you look at their bond rates – their sovereign bonds, they’ve had a 200 base point compression in a very short period of time. So there’s a dis-link between the pricing of those bonds and the underlying risk in the economy. So we’re kind of careful about that. So a little cautionary in Europe, so kind of watching that, favorable on the US, favorable on EM, and on fixed income, we’re not so positive on core fixed income because, you know the interest rate sensitivity.
High yield, a jump ball, we want to go on overweight to high yield but we don’t want to lose that six percent yield either, so we’re kind of watching that. And then overall we like local … EMD local currency, we like a lot of the alternative fixed income, so structured credit, distressed if there is any distress, middle market direct lending are the areas and bank loans, even though bank loans, that alpha game may have kind of passed at this point. But we still think that that space represents value.
Courtney: [00:40:55] And, Peter, what areas are you emphasizing and avoiding?
Peter: [00:40:58] Well, so we like the US as a whole, we’re obviously conscious of a bit of supply kicking in some of the markets. But we think there’s some very interesting core and value add plays. As a whole, Europe we like as well but we tend to want to stick to the major liquid markets, you know, so if we’re going to be cautious in Europe, it’s sort of those secondary markets, particularly retail where we’re, you know, negative about how the retail market’s certainly looking in European periphery, some of those locations, some of those assets are looking a bit tired given the way the market’s throwing out. And that sort of secondary story is also true in Asia. We’re nervous of second tier markets, China for instance where there’s a lot of oversupply and other markets, Indonesia for instance. So as a whole we like the growth, we see recovery, we see Asia sort of slowing down a little bit. But it’s the supply side and that weaker growth in Euro Zone periphery, in Asia and a little bit in places like Brazil that we’re most nervous about. The one … I suppose the one key opportunity we like globally is debt. We do think there’s some really interesting debt investment plays, the mezzanine play, the junior play. I think that’s a really interesting story, it’s developing globally, so we also very much like that as an investment opportunity.
Alan: [00:42:06] I think, Courtney, there are other areas of the market that are of interest which we’ve just touched on before is China and Japan. So in Japan right now fascinating things are going on. [unclear 00:42:16] dropped them down because they didn’t put the VAT tax in. So they’re questioning the VAT taxes as not representing the appropriate discipline to get their fiscal states in order. But that, you know, right now, you know, the whole [unclear 00:42:29] economics is under review, there’s [unclear 00:42:32] referendum. But the fact is can they reflate the economy? Can they continue to stimulate? And they’ve got a lot of problems there right now. But it’s interesting, that could also be a swing, you know market for us to look at in terms of how that ultimately comes out. And China is a huge issue for in terms of the consumption of the emerging market, the exports. But right now you’ve got several structural reforms that are being attempted there. But you’ve still got a highly leveraged economy, 250% of GDP in terms of total debt. The government is trying to rein that in a little bit. But as a result China has also cut its growth rate from 7½ to 7%. But that’s a huge story, so we’re watching China.
Jay: [00:43:08] Probably putting some pressure on commodities as well, the main side of energy, had a lot of problems from China.
Peter: [00:43:15] That structural reform trend is something that of course, you know, all the economic analysts out there were pushing Europe, still pushing for the Euro Zone, you know, and that’s, you know, we so much forget really that central banks and governments don’t really have a lot of room to maneuver when they’re faced with another economic shock. And there is the worry of course going forward that there are countries who will try and sit through this kind of pressure to reform, you mentioned it earlier, about wanting to spend, certainly in places like with France in Europe. There is that reform drive and that’s a real important story about how the real estate property market’s going to evolve, subject to other unknowns which will take place in 2015. There is the possibility, we haven’t talked about it really, that the world just continues based on quantitative easing based on low interest rates. We don’t actually know what the peak of this interest rate cycle is at the moment, and we’ve alluded to it. That is also part of the story that we still have to figure out. We’ve never been in this position before. And reforms is part of that package, that … there does seem to be a lot of impetus really that’s taking place, certainly in Europe. And I think that’s one to watch going forward.
Alan: [00:44:17] The danger is to look to the ECB or The Fed as the sole driver of growth and stimulation, you can’t do that. You have to have job growth. You have to have money in the economy circulating. But they can do what they can do. And right now, another country we think is interesting is India, we’re not alone, India, the 10th largest economy, but you are struggling with bureaucracy and corruption and all kinds of issues. Now, Moti is in there, very favorable response from investors, their stock market is up. He’s trying to do structural reforms. Again, that key, structural reform is very important to see whether the economies will work.
Peter: [00:44:52] I love to talk as a researcher that when there’s a lot of liquidity trying to find a home, everyone loves a good story. And India is one country I’ve been asked about the most over the last 12 months. And if ever you go to look at echoes of the previous cycle of 2004, 2007, there is that need to find good stories, need to find reasons to invest in markets. India is a very interesting market. But the terrible thing about reforms is that it can take 10, 15 years to actually see the benefits of reforms taking place.
Alan: [00:45:23] Particularly in a democracy, yeah.
Peter: [00:45:24] Well, which is of course India. So you know, India is very, very interesting, it’s a huge potential obviously, the growth story is looking very, very promising. But you’ve got to be a little bit cautious about, you know, to what extent, investors who as a rule, the ones that we talk to, are still very, very nervous, still very conservative, want to chase income. But they’re looking for high yields. They’re trying to find higher yielding assets. And you’ve seen that movement to apartments outside of the US, you’ve seen that change into logistics, industrial high yields. You know, you’ve even seen things like data centers, you’ve seen self store with senior housing, these alternative classes which are pretty common in the US, growing in other places like Japan for instance. I’m cautious about India. I’m not terribly convinced that the Indian stories are…
Alan: [00:46:08] But we’re positive, we’re not like, you know, going crazy but we’re very positive as an emerging, you know, opportunity and we want to keep our eye on that. But you mentioned something also very compelling which is the search for income. And whatever age cohort you’re in will determine whether you’re more income oriented or capital, gain oriented. And so for the aging population which is coming more of, which is a good thing for those of us in it. Income is becoming a much more, you know, important element. So whether it’s in real estate or it’s in dividend paying stocks or it’s in structured credit, that theme is going to continue to propel different investment choices.
Jay: [00:46:49] We’re talking about chasing returns. And whenever I hear people talk about chasing returns…
Alan: [00:46:53] No, finding returns.
Jay: [00:46:53] Chasing returns, my antennae go up and my warning signs go up. And part of it is there’s been so much capital and so little velocity of what’s happening with that capital, we get mis-pricings because we chase things. So after six years of a bull run with the rates never going any lower ever again, you know, all else being equal, you know, I think there’s a little caution [unclear 00:47:18] because of the big chase for yield and returns.
Alan: [00:47:21] But I love mis-pricing, that’s where opportunity comes in. If you can…
Jay: [00:47:24] Yes, if you can short. I’m [unclear 00:47:26] doesn’t know, [unclear00:47:28].
Alan: [00:47:27] I know. I know, but if you can … or even on a private market play if you could find an intrinsic value play that is not paid to market value then you’re going to make money right there. And that’s the game, right, we’re in, is to make money. But I think what is also interesting is with all this optimism and positive glow I still think the psychology of the investor is still somewhat fragile. And I think that if there are any shocks to the system, any major dislocations, I think you’ll see a selloff. I think you’ll see a rotation back to risk … less risky assets as you’ve seen in other cycles. I don’t know how many folks will stay the course if the market starts to hit real headwinds.
Courtney: [00:48:04] Jay?
Jay: [00:48:04] Well, we’ll see, I think in small cap we’ve seen some of that, there’s been a flight from active to passive as it’s been a struggle. I think as we’ve … whenever we see hiccups in the market, the selling pressure accelerates. So I think liquidity has been an issue. There are days when all small cap stocks sell, it doesn’t matter what the fundamentals are because it’s easy today to trade in and out of an entire sector, not just an industry sector but a sector by market cap. So there can be a lot of pressure on a little bit of bad news, I think that’s true.
Alan: [00:48:38] Well, if the market … let’s say the DOW goes over 18,000, just let’s get crazy, alright, like I say, wouldn’t your instincts be to take a little money off the table at that point or do you think that that point at 18,000, we’re really getting into frothy territory?
Jay: [00:48:51] I focus company by company and stock by stock. So every day I’m taking money off the table or I chuck things that become overvalued, I’m trying to recycle that cash back into undervalued situations where I can try and do maybe a little arbitrage. But I think all else being equal profit taking is never a bad thing.
Peter: [00:49:08] So it sounds to me you guys are in the wrong business, it all sounds like high volatility, [unclear 00:49:11] in private real estate where there’s long term income drivers or long term alternative.
Alan: [00:49:16] And that’s the game if I didn’t have to mark to market every day, wouldn’t life be much easier?
Peter: [00:49:20] So I actually see growth … I think real estate volumes will continue to grow. I mean you know one of the overriding themes, [unclear 00:49:26] themes you’re seeing globally is of course cross border investing. You’re seeing more and more capital trying to chase real estate, find real estate, it is wary about pricing and it’s encouraging to see that, you’re not seeing cap rates come in to ridiculous lows where bond yields are. But we see that transactions volume, that story for real estate continue to grow. And one of the great stories about mis-pricing of course is the fact cities, which of course is our business really, they’re constantly evolving, they’re constantly changing, and occupying dynamics, occupying mixes change, investors sometimes don’t see this which is always encouraging when you look at the relative rent and cap rate stories. And the growth of TMT has been a big story about how cities are evolving. We’ve seen this in London for instance. So no, we’re very bullish and I think you’ll see transactions volumes just keep on growing in real estate.
Alan: [00:50:11] No, like in any asset class, quality does matter unless you go into let’s say those opportunistic plays where you’re looking for something that’s a little ugly and you’re going to make it better. So we like real estate as well and it’s a great inflation, you know, buffer as well, if you can index your leases to CPI, if you can do that.
Courtney: [00:50:26] Final takeaways, Jay?
Jay: [00:50:27] Final takeaways, let’s watch interest rates, let’s watch economic growth, let’s see what oil does to all of that and I think if things aren’t too out of control equity markets in the US are going to be just fine.
Alan: [00:50:40] Reasonably optimistic picture globally but be cautionary about where there’s areas of slow growth. I’m concerned about geopolitical issues that could flare up and destabilize. I think overall a positive framework, we would call it, you know, steady as she goes