Weekly Investment Commentary: Extra credit may be a plus for portfolios
Bottom line up top:
- Markets may be pricing in the best of both worlds: a soft landing atop a solid foundation. Rejuvenated optimism for a soft economic landing has helped propel gains for most risk assets over the past several weeks. Disinflation continues at a measured pace, signaling that this week’s Federal Reserve meeting may mark the final rate increase of the long tightening cycle. But while the end of the Fed’s hiking campaign could boost markets further, the benefits might be short-lived. That’s because interest rates will likely remain elevated even after the rate hikes stop, as the impact of hawkish monetary policy that began in 2022 has yet to come home to roost. These factors will eventually take their toll on economic growth, regardless of current market bullishness.
- The collapse of real estate appears to be greatly exaggerated. One area of the economy investors aren’t viewing through rose-colored glasses is real estate — historically considered a reliable prognosticator of economic contraction. Markets continue to expect a doomsday event for the sector, but so far it has remained relatively resilient amid steadily rising rates. June’s data for U.S. building permits, housing starts and the National Association of Home Builders confidence index provided a glimpse into the state of the U.S. residential real estate market. Although some of this data came in below consensus expectations, the misses were mostly benign. Both single-family building permits and the NAHB index hit their highest levels in 12 months (Figure 1).
- Commercial real estate can still yield benefits. Like the U.S. housing market, commercial real estate continues to weather headwinds reasonably well. The recent regional bank failures and ongoing challenges faced by the office sector has kept skittish investors from adding exposure to CRE. Yet the banking turmoil has remained contained, and there’s been no widespread contagion of weakness from the office space to other CRE sectors. Additionally, while data from Fitch Ratings shows delinquency rates for commercial mortgage-backed securities have ticked up to near 2%, that’s well below the 9% level reached during the Global Financial Crisis and the 5% mark we saw during the early stages of the Covid pandemic. Furthermore, the rise in delinquencies has been limited primarily to sectors such as office, lodging and retail, while delinquencies in sectors like apartments and industrial properties are within historical norms.
“Despite negative headlines surrounding the office sector, we see compelling opportunities within real estate.”
Portfolio considerations
Against this backdrop of economic resilience, a likely stop to Fed rate hikes and little evidence of broadly deteriorating fundamentals, we believe commercial real estate — along with select “plus” fixed income credit sectors — warrant consideration for investors seeking higher yields and total returns. Fixed income credit exposure in particular has been a winning choice for investors year-to-date, with sectors such as high yield corporates and emerging markets debt outperforming broad investment grade benchmarks.
But not all credit sectors offer the same opportunities. We advocate a flexible and nimble approach to allocating among different areas of the global fixed income market. Beginning a couple of years ago, for example, we began to believe that investment grade bonds were starting to look slightly expensive given their tight spreads relative to Treasuries. Likewise, we felt agency mortgage-backed securities weren’t offering high enough yields over Treasuries to compensate for their risks.
In contrast, we saw better opportunities developing in emerging markets debt, given still-supportive growth levels and, more recently, central bank moves to cut policy rates in China and (we anticipate) Brazil. Nonoffice commercial mortgage-backed securities have also become more compelling compared to investment grade bonds, as the sector has benefited from rigorous underwriting standards and improving loan-to-value ratios over the past decade. The CMBS asset class currently offers a highly attractive 10.6% yield and a spread of 450 basis points over Treasuries — its largest ever outside of a recession. Figure 2 shows how a hypothetical flexible fixed income portfolio could have adjusted allocations in light of these advantages, rotating out of investment grade corporate bonds and into CMBS.
“We see value in taking on credit risk in fixed income, while also maintaining a flexible asset allocation approach.”
Nuveen’s Global Investment Committee (GIC) brings together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets.
Regular meetings of the GIC lead to published outlooks that offer:
- macro and asset class views that gain consensus among our investors
- insights from thematic “deep dive” discussions by the GIC and guest experts (markets, risk, geopolitics, demographics, etc.)
- guidance on how to turn our insights into action via regular commentary and communications
Endnotes
Sources
All market and economic data from Bloomberg, FactSet and Morningstar.
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