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Emerging market (EM) real estate equities, measured by either the FTSE EPRA/NAREIT EM or the MSCI EM Real Estate, underperformed EM equities (MSCI EM) and developed market equities (MSCI World) in the first ten months of the year. The fall in Chinese real estate equities contributed to the underperformance. Indeed, EMs face several headwinds. First, Sino-US trade tensions continue to weigh on sentiment. Despite the Democrats taking back the House – which likely means Congressional gridlock for the next two years – President Trump can still impose more tariffs through executive order. Second, Eurozone growth hit a soft patch again, with Q3 GDP slowing to 0.2% qoq from 0.4% qoq in Q2. German GDP growth moderated as trade tensions and slowing Chinese demand hit its export sector and the auto industry. Italy stagnated with zero percent growth, re-igniting recession concerns. Also, the conflict between Rome and Brussels continued to escalate, with the EU rejecting the fiscal budget proposals by the new Italian government. Third, the Chinese growth slowdown was confirmed by recent activity and credit data, affecting both Chinese assets and other EM assets exposed to Chinese demand.
Meanwhile, the Fed is set to continue its monetary tightening despite recent softness in global demand, as the US consumer sector remains healthy. Indeed, personal consumption accelerated to 4% qoq seasonally adjusted annual rate (saar) in Q3, with real disposable income growing at 2.5% annualised rate for a second consecutive quarter. Wage growth just hit a nine-year high in October. 10-year US Treasury yields continue to grind higher against such a backdrop, another headwind for defensive sectors such as real estate. Many EM central banks had to hike interest rates in response to higher US Treasury yields and a strong USD.
Among the dark clouds to softer global growth and the Fed tightening, a few silver linings are appearing. First, excess liquidity due to the Chinese monetary and credit easing may find its way into some Asian real estate markets. The most recent economic commentary by the Communist Party has erased wording about deleveraging or regulatory tightening against the domestic housing market, suggesting regulatory easing at the margin. Second, several countries, e.g. Singapore, Hong Kong, Thailand and Mexico, have managed to avoid sharp monetary tightening this year as they benefit from strong national balance sheets and resilient currencies against the US dollar. That somewhat shields the domestic real estate markets from external pressures. Indeed, real estate prices continue to grow in real terms in those markets. Third, real estate earnings are primarily exposed to the domestic economy and are less vulnerable to elevated trade tensions than export-oriented sectors.
Looking ahead into 2019, we think external headwinds may moderate. For instance, the Fed may hike fewer times in 2019 than in 2018 as the Fed Fund Rate gets closer to the “neutral” level and US growth may moderate as the impact of this year’s fiscal stimulus fades. The ECB may continue to maintain an accommodative stance, partly to prevent Italian bond yields from rising to a level that could derail the Eurozone economic recovery.
Against such a backdrop, we believe opportunities will surface in countries and markets with resilient private consumption, supportive (or at least neutral) monetary conditions and/or attractive equity valuations. For instance, Chinese household consumption, which is domestically focused and benefits from potential tax cuts, may prove relatively resilient against trade tensions, supporting the real estate sector. Also, growth in countries like Mexico and Brazil is likely to accelerate in 2019 from the current low base.
The FTSE EPRA/NAREIT EM lost 21.6% in USD terms in the six months until the end of October. Its P/E ratio is trading at 7.2 times (Chart 1) - versus a five-year average of 10.9 times – and is the lowest since 2009. Our country allocation for real estate equities is broadly geared towards a less benign environment for equities, but we have identified opportunities with attractive valuations.
We are neutral on real estate equities in Brazil and Singapore due to policy uncertainties, as well as China and South Africa due to growth headwinds.
*The publication reflects asset performance up to October 31, 2018, and macro events and data releases up to November 8, 2018, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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