25-Oct-23 Equities
John Vojticek

John Vojticek

Head of Liquid Real Assets, DWS
Annie Del Giudice

Annie Del Giudice

Senior Portfolio Management Specialist – Liquid Real Assets
Geoffrey Shaver, CFA

Geoffrey Shaver, CFA

Portfolio Management Specialist – Liquid Real Assets

Equities retreat as earnings disappoint

Weekly Edition

Market index returns

Week to date since October 18, 2023 as of October 25, 2023

Index definitions: Global Real Estate = FTSE EPRA/NAREIT Developed Index; Global Infrastructure = Dow Jones Brookfield Global Infrastructure Index; Natural Resource Equities = S&P Global Natural Resources Index; Commodity Futures = Bloomberg Commodity Index; TIPS = Barclays US TIPS Index; Global Equities = MSCI World Index; Real Assets Index = 30% FTSE EPRA/NAREIT Developed Index, 30% Dow Jones Brookfield Global Infrastructure Index; 15% S&P Global Natural Resources Index; 15% Bloomberg Commodity Index, 10% Barclays TIPS Index. Source: Bloomberg, DWS. Past performance is not indicative of future results. It is not possible to invest directly in an index.

Market commentary:

Following the 10-year U.S. Treasury yield’s brief breach of the psychologically important 5% level, equity markets ceded additional ground this week. Heightened economic and geopolitical uncertainty have created a challenging environment. Risk assets, broadly speaking, were not spared. Among the Real Asset classes, TIPS, Commodities, and Global Infrastructure fared relatively better than broader equity markets; pockets of strength in metals and select utilities segments provided some support. Conversely, Natural Resource Equities and Global Real Estate securities were the laggards.

Why it matters: Indicators we track continued to flash yellow this week – volatility (as represented by the VIX index) has headed north of the 20 level, inflation breakeven rates are struggling to stabilize after a recent liftoff, high-yield credit spreads have quietly widened by about 17 bps since the end of September, and the U.S. dollar and Gold are both trading higher together, a deviation from their normally inverse relationship and a telltale sign that investors are seeking safety. Broader equities have witnessed a significant erosion of year-to-date gains, which peaked at 19% near the end of July and currently stand at 8% as of our most recent period-end, with a handful of mega caps providing much-needed support. In this environment, we believe stock selection will be of critical importance. Liquid Real Assets offer a diverse opportunity set where stock-level dispersion (and therefore, alpha opportunity) has been historically high. For example, across the Global Real Estate securities categories represented in our accompanying dashboard, stock-level dispersion (the difference between the best and worst performing stock in each category) has averaged between ~50-60% over the last three calendar years. Active managers with strong stock-selection capabilities are best placed to take advantage of relative value opportunities, which are likely to increase in the current environment.

Digging deeper: This week we recap major macro developments, including key data releases in the U.S. and a rate decision from the European Central Bank (ECB) as it tries to chart a safe economic course for the bloc. We then take a deep dive into another M&A deal in the energy sector as we consider how the energy landscape might evolve over the next few months and years.
  • GDP stands for…: Technically, it still stands for Gross Domestic Product. However, we think a fair second option for this month’s print is Government spending and Deep Pockets. On October 26th, the U.S. Bureau of Economic Analysis (BEA) released its advance estimate of third quarter GDP, which revealed that the U.S. economy expanded at an impressive pace of 4.9%, thus matching China, trouncing the U.S. Q2 print of 2.1%, and exceeding economists’ estimates of 4.5%. It also marked the strongest print since Q4 2021. Generous contributions from Uncle Sam were certainly one factor, but as tight labor market conditions persisted and inflation trended lower, consumers were apparently emboldened to dig into their pandemic-era savings and spend freely, fueling economic growth. This validation for recession naysayers will undoubtedly complicate the Fed’s next rate decision.
  • Is the ECB on the backfoot?: Markets certainly seem to think so. On October 26th, in a widely anticipated move, the ECB left its deposit rate unchanged at 4%. So ends the central bank’s 10 in-a-row hiking streak, which saw rates head 4.5% higher since July 2022. President Christina Lagarde echoed guidance from prior weeks, insisting on a “steady” course while offering little new information, but her position and prose are screening increasingly dovish. Capital markets are not buying her characterization of a discussion on potential cuts as “totally premature”, and for good reason. Incoming economic data suggests that a recession is already here, while other supporting indicators such as sentiment and consumer spending are flagging. Currently, investors are betting that the ECB could start backpedaling as soon as April 2024.
  • PCE data doesn’t make Fed job easier: Personal Consumption Expenditure (PCE) data for September was released just after our review period, and while it won’t likely tip the U.S. Federal Reserve towards a rate hike at their meeting next week, it will give them a lot to think about and discuss. While the PCE prints were largely in line with expectations, the headline PCE Deflator at 0.4% month-on-month and 3.4% year-on-year were unchanged from August, showing no signs of inflation abating. The core prints, which exclude volatile food and energy and represent the Fed’s preferred inflation measures, rose to 0.3% month-on-month, the highest since April of this year, while the Core PCE year-on-year of 3.7% fell only 10 bps from August (which itself was revised down by 10 bps). While the futures market currently ascribes almost no chance of a rate hike when their next policy meeting concludes on November 1st, additional rate increases could still be in play for their meeting in December or January of next year.
  • Chevron plays Hess in upstream chess: This week, upstream energy behemoth Chevron announced it would purchase Hess Corporation in an all-equity deal valued at $53B. The move follows supermajor ExxonMobil’s acquisition of Pioneer, which strategically expanded its footprint in the Permian Basin. Hess is a small but uniquely positioned U.S. exploration and production company with valuable international assets in oil-rich Guyana that afford an acquirer like Chevron (which has high risk concentration in the Permian Basin) an opportunity to diversify and grow. We expect more consolidation across the upstream energy segment as the energy transition gets further underway globally, with the International Energy Agency’s (IEA’s) recent call for oil demand to peak by 2030. As earnings slip under current conditions, strategic acquisitions that offer diversification benefits, flexibility, are cost-effective, and reduce time-to-market may make the most “cents”.
What we are watching: This week, we breathe a collective, if not slightly nervous, sigh of relief following the long-awaited election of a leader in the House before turning our attention to the state of geopolitical affairs (spoiler alert – it’s not great). We end with our thoughts on two rather attractive opportunity sets within the Real Assets universe.
  • House elects a speaker: On Wednesday, October 25th, the U.S. House of Representatives finally elected a speaker after weeks of division and dysfunction. Despite the conflicting views that characterized prior rounds of voting, Republicans voted unanimously for the new speaker, Representative Mike Johnson of Louisiana. Johnston, a staunch conservative and longtime Trump ally, has nonetheless voiced a desire to work across the aisle to make progress on passing key legislation. This is (hopefully) a good thing for the American public, as he now finds himself with quite a lot of ground to cover to make up for lost time over the last few weeks. In terms of pressing matters on the docket, a resolution supporting Israel has already passed with bipartisan support, which leaves the small matter of funding the federal government by November 17th in order to avoid a shutdown.
  • A game of strategic conquest: While geopolitical risks have been looming in the background for some time, they are now coming to the foreground, threatening near-term disruption across global markets. The U.S. is funding multiple “wars” on multiple fronts far from its own shores. It was already sending aid to Ukraine to support its defense against Russia’s protracted invasion. Now, it has both approved funding and sent warships to the Mediterranean in support of Israel (and to deter Iran) in its pursuit of eradicating Hamas. This is a dangerous moment where the probability of escalation is high. For one, the Israel-Gaza conflict could erupt and expand should Iranian military proxies join in from across the Middle East. Second, China could move to exploit the seemingly overstretched state of the U.S. and make a play for Taiwan. At some point, capacity may become an issue, while bipartisan divisions in Washington could complicate and delay decision-making. As a real-life, high-stakes game of “Risk” unfolds before our eyes, we will be paying close attention.
  • Mega-what??: This week, we turn to the outlook for Data Centers, a niche listed real estate sector with exceptionally strong growth prospects that have been magnified as global firms race to adopt artificial intelligence (AI). If leasing activity is any indicator, the demand case is downright astounding. According to a recent release by datacenterHawk (an industry data provider), aggregate new leasing activity topped 1,400 megawatts (MW) in the third quarter. For context, the prior record was ~1,000 MW. Robust absorption is occurring across all regions, including the U.S., Europe, and Asia Pacific. As power limitations are curtailing supply and AI euphoria is showing no signs of abating, we think the foreseeable future is looking bright for this corner of listed real estate markets.
  • Mixed metals: Precious metals and industrial (or “base”) metals lead Commodities returns this week, but the outlook is decidedly mixed. From here, we expect base metal prices to stabilize, with no clear direction at present. We do not see a meaningful recovery in base metals absent a significant recovery in China's property sector. Rising energy prices globally are becoming a bullish risk, however. By contrast, we continue to see better upside in precious metals, particularly Gold, whose spot price challenged the $2,000/oz level this week. While risk concerns have helped the gold spot price increase on the margin, it has also moved in concert with U.S. Federal Reserve (Fed) officials’ discussions regarding peak nominal rates. We view the current outlook for a stable policy rate, followed by the potential need to cut policy rates to support a slowing economy, as very supportive for gold prices.

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