The 10-year Treasury rate is a barometer for inflation expectations. The recent rise in 10-year Treasury rates indicates that investors are fearful of inflation again. Alex Popov, Head of Illiquid Credit Strategies at The Carlyle Group, joins Hani Abuali, CEO of Petiole Asset Management AG to explain this phenomenon and advise investors accordingly.
A Sharp Rise in Treasury Yields
Alex explained that markets have expressed serious concerns over inflation on multiple occasions during the last decade when prices of oil and metals surged in 2010 and 2011, during the Taper tantrum in 2013, and in 2018 when the Federal Reserve raised rates and oil reached US$70 per barrel.
The 10-year Treasury rate is attractive to foreign capital, particularly after the elections. It has risen steadily from 0.1% as markets adjusted. The 10-year bond on a currency-hedge basis is at a five-year high to Japanese and Euro investors, which attracts foreign investors, moderating the Treasury sell-off over the last few weeks. The market is readjusting to a fairer compensation after the meaningful sell-off in credit over the last few months.
The rise in 10-year Treasury yields to a record 2.35% since 2013 is driven by inflationary expectation in industries that have seen serious supply constraints following the pandemic. Demand has risen faster than supply, while the rising cost of shipping, transportation, logistics, and plastics indicated runaway inflation.
But inflation has strong mitigants. GDP is not higher than last year, unemployment is high, payroll remains low, and the industry has ample idle capacity. Digitization especially has fueled changes in the economy with the pandemic, but this should not cause worry. Competing dynamics are moderating and compensating for inflation.
Asset Classes that Tend to Fare Well in Such an Environment
Investors need to ask whether real estate as an asset class is undergoing transitional or structural change after 2020. Changes for real estate investors during this pandemic are more pronounced than ever. A key characteristic of real estate has always been that supply adjusts slowly and is sensitive to capital. Capital increases supply in anticipation of demand. But demand may adjust overnight and create massive supply-demand imbalances as those created during the 2020 pandemic.
Residential and logistics asset classes, the biggest beneficiaries of the decade-long demographic and technological changes, were accelerated massively by the events of the last 12 months. Capital had favoured such assets and flowed towards it more willingly.
Office space and hotels are in an uncertain phase. Are they undergoing a transitional change or a fundamental one? The future of hotels will be known before that of office space as vaccinations progress and the pent-up demand for vacations and leisure is released. Change in the office market will be slower, relying on longer term commitments and contracts from tenants.
Another important question for investors is whether they should reduce risk and ride the market with low returns as many investors have done. Alternatively, investors may choose opportunities in the market selectively and seek value in less active, riskier positions. It all depends on whether the sector is undergoing a transitional change or a structural one.
For example, Alex cited asset-heavy companies, including residential home builders and niche assets, such as infrastructure for marinas, leisure or entertainment venues. Real assets that were affected by the pandemic in a transitional way are expected to rebound.
Lessons Learned in Real Estate Investment
Alex stressed that real estate in not a monolithic asset class. It is affected by downturns and other crises. People worry generally about real estate in an environment of long-term inflation and low interest rates. Capitalization rates (operating income over value) depend on the 10-year Treasure yield, the risk premium and the economy.
Secondly, there must be distress opportunities in properties clearly affected by the events of last year and the reluctant supply of capital.
Asset classes that have changed structurally cannot weather this crisis. Real estate and credit in different corporate businesses will undergo structural changes. Most asset classes will rebound certainly, but not all. Consequently, investors must consider long-term changes.
Questions and Answers:
Europe versus the US. Popov mentioned that Western Europe and North America are not correlated directly. At the beginning of 2020, the capital need was recognized in North America. During the last few month, the pipeline has shifted to Europe. The two markets have different value propositions in different times.
Best Regions for Real Estate Investment. Alex stated that Carlyle has worked historically in liquid credit and real estate credit in North American and Europe. During market dislocation, capital tends to flow towards clean businesses with a clear future. By default, better value can be found outside those markets. Look for areas of geographic dislocations. European markets have more dislocation and better opportunities.
Market Trends. Investors should seek supportive trends. Today, market trends support residential, industrial, and logistics. As the economy recovers and the COVID-19 crisis subsides, supportive trends may arise in hospitality and leisure travel. Investors should avoid the pitfalls of offices and retail.
Remote Office Work. Alex detects worldwide fatigue from remote work, which does not separate work and personal life clearly. Although the last 12 months have proven the efficiency of working remotely, the ultimate resolution is a hybrid of remote and in-office work.
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