Alternatives investment views for a post-pandemic world
Anton Pil, Global Head of Alternatives, J.P. Morgan Asset Management, oversees more than $150 billion in client assets under management in alternative asset classes from private credit to hedge funds. In the new commentary below, he discussed how the investment outlook for alts has changed in light of the recent COVID-19 vaccine news and the incoming Biden administration, warning in particular that rates may climb faster than investors currently expect.
Recent macro developments have crystallized seven key themes that will significantly impact alternative investments in the medium-term:
While the U.S. Federal Reserve will clearly keep interest rates lower for longer, term rates may well move sooner than the Fed, potentially surprising investors and impacting the attractiveness of traditional fixed income
The Federal Reserve has already signaled that rates will remain at zero through the end of 2023. However, with the prospect of a vaccine in 2021, it does appear that the U.S. economy may be able to get back to normal much faster. The Fed won’t hike rates in 2021, but the days of term cheap money may be numbered. A lot depends on what the next round of stimulus looks like, both on the size of that spend and where it is directed – to consumers, assets or corporations. While size is perhaps constrained by the lack of a blue wave in Congress, it is reasonable to expect that that the spend will be directed at consumers since the Fed has signaled it is doing all it can on the corporate and asset support side. On the back of additional stimulus and as demand comes roaring back, the economy should surprise to the upside. A Fed that is in play sooner than expected would be a headwind for fixed income and may even change stock/bond correlations, posing portfolio risks. Alternatives investors should take advantage of this window by locking in and adding attractive, accretive leverage to real assets now.
Given the persistence of liquidity and yield compression in public markets, private market credit spreads have tightened. We believe spread and yield compression will continue as inflows seek yield in private markets. Origination standards need to be differentiated and selective based on individual credits: it’s critical for investors to understand the difference between short-term disruption versus value destruction.
Consumers are spending again
Prior to pauses in re-openings across the U.S., sales at certain retail malls had recovered to roughly 90% of pre-Covid levels. In the short-term, people will continue to spend money on goods over services. As the economy comes back online, however, we would expect consumption of services to also increase. Services are inherently local, suggesting that domestic spending should rebound into the end of 2021. Global vaccine distribution will be a multi-year endeavor, especially in the developing world. Domestic U.S. travel should rebound first, and likely sooner than consensus expects.
We may see a boost in US and European pharmaceutical manufacturing
The pandemic revealed the need for ready access to essential goods. However, bringing back manufacturing to the US and Europe will lead to higher costs, and therefore pressure margins. This increases the risk of automation. Life science and lab space are likely big beneficiaries of the move to “homemade” necessities, potentially putting an interesting spotlight on domestic pharmaceutical manufacturing facilities for U.S. real estate investors.
Return to the office, re-opening the economy
The recent strong rally seen in REITs in response to the vaccine news suggests the market’s confidence in the long-term viability of the office sector post-Covid. The timeline for a return to normalcy has likely been accelerated with the vaccine announcement, hopefully resulting in a larger proportion of the work force getting back to offices and travelling for both business and leisure. This will relieve the pressure that has been felt throughout the pandemic by transportation assets such as airports and toll roads. In addition, the demand for oil and gasoline is likely to pick up, stabilizing power prices, which are still below pre-Covid levels across many geographies and aiding mid-stream assets as through-put increases.
Forecasts suggest 80% of workers will be back in the office by the end of 2H21. Despite its shortcomings, the history of the co-working business model has proven one thing – that even when folks can work from home they prefer to work in the company of others, even strangers. In the U.S., while work from home creates a modest drag for the office sector, we think the mix of industries occupying office space is more dynamic than a decade ago and will be supportive of the sector’s rebound.
We see the performance premium of last mile warehouses over rural ones continuing to increase. We expect suburban residential rental locations to continue to outperform as well as Sunbelt locations with low costs and high educational attainment. In Asia, the prospect for continued remote working is limited by small home sizes and cultural considerations.
The catalyst for the US to catch up to Europe on ESG/Climate Change?
Changes to U.S. energy policy could be enacted mostly through presidential executive orders and regulatory action, which may limit the impact of such policies. However, the Biden administration is likely to be more apt to work towards net-zero targets and re-enter global climate accords, which could be beneficial for renewable energy investments and the sustainability agenda. Investors are increasingly focused on what we believe is the defining investment trend of our times – ESG. The environment, income inequality, diversity and social justice are increasingly on the minds of clients, and popping up often in strategy and manager due diligence. This trend is further underscored by the strong performance of sustainable alternative strategies throughout this period.
Transaction markets open
Private Equity markets will likely remain active with ample dry powder, however the level and nature of activity will largely depend on the capital market landscape, as well as potential changes in taxation levels and regulation. Deal activity has been elevated with sellers already considering near-term exits now motivated to pull forward exit activity ahead of any changes. If the Biden administration can’t get through the tax changes they propose, it removes some of the impetus for certain companies to transact. However, the overall uncertainty in the market and continued COVID impacts, as well as the pending Georgia Senate runoffs, are all still creating lots of opportunity especially in co-investments in the near to mid-term. The venture capital market continues to be robust with significant early and late stage capital opportunities. Many VC-backed sectors have seen strong acceleration of growth during COVID and should be stable coming out of it, especially if they have raised recent rounds of financing. It has never been cheaper to start a new business (thanks to cloud computing and remote workforces). The VC backed IPO market has been strong this year, surpassing last year already.
US real estate tailwinds
With bond yields staying low, the average 6%+ internal rates of return that we’re seeing in U.S. real estate for new unlevered core property acquisitions remain historically wide to BBBs – the current 400 basis points spread is in the top 8th percentile over the series’ history. The current negative real interest rates environment will also tend to support higher prices as inflationary expectations are built into cash flows, while low nominal Treasuries tend to reduce discount rates and increase use of leverage. Even before the good vaccine news, we had shrunk our projection of peak to trough property appreciation declines because of the powerful impact of the supportive capital markets environment. We now see the vaccine news in particular as creating a more concrete end point to the crisis and that creates further upside potential. We expect the cumulative index price decline to be in the 3% to 6% range, reversed by 4% income yield. We believe there is a good chance that for the calendar year 2020, the total return for US core real estate may end up positive, and may enjoy a significant bounce in 2021.
While the positive impact of encouraging vaccine news will take time to materialize, we’re proactively adjusting tactics and strategies, where appropriate, as this new playing field evolves.