As sentiment improves, 2015 will be the year of the U.S. consumer
After a long stretch of sluggish growth, the U.S. economy is finally kicking into higher gear. Give much of the credit to a rejuvenated American consumer. On the four economic measures most important to consumers—the unemployment rate, gas prices, home prices and stock prices—Americans see steady, and in some cases dramatic, progress. The pace won't let up: 2015, we believe, will be the year of the U.S. consumer.
A surge in consumer confidence
The mood has already shifted. During the last six months, consumer confidence, as tracked by the University of Michigan survey, has suddenly surged. In February, the consumer sentiment index stood at 95.4, just below January's expansion peak of 98.1 and well above the 81.6 level that prevailed in February 2014. As can be seen in Exhibit 1, Americans are far more hopeful about the economic environment than they were just six months ago.
No economic data point has done more to fuel that sense of optimism than a falling unemployment rate, which reached 5.5% in February. Without question, the job picture has brightened. The U.S. economy produced almost 900,000 net new jobs in the three months ending in February and over 3.1 million in 2014, the best year for U.S. job growth in this century.
To be sure, wage growth has been a major disappointment; in February, average hourly earnings for production and nonsupervisory workers increased 1.6% from a year earlier. But some economic indicators point to healthier paychecks ahead. Not only are there more workers, but they are also on the job for longer hours—non-farm business hours worked, which combine these measures, rose 5.1% in 4Q 2014, the biggest jump in 16 years (Exhibit 2). In another hopeful sign, a growing percentage of small businesses plan to increase employee pay. Historically, this measure coincides with a move, nine months later, in actual wages and salaries.
Lower gas prices benefit those who need it most
Along with a falling unemployment rate and cheap gasoline prices, a rebound in household net worth reaffirms the swelling optimism of the American consumer.
The recent plunge in gas prices has delivered a major boon to consumers, with the greatest benefit felt by those who need it most. The percentage of household income spent on gas and motor oil is six times greater for households in the lowest quintile of pre-tax income than it is for households in the highest quintile. Spending on gas for the average family should decline $750 a year, the equivalent of a mini-tax cut. Given that imbalances in global oil markets help determine the price of gas at the pump—the picture is complicated, but the essential theme is excess supply and less-than-robust demand—low gas prices may linger for a while.
A rebound in household net worth
Along with a falling unemployment rate and cheap gasoline prices, a rebound in household net worth reaffirms the swelling optimism of the American consumer. At the end of 2014, household net worth totaled $82.9 trillion, well above the pre-crisis high of $67.8 trillion in the second quarter of 2007. Those gains testify to a six-year bull market in U.S. equities as well as rising house prices. On the housing front, consumers are encouraged by recent data: Moderating home prices, coupled with very low mortgage rates, are making housing more affordable. At the end of 2014, average mortgage payments accounted for 14.1% of household income; since 1975, that percentage has averaged 20.3%.
How should we assess the investment implications of a resurgent U.S. consumer? Given that consumer spending accounts for roughly two-thirds of GDP, we expect decent economic growth this year, a 2.5% increase in GDP, despite the higher dollar's drag on exports. Positive economic momentum should keep the Federal Reserve on track to raise the fed funds rate sometime this year.
At its mid-March meeting, the Fed modified its forward rate guidance to reflect the improved state of the economy, removing the assurance that it would remain “patient” in raising short-term rates. Emphasizing that its decisions will be data-dependent, the Fed signaled that a potential rate hike will be evaluated on a meeting-by-meeting basis.
Past experience tells us that stocks may react negatively over the short-term period leading up to a rate increase. Over the longer term, equities tend to rebound because earnings growth remains solid despite incrementally higher rates.
Fed rate hikes will likely push short-term U.S. bond yields higher.
Fixed income investing can be trickier. Fed rate hikes will likely push short-term U.S. bond yields higher. Significant global demand should keep longer-dated bond yields more anchored, although a stronger U.S. economy and higher inflation expectations can eventually put upward pressure on longer-dated yields as well. An improving economy bodes well for corporate bond issuers, as it should keep default rates in check. Finally, bond investors have many more options to invest outside their home markets: Non-U.S. bonds represent 60% of the total global bonds outstanding. When the Fed does move to normalize rates, a balanced bond portfolio, diversified across regions, strategies and sectors and managed with careful attention to security selection and risk control, can be especially effective.
Enhancing defined contribution plans
Making enhancement to plan design and investments can help put employees on the right path to retirement security.
Offering a defined contribution plan as a supplement to your company's defined benefit plan can help your employees live more comfortably in retirement.
A defined benefit (DB) plan provides a significant and valuable retirement benefit for employees. For most retirees to achieve an adequate level of retirement income, personal savings— including those accumulated in defined contribution (DC) plans—will likely be needed. Employers who offer both a DB and a DC plan can drive better retirement outcomes for their employees by increasing their levels of savings and investment for retirement.
Consider the following DC plan design strategies for optimizing your plan's effectiveness.
Include Target Date Funds in the lineup
Target date funds continue to gain popularity in defined contribution plans for a number of reasons, chief among them being:
- They provide age-appropriate diversification and asset allocation throughout the plan participants career (often referred to as a ""glide path"")
- They allow DC plan participants access to professional management, a key strength of defined benefit plans that can significantly improve investment outcomes.
Asset allocation is dynamic and may be adjusted based on a manager's strategy, as well as how the manager prioritizes different market-related risks, such as inflation, rising interest rates, asset class volatility and changing market conditions. Relative to less diversified investment options, target date funds may be less volatile, an important factor in helping more participants reach their desired income replacement level at retirement.
As shown in Exhibit 3, participants who used target date funds experienced less extreme outcomes in their defined contribution plans in the range of their five-year personal rates of return than those that elected to make their own investment selections.
Conduct a re-enrollment
A plan re-enrollment helps position participants for retirement success by defaulting them into the target date funds that are the most appropriate for their age, while still allowing those who want to take a more active role in choosing investments to make their own decisions. Re-enrollment helps participants by potentially improving asset allocation and can also help strengthen a plan sponsor's fiduciary standing.
Other benefits of re-enrollment:
- Helps new and existing participants
- Provides potentially stronger protection from investing liability for plan sponsors
As shown in Exhibit 4, plan sponsors who conduct a re-enrollment typically see a 55% to 85% adoption rate of target date funds. By contrast, plans that simply add target date funds to their plan lineups generally see an adoption rate of less than 5%, even after the TDF option has been available for several years.1
Reduce traditional core menu options and add asset allocation strategies
Employers should be as thoughtful about what they don't offer in a plan as in what they do offer. For example, providing more investment choices often leads to inertia on the part of employees who may not know how to properly allocate their savings among the different options.
Given the fact that too many investment choices can often result in inaction, a better solution may be to provide diversification in the form of asset allocation funds, such as diversified portfolios of stocks, bonds or cash equivalents, which offer diversification within a single asset class.
This approach ensures that experienced, professional managers with expertise in investing over different market cycles are actively driving asset allocation and portfolio construction.
As illustrated in Exhibit 5, the majority of plan sponsors and participants are not very confident that participants know how to best allocate their assets. Even so, most assets reside in the core menu, requiring participants to make their own allocation decisions.
Understanding the changing defined contribution landscape
As retirement products are ever-changing, it's critical to find the right partners to help you stay current on the market environment, legislative and regulatory updates and trends. By leveraging industry resources such as advisors, consultants and asset management companies, you can gain information to make more informed decisions about your plan. Additionally, attending industry conferences and events to network with peers will give you the opportunity to share ideas and gain valuable insight on potential plan changes that could have a positive impact on your plan and your employees' retirement outcomes.
2015 U.S. commercial real estate outlook
High quality core properties on a roll?
Commercial property prices have rebounded strongly since the start of the economic recovery. Indeed, appreciation has been vigorous enough that some investors worry that current valuation levels are unsustainable. We now see high-quality unleveraged core properties trading at internal rates of return (IRRs) at just 6%, based on our current underwriting. This is a low and, for some investors, a psychological barrier that makes real estate feel more like bonds than equities. However, these IRRs are still at a historically wide spread to 10-year U.S. Treasuries, and our real estate return expectations remain closer to our firm's long-term capital markets assumptions for equities than for bonds.
The inevitable back-up in interest rates will most likely come from good economic news, so we target properties that will benefit from the resulting improved tenant demand as well as muted supply.
Market Overview – Office Sector
The office market recovery nationwide had been slowed by weak hiring in finance and law but some stability in investment banking payrolls—thanks partly to M&A activity—and continued growth of asset management payrolls have driven top line financial job growth (excluding bank branches) to its fastest pace since 2006. Law firm hiring has remained weak, but an exclusive group of white shoe firms that cluster in high quality central business district (CBD) office buildings have enjoyed business gains from the M&A boom. InfoTech, management consulting, accounting, architectural and other business and technical services are all hiring rapidly now as well. Overall, we think the count of office submarkets falling below equilibrium vacancy will continue to rise—with only moderate development to mute the resulting sharp rent increases.
Since the start of 2013, more than 25 million square feet of office buildings in structures more than 100,000 square feet have been razed.
Supply remains delayed even as demand accelerates. Scarce construction financing has been one factor, but so has a lack of pre-lease-sized leasing requirements in most markets. Perhaps more importantly, the highest use of land in many of the nation's most dynamic urban cores has been residential. Since the start of 2013, more than 25 million square feet of office buildings in structures more than 100,000 square feet have been razed. As a consequence, net additions to stock were still less than 0.5% in 2014. Large tech firms continue to disperse in search of talent—creating dynamism in certain CBD or near-CBD submarkets, offering local amenities that attract the best workers. Seattle, Portland, Los Angeles, Chicago, New York, Denver, and Boston, among others, see dynamism outside their traditional CBDs but still within urban cores. Sterile boxes in suburban office parks or amenity deserts within CBDs face near term headwinds—especially if they cannot be easily commuted to from urban, infill residential locations.
Consequently, we think even functional, Class A towers in CBDs located in Austin and LA remain bad bets. Additionally, minimally amenitized suburban locations near dynamic CBDs will continue to face headwinds—including some locations around Chicago, New York and even San Francisco.
Market Overview – Retail Sector
We continue to expect Class A malls to deliver the agglomeration economies favoring strong overall mall revenue growth for existing concepts and the best returns for new uses such as high-end restaurants. In theory, Class B malls should be enjoying tailwinds. First, lower oil prices are democratizing the consumer recovery because energy costs account for a larger share of the spending by moderate income households. Second, continued low interest rates remain as a nice tailwind to mid-tier retailers struggling with high fixed costs. Finally, labor markets are improving for middle income Americans. Mid-tier in-line stores have continued to close at a rapid pace while luxury brands continue to grow. As we have noted before, marginal clothing retailers are suffering at the hands of fast fashion brands that have developed logistics chains that can update fashions continuously instead of once or twice per year. Fast fashion firms quickly copy luxury couture styles but, ironically, hurt mid-tier shops most by matching their pricing, but with more up-to-date fashion. Through third quarter, same store sales growth at Class B malls has remained negative. For Class A malls, same store sales growth has decelerated but is still positive.
Labor markets are improving for middle income Americans.
We remain, as we have over the past decade, least enamored by power centers except, perhaps, within dense urban areas.
Large boxes in far-flung locations are on the wrong side of virtually every trend we are observing. Grocer/drug anchored centers with convenience and services-oriented in-line stores are good plays on organic economic growth as long as they are in infill locations. Large outdoor formats continue to work if they have high proportions of small shop space; in areas with high density/income/educational attainment, a broader array of formats will perform well.
Market Overview – Industrial Sector
The warehouse market's great recovery has been driven largely by costly demand from consumers that internet—purchased goods arrive in just one or two days. Holding excess inventories to guarantee quick delivery, along with other logistics costs, goes a long way to explaining why Amazon generates thin profits. Low interest rates and cheap gasoline help a little but do not significantly reduce the drag. Meanwhile, UPS and FedEx rejected some last minute Christmas time express deliveries from retailers that exceeded their previously agreed-upon limits. This form of rationing was put in place to avoid last year’s late delivery fiasco, and it may moderately reduce growth in warehouse demand. However, at some point a larger share of excess inventory and logistics costs will have to be passed to consumers, who should then be expected to reduce their demand for quick deliveries.
Some economizing in the logistics chain is already incrementally moderating warehouse occupancy growth.
In the near term, some economizing in the logistics chain is already incrementally moderating warehouse occupancy growth at the same time supply is rising. Tenant-demand growth for very large boxes (500,000+ square feet) in far flung locations on cheap land has slowed, making it even more difficult to drive rent growth. Small infill boxes should achieve higher rent growth, especially as they take advantage of the new-urbanist trend and consumer demands for faster internet delivery. These commercial properties also enjoy locations that are typically more supply constrained, as warehouse use in these places is often not perceived the highest and best use of land. Unfortunately, small infill box portfolios do not trade often and are expensive when they do.
Market Overview – Residential Sector
Net operating income growth for apartments has re-accelerated modestly as the housing market recovery delay has raised tenant demand for rentals. This impact is most strongly felt in economically-dynamic Western region markets, but we’ve also seen stability and recovery in rent growth in Northeastern and Midwestern region markets as well. Rents in many tech markets will have to decelerate over the next year as reduced affordability drives tenants to alternatives (rental houses, roommates, etc). As we noted previously, pockets of oversupply have cropped up and starts are accelerating. Since the apartment market is largely priced above replacement cost, we think appreciation should be muted in the long run and that the best risk-adjusted returns for core investors may well be found in development.