By: Stash Graham
The domestic indices rebounded to post gains for February, but it was the final week of trading that caught the attention of investors. The S&P 500 fell seven of the last nine trading days of the month as United States Treasury yields at the long end of the yield curve started to spike. This pronounced move in the long-duration interest rates put pressure on a wide range of financial assets. Gold prices came under pressure for a second straight month (falling approximately 6%) while our commodities basket (Invesco Diversified Optimal ETF, ticker: PDBC) produced another good month finishing north of +10%. We believe one of the major storylines from 2021 will be the material weakening of the US Dollar. The US continues to operate at a sizable deficit adding to a historically high debt level. The current account balance is still well into the negative (import-export trading totals). Adding both negative variables together produce the largest “twin deficit” in the modern world. As such, over the intermediate term, we expect the US Dollar to continue to weaken against all other currencies and real assets. However, in the short term, we could see the US Dollar stabilize as emerging economies could look to buy the greenback to hedge inflation risk.
The Federal Reserve released their semi-annual Monetary Policy Report ahead of Fed Chairman Jerome Powell’s testimony on Capitol Hill, which occurred in late February. The report is a wide-ranging report covering a host of topics, but this report centered around real estate. In residential real estate, the central bank notes how the very recent rise in the 10- and 30-year US Treasury yields have suppressed pending new orders. Separately, more Americans are putting less down (10%) for a house than during standard times (20%). As a result, the Federal Reserve is worried about the small equity portion of the highly levered asset. If homeowners become underwater (they owe more than the house is worth), they become less likely to spend and save more. The Monetary Policy Report also discussed the commercial real estate market. The report stated, “prices remain at historically high levels despite high vacancy rates and appear susceptible to sharp declines, particularly if the pace of distressed transactions picks up or, in the longer term, the pandemic leads to permanent changes in demand.” We remain concerned that this looming issue (wide-ranging defaults on commercial mortgage loans) goes unattended. In early February, the S&P stress-tested a wide variety of office-building real estate investment trusts and found significant deterioration in all credit metrics of the underlying real estate firms over the next three years. The earliest the S&P team seems stabilization is in 2025. This downward pressure will make it hard for the Federal Reserve to increases interest rates soon as higher rates put further pressure on building owners. In the end, defaulting building owners makes lives difficult for the Federal Reserve’s member banks.
There was a widely shared article on Bloomberg Terminal by Barron’s Andrew Bary discussing the utility sector, “The Coming Green Boom for Utilities.” As you are aware, in the Fall of 2020, we initiated a few positions within the industry. Mr. Bary summarized our overarching thesis for having an allocation in the sector pretty succinctly: “In the coming years, utilities — now yielding an average of 3.5% — are likely to have annual earnings growth of 5% to 8%. Those results will be driven by heavy investment in renewable-energy sources, batteries and other power-storage devices, new transmission lines, and investments to harden the electrical grid to help avoid blackouts and breakdowns — a need strikingly evident in the recent freeze that nearly collapsed the grid in Texas…. All of this could translate into 10% annual total returns, which would be competitive with the S&P 500 and much better than those in the bond market, where Treasuries and municipals yield just 1% to 2%.” From a risk/reward perspective, we continue to find the utility sector as representing good value and will continue to monitor the space closely for new investment opportunities.
Geo Group 5.875% Senior Notes (Maturing in 2022)- The real estate investment trust announced a capital raise from a convertible bond offering towards the end of the month. The trust intends to use the $200 million proceeds to retire our bonds early. Geo Group management has not made the formal declaration yet, but we expect notice shortly. There must be a minimum of 30 days between the statement and the bonds’ actual early redemption. During these 30 days, we will continue to accrue interest at 5.875%. We are disappointed to see these bonds called early. Still, as interest rates remain favorable for corporate borrowers to refinance at lower levels, we expect to see more early redemptions in the future. We will par value plus accrued interest owed at the end of the 30 days.
American Electric Power (Ticker: AEP)- The transmission giant reported a bottom-line beat for the 4th quarter of 2020. AEP leadership raised their 2021 earnings guidance range to $4.55-$4.75 per share. Additionally, the management team expects 5-7% annual earnings growth for the foreseeable future. In late January, the company declared a $0.74 per share quarterly dividend payable on March 10th to shareholders of record.
AT&T (Ticker: T)- The wireless giant has had a busy start to the year. First was their participation in the highly anticipated 5g spectrum auction where AT&T and Verizon were the greediest. The spectrum auction turned a lot of heads as Verizon and AT&T together spent almost $70B for spectrum assets. We believe these transactions further promote the high entry barriers that these companies will enjoy for the foreseeable future. The cost to enter the wireless services sector is going to be merely prohibitive to any challenger. The second development was their joint venture with PE firm TPG in their “spin-off” of DirectTV. The DirectTV transaction will still provide AT&T with 70% economic ownership, but will also free up almost $8B in cash proceeds that AT&T will use to pay down their outstanding debt. Even after the DirectTV sale, the company is projecting operating free cash flow to be around $26 Billion in 2021, consistent with their previous estimates before the transaction. Management guides that most of this year’s free cash flow will be used to pay for the recently purchased 5g spectrum and pay down further debt. As we continue to see renewed pockets of volatility, now in United States Treasuries, be rest assured that we are monitoring these impacts on your portfolio. The 8 out of 9 trading day losing streak to the end of February seems all too familiar to 2020. We certainly know that circumstances have changed as the state continues to administer vaccinations around the country.
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