From fear of inflation to fear of recession, and 2 factors to drive outperformance

The Australian REIT sector continued its rollercoaster ride of performance, delivering a +5.2% return in April, after the RBA’s pause in rates at 3.60%.

The unexpected 25 bps cash rate rise to 3.85% on 3 May 2023 took the market by surprise, having expected the RBA to pause for the second time following its decision in April.

Whether the RBA continues to raise rates will depend on the unemployment rate and what’s happening in the U.S., with the market currently pricing in for a recession by the end of the year. This is reflected in the inverted yield curve where the Australian 3-year bond yield is below the cash rate.

Looking at the health of the economy, inflation is still high at 7% (well outside the 2%-3% RBA target range), employment levels are still strong (with the unemployment rate at 3.5%), the housing shortage, and affordability, remains a concern with vacancy rates at an all-time low (<1%), and with strong recovery in migration expected over the next two years.

So how are we positioned?

The market will remain jittery as inflation remains high, but the risk now seems to shift from high inflation to slowing growth. As we enter into a weaker economy, this tends to drive earnings downgrades and the outperformance of defensive over cyclical sectors.

For AREITs this means convenience retail over discretionary, and alternative assets such as healthcare, childcare, and retirement living over core office, retail, and industrials.

As interest rates stabilise, we are starting to see more confidence in the recovery of residential fundamentals with the CoreLogic home value index data released in early April posting a +0.6% monthly gain. This was the first month-on-month gain in national house prices since the housing downturn started in May 2022.

There are two factors why we think residential REITs will outperform over the medium term:

• With the embedded lack of housing supply (vacancy rates <1%) and affordability issues in Australia, we believe that housing, especially affordable housing, will continue to be supported; particularly as migration is set to pick up remarkably in the next couple of years (700,000 new migrants expected to come to Australia by the end of 2024), well above the long term average.
• Rate hikes are slowing, which should be supportive for residential markets, and more importantly, the market is pricing in a rate cut later in the year as the risk of the U.S. going into a recession increases.

Investors could be wise to support defensive retailing with exposure to convenience retail anchored by supermarkets and essential services, and exposure to affordable housing such as Stockland Group (SGP), Lifestyle Communities (LIC), and Peet Group (PPC).