While cap rates remained relatively unchanged, the rise in corporate bond yields resulted in tighter relative pricing through 4Q18. Corporate bond yields rose by close to a full percentage point through the final months of 2018 in response to heightened stock market volatility. The cap-rate-to-corporate-bond ratio declined to 111.0. Despite the narrowing spread between cap rates and corporate bond yields, real estate remained “fairly” priced on a relative basis.
Despite strong property market fundamentals, recent stock market and interest rate volatility weighed on listed sector returns, resulting in a -5.9% total return during the final quarter of 2018. While listed sector returns retracted, private real estate performance remained positive, producing a quarterly return of 1.4% in 4Q18. The return represented modest deceleration from recent quarters, largely fueled by the retail sector’s lackluster performance and diminished capital growth across all property sectors.
An indication of growing economic uncertainty and expectations for slower growth moving forward, the yield curve continued to flatten through the early part of 2019, as the 3-month/10-year Treasury spread contracted to 29 bps in January – the lowest level since midyear 2007. Since the Fed has indicated fewer rate hikes in 2019 than previously anticipated, the reduced upward pressure on the short-end of the curve should, ideally, stimulate growth and allow for a widening of the term spread.
After 28 months of consecutive growth, the U.S. Leading Economic Indicators Index (LEI) declined modestly in December 2018, decreasing by 0.1% from the previous month to 111.7. The recent decline in stock prices, manufacturing orders, and building permits offset positive gains in other contributing indicators. Although up 4.3% year-over-year, the LEI’s recent decline may indicate a deceleration in economic growth in the coming quarters.
The unemployment rate is often acknowledged as a lagging indicator. However, the trend, and more specifically a trough, in the unemployment rate, has shown to be a leading indicator for an economic correction. After reaching a multi-decade low of 3.7% earlier in the year, the unemployment rate rose to 4.0% as of January 2019. While a single month-to-month increase is not necessarily alarming, a sustained rise in the unemployment rate relative to trend would raise red flags.
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