September 2016

After struggling in recent years, international equity markets have been performing well so far this year. Year to date, as of September 29th, developed equity markets, as measured by the MSCI EAFE Index, gained nearly 3%, despite all the problems ranging from negative interest rates to Brexit. Emerging markets equities, as measured by the MSCI Emerging Market Index, did even better, jumping nearly 18%, far exceeding the 7% gain of the S&P 500 Index. However, international equities are facing a huge test: the upcoming US presidential election. Although these markets deal with this every four years, the stakes are even higher this year due to the unique characteristics of the two candidates.

Mr. Trump, the Republican Party nominee, has almost made this US election all about unfair international trade—unfair trade has caused job loss in the US, unfair trade has caused huge national debt, and unfair trade has made the US not so great. Apparently, if Mr. Trump wins, and follows through with his anti-trade election rhetoric, international equity markets will be affected, as a number of countries still rely heavily on exports to the US to grow their economies. However, potentially more damaging and less dramatized by the media is his anti-Federal Reserve (Fed) rhetoric, and he truly may mean it. Mr. Trump shares a quite popular view among many that the Fed is too political, keeps interest rates too low for too long, and is creating a huge asset bubble that is bound to burst. If he becomes the next president, and rushes to reverse Fed policy in his “Trump” style, interest rates could potentially jump and the dollar could surge. Whereas the sudden change and chaos may affect financial markets worldwide, emerging markets are likely to be hit the hardest. Currency values of many emerging markets countries are somewhat pegged to the US dollar, and some of them use the US dollar as their currency outright, without bothering to issue their own currency. As a result, their monetary policies are highly dictated by the Fed, and for some, the Fed is essentially their central bank as well. A sudden rise in both US interest rates and the dollar means monetary policies can tighten quickly, a shock that few emerging markets economies, (which tend to have relatively fragile financial systems), can handle.

Ms. Clinton, the Democratic Party nominee, is a status-quo candidate, and the status-quo, while not ideal for all stakeholders of the economy, has been great for most investors in recent years. As the former First Lady, US Senator, and Secretary of State, Ms. Clinton may have greater insight into the international situation, and she is also a more familiar figure to leaders of other countries. From this familiarity perspective alone, Ms. Clinton may be less of a risk than Mr. Trump for international equity markets. The TPP (Trans-Pacific Partnership) is so far about the only thing in which Ms. Clinton differs from President Obama, as she has switched from supporting to opposing TPP when her presidential campaign started. She may very well switch back if and when she becomes president. TPP is not really a giveaway from the US to other countries, and so far only 12 countries are included in the deal (China is not even part of it). There should be limited damage to the international equity markets if TPP is revoked.

In November 2014, S&P Dow Jones Indices and MSCI Inc. issued a press release announcing the creation of an 11th sector under the Global Classification Standard (GICS) structure. That sector, Real Estate, was implemented last week—marking the first time the GICS structure has been updated since it was created in 1999. Although the impact of this decision will play out over time, it now is clear that Real Estate Investment Trusts (REITs) have found their own home.

Formerly housed under Financials, the Real Estate sector will include equity REITs (REITs that own physical property), as well as real estate management and development companies. Mortgage REITs (REITs that comprise mortgage-backed securities) will remain within the Financials sector. The most immediate impact of this decision is its effect on various benchmarks widely used by investors. For example, the S&P 500 will include the Real Estate sector in its asset allocation beginning September 16. This will result in a 3.23% weight for Real Estate within the S&P 500 moving forward—which is greater than both Telecommunication Services and Materials. The market weight for Financials, on the other hand, will dip from 15.75% to 12.52%, and will rank below Healthcare as the second-largest sector within the index. The impact on many smaller cap indices—in which REITs make up a greater percentage of publicly-traded companies—is likely to be even more profound.

Asset managers undoubtedly will be forced to rehash how they both view the Real Estate sector and implement REITs in their portfolios. Historically, many asset managers and investors alike have underweighted REITs, since they were not deliberately carved out within their benchmarks. That is, a benchmark-aware investor could avoid REITs altogether by investing in enough financial stocks to remain sector-neutral. As asset managers who once underweighted real estate in portfolios begin to change their tune, demand for REITS could increase significantly, and potentially be a boon for the sector as a whole.

Whereas the increase in demand seems a foregone conclusion, investors should remain wary. Adding the Real Estate sector to the major indices also makes REITs far more visible than when they were hidden within Financials. Analysts and stock pickers often neglected REITs because they failed to understand that traditional accounting metrics do not accurately reflect REIT valuations. Ratios such as price-to-earnings (P/E) or earnings per share (EPS) do not apply nearly as well as either price-to-funds from operations (FFO) or the capitalization rate for REITS. This increased visibility is likely to result in increased scrutiny as analysts and portfolio managers are forced to become more familiar with REITs. As Wall Street shifts its focus to the new Real Estate sector, the market for REIT shares could become more efficient—materially changing the risk/return dynamics. For a market area that has outperformed the broader equity market dramatically over the early part of the 21st century, it’s anyone’s guess as to what this could mean moving forward.

At the end of the day, we can draw one conclusion for certain:  Real estate deserves a seat at the table within in a well-diversified portfolio. The asset class has grown tremendously over the past quarter of a century—breaching the $1 Trillion mark in total equity market capitalization in recent months. S&P and MSCI have responded by offering real estate its own home for the first time.