Specialty Asset Management Update
Macroeconomic fundamentals continue to be strong, risks bear watching
Despite rising trade tensions, the current macroeconomic backdrop for specialty assets remains positive. The global economy continues to be in the midst of a broad-based, cyclical upswing, which is driving consumption growth in emerging markets. Notwithstanding trade policy risks, accelerating global growth in 2018 and 2019 should continue to support worldwide consumption of energy, U.S. agricultural exports, and the global demand for housing, and underpin the demand for key specialty assets such as farmland, timberland, and oil and gas. Additionally, as the U.S. economic expansion enters its 10th year, strong consumer optimism and a robust U.S. labor market point to generally healthy conditions for commercial real estate. In addition to these cyclical factors, various structural trends are projected to drive demand for specialty assets in the long term, notably, a growing population, rising urbanization, improvements in infrastructure, higher personal incomes and changing consumer preferences in the emerging markets. As middle class consumers in emerging markets shift to consume more diverse foods, advanced housing, and other higher-value goods, this growth in per-capita consumption should generate an increased demand for U.S. exports. Additionally, pent-up housing demand from U.S. millennials is expected to support home building in the coming years, pushing up the demand for timberland. Supply constraints should also drive land values higher as industrialization, erratic weather patterns and soil erosion threaten the world supply of arable land. These supply-side pressures reinforce the importance of global trade for meeting the worldwide demand for food. However, recent trade tensions between the U.S. and key global trading partners threaten to disrupt the international trade ecosystem in which U.S. exporters benefit from these evolving global spending habits. The agricultural sector, specifically, has been a frequent target of retaliatory tariff threats in recent weeks, and the resulting market uncertainty could cause commodity price pressure in the near term. We are continuing to assess any changes in trade rhetoric — from threats of a U.S.-China trade war to the renegotiation of the North American Free Trade Agreement (NAFTA) — as any new developments in trade policy will have important implications for the exports of U.S. agriculture, lumber, oil and gas. In the end, escalating trade confrontations could have serious short-term consequences for specialty asset investments. However, since these investments are generally intended to be held over long-time horizons, global supply and demand fundamentals, as highlighted above, should help to mitigate any long-term impacts of a larger trade war.
Fundamentally, farmland continues to make a strong case for long-term investment due to increasing global populations and macro demand for food commodities, coupled with the finite supply of productive and arable land.
Farmland
Farmland values, since the beginning of the year, have trended toward listing prices that are more technically aligned with cash lease yields. This adjustment has led to increased market activity; an overall improvement when compared to previous years’ thin inventories of listed farms. Commodity prices have experienced increased support for the first half of 2018 despite foreign trade uncertainty. Additionally, during the first half of 2018, global export demand has continued to erode domestic grain inventories, thereby supporting grain prices and farmland market activity.
A long-term outlook is essential, and prudent investors should put less importance on short-term trends and continue to focus on the horizon. We think the sunrise may be impressive.
Timberland
Timber price recovery has shown improvement. Prices in the Pacific Northwest have substantially increased year over year, driven by exports, rising housing starts, strong pulp markets and the declining oversupply of British Columbia salvage wood. The negotiations around the softwood lumber agreement with Canada (and/or the renegotiation of NAFTA) are not thought to carry significant risks to this market at this time.
We are also observing some price recovery in the Southeast, though at this point it is limited to specific regional markets and is not yet a broad recovery. Some Canadian firms are moving mills to the Southeast, raising demand. Favorable demand and supply movements suggest the long awaited Southeast recovery may be starting.
These positive indicators should prove favorable for current investors, but those entering the timberland market may be faced with extensions of the acquisition period or compression of anticipated total return due to higher acquisition costs. We still believe the asset class is attractive even at reduced discount returns, but still good risk-adjusted returns for those investors who seek a dynamic store of wealth, capital preservation/appreciation, and risk diversification to dampen the substantial volatility and risks associated with equities markets. We also remind investors that timberland returns are driven primarily by biology, and it takes time for timber to grow into higher valued products.
Even as renewable sources like wind and solar gain some ground, conventional energy — coal, oil, and natural gas — will remain the dominant energy source over the intermediate term.
Energy
Brent crude oil spot prices (the international benchmark price) have continued to climb, reaching $77 per barrel in May. West Texas Intermediate crude oil prices (the domestic benchmark price) have lagged a bit behind Brent prices — by about $7 per barrel — due only to constraints with takeaway capacity (pipelines) in the Permian Basin of West Texas and New Mexico. Drilling in the Permian Basin, however, continues at very high levels, and total active rig counts in the U.S. have increased steadily since 2015.
Primarily due to Permian Basin activity, U.S. crude oil production has continued to climb, reaching 10.7 million barrels per day in May. Average U.S. crude oil production in 2019 is expected to exceed 2018 by 1 million barrels per day. As a result of this increase in domestic crude oil production, net oil imports in 2019 are expected to reach their lowest level since 1959.
As the cost of electricity generation using renewable sources (wind, solar, and hydroelectric) has dropped, it has become competitive with fossil-fuel generation. Last year 17% of the country’s electricity generation came from renewable sources, and it is expected to increase each year for the foreseeable future. Currently, almost half of new large-scale power generation in the U.S. use renewable sources.
In a recent meeting of OPEC members, a modest increase in OPEC production was agreed to. As most OPEC members are already producing at capacity, we do not expect the recent agreement to increase production will reverse the crude oil price trend.
Vacancy rates for the major property types (apartments, industrial, office and retail) remain low and within reach of long-term averages — and are expected to continue throughout this year for many sectors.
Commercial Real Estate
In this late stage of the commercial real estate (CRE) cycle, following several years of CRE recovery, key demand generators are still firmly in place mid-way through the year with continuing good prospects for jobs, consumers, growth in GDP and overall momentum stemming from new tax laws and a tilt toward deregulation.
Overall there does not appear to be significant overbuilding with CRE supply largely balanced with demand for most property types and markets. And, CRE lending so far has been disciplined which has led to relatively modest supply growth which has now generally caught up with demand. Unregulated non-bank lenders are stepping into the construction loan market where lending activity from regulated banks has been noticeably muted.
Notwithstanding rising interest rates, CRE debt for construction and term is available and pricing remains very attractive from a historical perspective.
In Summary
In these times of market and economic uncertainty, investors who are focused on the long-term horizon can find favorable investment diversification by considering real assets in their investment portfolios. In addition to providing uncorrelated returns in a volatile market, real assets may also serve as a hedge against inflation, produce favorable risk-adjusted returns, generate cash flow and provide tax advantages for high-net-worth investors. We recommend investors look to real assets as a way of managing risk and return going forward.
U.S. Trust Specialty Asset Management Team
The Specialty Asset Management Team at U.S. Trust can offer the strategic insight and specialized expertise required to manage and maximize the potential of these investments.
U.S. TRUST, BANK OF AMERICA PRIVATE WEALTH MANAGEMENT
John Kelley, SAM National Executive, Farm and Ranch and Oil and Gas Executive
Doug Donnell, National Timberland Executive
Andrew Tanner, National Private Business and Real Estate Services Executive
Justin Die, Senior Vice President, Farm and Ranch Services
David Koletic, Senior Vice President, Real Estate Investments
NATIONAL SALES
Christopher Aiello
Dennis Moon
Jeffrey Tiger
Nonfinancial assets, such as closely held businesses, real estate, oil, gas and mineral properties, and timber, farm and ranch land, are complex in nature and involve risks including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations and lack of liquidity. Nonfinancial assets are not suitable for all investors. Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy. Client eligibility may apply.
