In his July 2 sector report, UOB Kay Hian analyst Jonathan Koh has maintained his “overweight” call on Singapore REITs (S-REITs), as the sector has “weathered the sell-down” caused by interest rates staying higher for longer.
He notes that major banks have been cutting rates in recent months, with the Swiss National Bank cutting its main policy rate by 25 basis points (bps) to 1.5% in March and the Bank of Canada lowering its overnight rate by 25 bps to 4.75% in June, the first G7 country to cut interest rates.
Koh adds that the European Central Bank has also cut the interest rate on its main refinancing operations by 25 bps to 4.25% in June.
“With inflation slowly and gradually receding, the US Federal Reserve (US Fed) is expected to institute the first rate cut in 4QFY2024,” notes Koh.
“The median projected path for US Fed funds rate is 5.1% by end-FY2024 and 4.1% by end-FY2025, indicating rate cuts of 25 bps in 2HFY2024 and 100 bps in FY2025. We expect the Fed to institute the first decisive rate cut in 4QFY2024. The US Fed can afford to wait for clearer signs of disinflation given the current resilient economic growth and tight labour market,” writes the analyst.
Meanwhile, core personal consumption expenditures (PCE) inflation eased 0.2 percentage points (ppts) to 2.6% y-o-y in May, while the m-o-m momentum also moderated to an “acceptable” 0.1%, compared with the “firmer” 0.3% in April.
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On this Koh writes: “While the data release met expectations, it is encouraging because core PCE inflation has been stagnant at 2.8% for the past three months from February to April. While one swallow does not make a summer, the deceleration of inflation, as seen in the core PCE inflation figure for May, is a welcome relief.”
In the US, 272,000 jobs were added and the unemployment rate was low at 4.0% in May. Labour force participation rate for people aged 25 to 54 improved 0.3 ppts y-oy to 83.6% in the same month, remaining above pre-pandemic levels, while average hourly earnings eased slightly to 4.0% y-o-y.
With this, Koh sees that interest rates may remain higher for a potentially longer time frame. Referring to the paper, An analysis of pandemic-era inflation in 11 economies published by economists Ben Bernanke and Oliver Blanchard in May, the economists observe that labour market tightness has become a more important source of inflation during the last mile to get inflation under control.
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“The US Fed may need to loosen labour market conditions to achieve its inflation target. It suggests that the vacancy-employment ratio needs to fall below 1.2 times to get inflation down to 2%,” notes Koh, referring to Bernanke and Blanchard’s observations.
In June, the US Fed tapered the pace of reduction for its holdings of treasury securities from US$60 billion ($81.5 billion) to US$25 billion per month, and the pace of reduction for agency mortgage-backed securities remains unchanged at US$35 billion per month.
“The move could reduce volatility in treasury markets. The US Fed has already reduced the size of its balance sheet by US$1.5 trillion as of March,” writes Koh.
Action on S-REITs
Despite the higher-for-longer-interest rates, many blue-chip S-REITs are still trading at attractive distribution yields of 6% to 7% after a long-drawn correction of 7.7% in FY2020, 15.0% in FY2022 and 14.1% in 1HFY2024. Recovery for the sector looks to arrive as inflation moderates at a slow and gradual pace in 2HFY2024, notes Koh.
Meanwhile, bond yields remain elevated. The US 10-year government bond yield surged 52 bps to 4.40% in 1HFY2024 due to sticky inflation. Similarly, the Singapore 10-year government bond yield rose 50 bps to 3.21% during the same time frame, with the yield spread for S-REITs expanding by 30bps to 2.93% in 1HFY2024.
Koh writes: “We have lowered our target prices for S-REITs by an average of 7% after adjusting our risk-free rate higher by 25 bps from 2.75% to 3.00%. For US REITs, we have raised the risk-free rate by 25bps from 4.0% to 4.25%.”
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He continues: “Our target prices for US REITs have similarly been reduced by an average of 3%. We have also tweaked terminal growth for S-REIT with exposures to China lower, such as Keppel DC REIT (KDC REIT), Mapletree Industrial Trust ME8U (MINT) and Mapletree Asia Commercial Trust (MPACT).”
The analyst’s top “buy” picks are Far East Hospitality Trust Q5T (FEHT) at a target price of 77 cents, Keppel REIT at a target price of $1.15, Lendlease Global Commercial REIT JYEU (LREIT) at a target price of 85 cents, MINT at a target price of $2.78 and MPACT at a target price of $1.73.
Sector catalysts noted by the analyst include hospitality, retail and office REITs benefitting from the reopening of the economy and easing of Covid-19 restrictions in Singapore and around the region, as well as a limited new supply for the logistics and retail segments in Singapore.
Conversely, risks include the escalation of the Russia-Ukraine war and the Israel-Hamas war.
