By Anqi Dong, CFA, CAIA, Senior Research Strategist
While the broad US equity market posted its sixth straight month of gains in Q3, the tug of war between value and growth has intensified, evidenced by record high volatility of return differences between value and growth indices.1
Meanwhile, our economists believe that although inflation driven by supply chain disruptions and pent-up demand during the pandemic recovery might be peaking, rising rent and housing costs may keep inflation elevated next year.2
While the market historically has tended to be bumpier in Q4, inflationary pressure and some secular industry trends may persist regardless of short-term market sentiment. Therefore, we see three industry opportunities for the final quarter of 2021.
REITs: Pursue Income and Total Return in an Inflationary Environment
With interest rates near pre-pandemic lows and actual inflation as well as inflation expectations elevated, US REIT funds’ ability to provide dividend income exceeding inflation has attracted investors this year. Because most leases are tied to inflation, income from leases and property values tend to increase when overall price levels rise.
This supports REITs’ dividend growth and helps investors to pursue real income during inflationary periods. In all but three of the past 20 years, REITs’ dividend increases have outpaced inflation as measured by the Consumer Price Index.3
Although the dividend yield of the US REITs industry has declined to around 3% as some REIT share prices increase, this income level is still much higher than inflation expectations and yields of investment-grade bonds.4 As the REITs sector continues to recover from the economic downturn, increases in lease payments likely will boost dividend distributions.
From a total return perspective, REITs also provide investors a powerful tool for inflation hedging. Rolling 12-month average of CPI inflation rate has increased for six straight months in August and now sits at 3%, well above the historical median. While inflation has shown signs of peaking recently, it’s likely to remain elevated in the coming months as the economic recovery continues.
And when 12-month average CPI inflation has been in the top two quintiles, REITs have outperformed broad equities, US Treasury Inflation-Protected Securities (TIPS) and high yield bonds and been on par or slightly exceeded broad commodities, as shown in the chart below. This underscores REITs’ total return advantage over other assets in a high inflationary environment.
Although REIT mutual funds and ETFs have attracted more than $12 billion on a trailing 12-month basis, flows relative to the sector’s asset base are around the historical median of 6% and well below the average of 11% from 2010 to 2012 when the US economy recovered from the last recession.5 This may indicate investors are not overcrowded in terms of sector positioning.
Semiconductors: A Beneficiary of Surging 5G Adoption and World Digitalization
The worldwide semiconductor market is projected to grow 25% to $551 billion in 2021, following 6.8% growth in 2020, according to World Semiconductor Trade Statistics.6
Strong demand for chips may persist in the coming years driven by increasing penetration of 5G smartphones, Internet of Things, and a post-pandemic digital transformation that spurs demand for data centers and cloud services.
5G smartphones have rapidly gained mobile phone market share, as shown in the chart below. With more mobile phone brands launching 5G-compatible models, the momentum is expected to continue. IDC forecasts that 5G smartphones’ share of global shipments will increase to 69% in 2025.7
As one of the most critical and high-value components of 5G smartphones, smartphone semiconductors are estimated to capture nearly two thirds of the revenue from 5G smartphones,8 one of the largest beneficiaries from the increasing penetration of 5G handsets.
The Internet of Things (IoT) presents long-term and diverse growth opportunities for semiconductors in the 5G era — from smart home devices to industrial and automotive applications.
Integrated circuits that process and store data and execute commands are the essential element of IoT, enabling fast and energy-efficient connections for machines and devices. The IoT may significantly boost semiconductor revenues by stimulating demand for microcontrollers, sensors, connectivity, and memory chips.
Another secular tailwind for the semiconductor industry is the pandemic’s acceleration of digital transformation. The increase in remote work and migration of digital assets to the cloud are two of the largest enterprise shifts that will most likely remain after the crisis.9
The strong demand for data center capacity in enterprise markets has spurred capital expenditure by hyperscale data center operators such as Amazon AWS, Microsoft, Google, and Oracle this year.10 The memory integrated circuit makers are the key beneficiary of this rapid growth, as the segment is the industry’s largest growth contributor.11
Biotech: A Secular Growth Opportunity with Attractive Valuations
The biotech industry had a maximum drawdown of 32% since its peak in February this year.12 Even after rebounding 12% from its August trough, the industry still lags the healthcare sector and broader market by 23% and 25% year to date.13
Over the past 15 years, there were only two periods when the industry suffered a loss greater than 30% over a six month or longer period: 2015-2016 triggered by Hillary Clinton’s tweets about drug pricing and 2008-2009 during the global financial crisis.14 Both times biotech recovered from the downturn to stage a strong multi-year rally.
Historically, when the biotech industry has had more than a 10% drawdown, returns for the following years have most often been quite positive, as shown in the histogram chart below. The average return for the next 12 months after a 10% drawdown was 24%, with 81% of the time producing positive returns.
Longer-term performance was even stronger, with 46% and 65% average cumulative returns for the following two and three years, respectively. Therefore, historical statistics suggest this year’s biotech selloff might create a great entry point for investors who are looking for long-term growth opportunities but can also stomach the sector’s high volatility.
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Photo Credit: phsymyst via Flickr Creative Commons
1FactSet, as of 10/1/2021. Value and Growth are represented by the S&P 500 Value and S&P 500 Growth indices.
2Weekly Economic Perspectives Quarterly Edition, September 27, 2021.
3Nareit, S&P Global Market Intelligence, as of December 2020.
4Bloomberg Finance L.P., as of 9/24/2021.
5Morningstar, as of 8/31/2021.
6Worldwide Semiconductor Market Outlook, World Semiconductor Trade Statistics, 8/16/2021.
7IDC, as of 3/10/2021.
8IDC forecasts $522B semiconductor market in 2021, May 2021.
9How COVID-19 has Pushed Companies Over the Technology Tipping Point and Transformed Business Forever, McKinsey, October 2021.
10AWS, Microsoft, Google Lead $38B Data Center Capex In Q1, CRN.com, June 2021.
11Worldwide Semiconductor Market Outlook, August 2021, World Semiconductor Trade Statistics.
12Bloomberg Finance L.P., as of 9/23/2021.
13Bloomberg Finance L.P., as of 9/23/2021.
14Bloomberg Finance L.P., as of 9/23/2021.
15FactSet, as of 9/16/2021.
16Biotech Industry Survey, CFRA, September 2021.
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