The Search for Real Returns

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Jeffrey Tang's picture

The Search for Real Returns


Central banks in developed countries have reduced yields to record lows, which has left investors searching for greater returns. As central banks have expanded their balance sheets, money supply has expanded as more cash is injected into economies and inflation is expected to pick-up as developed economies recover. Central banks have further signaled to investors that they plan on keeping interest rates near zero until 20151. With interest rates near zero, institutional investors have sought underpriced assets to generate enough returns for their clients. This essay will look at the notion of underpriced assets, the plans of central banks and examine two underpriced assets: Stocks and REITs.

What is an underpriced asset?

The notion of underpriced assets assumes that capital markets are inefficient and asset mis-pricings exist. If capital markets were efficient, all information would be incorporated into the asset prices as investors would only buy or sell those assets at fair prices and no asset would be underpriced.

However, financial markets are fallible and participants can make irrational and biased decisions. Research has shown that the efficient market hypothesis does not completely hold true because of unrealistic assumptions2 and empirical evidence such as investors like Warren Buffett who outperform their benchmarks by seeking underpriced stocks.

However, it is difficult to find underpriced assets in a market where most participants are more qualified than an individual investor. However, opportunities do exist for those who understand market biases to find underpriced assets. This essay anticipates asset price recorrections when investors shift their funds to riskier assets such as REITs and stocks as the North American economy improves.

Current and Future Central Bank Monetary Policies

Central banks around the world have been using expansionary monetary policies as part of their mandate to stimulate economies and prevent deflation. Ben Bernanke's statement exemplifies the intentions of central banks "We expect to keep the short-term interest rate at exceptionally low levels to at least mid-2015... so long as price stability is preserved, we will take care not to raise rates prematurely."3 The assurance of low interest rates means that central banks like the Federal Reserve are unlikely to discontinue their expansionary monetary policy until 2015.

Through central banks' conventional and unconventional policies like quantitative easing, short-term bond yields have been pushed to near zero. As a result of these expansionary monetary policies, asset prices will be inflated as a result of an increase in the supply of money.

Credible Economic Inflation

Central banks in developed countries have signaled their intentions to maintain current low bond yields until economic conditions improve and inflation stabilizes.

The Federal Reserve has forecasted inflation to be around 2%4. This amount of inflation is credible since financial markets have incorporated an inflation premium of a 2.6% yield difference in Treasury Inflation-Indexed Bonds over Non-Inflation Indexed Bonds as shown in the graph below:


In terms of a real return, investors often seek 2 types of assets to hedge against inflation, commodities and property. It is unlikely that commodities would return more than REITs because the key driver of recent inflation is monetary policy by central banks and not a supply side shock like oil in the 1970s. This essay will argue that REITs and stocks are undervalued and investors will eventually seek them as they move their funds away from bonds.

General Market Outlook

Investors are seeking better returns through more risk as their risk appetite grows. They sought high-yield bonds in 2012, which performed well in 2012. High-yield bond indices such as the BofA Merrill Lynch US High-Yield Master II have had their yields drop to 6%, lower than its pre-recession low of 7%. This is evidence that investors are seeking more returns by increasing their risk appetite.

Consequently, investors will eventually move their funds into assets that return more but are riskier than high-yield bonds. The logical progression of this increasing risk appetite means that investors will seek out REITs and stocks as they have the potential to return more than government or high-yield bonds in the current low interest rate environment. Thus, REITs and stocks are underpriced now and will correct themselves when their prices rise.

How do REITs generate returns in a low interest rate environment?

Real Estate Investment Trusts or REITs make money by buying properties with investors' money and renting the property out for income. Investing in REITs that own property can be a hedge against inflation from central banks because income from REITs increases when rent is adjusted upwards for inflation5. The supply of property is limited since the quantity of real estate is difficult to increase as prices rise. This gives more upside to REITs compared to commodity assets that are easily produced with more capital.

Why is the market underpricing REITs?

Investors still demonstrate some aversion to real estate as a result of the 2008 crash in US housing. They are afraid that their investments in real estate will turn into a loss. This is exemplified by the slump in US housing prices from the Case-Shiller index which have bottomed out and has yet to increase in line with stocks or bond indices as shown below.


Property prices will increase after re-correcting themselves when investors have a bigger risk appetite. In an expansionary monetary environment, real estate will offer more than real returns when investors bid up the price of real estate and REITs in search of assets that expect to have greater returns than bonds.

Upsides and Downsides of REITs

The US real estate fundamentals are slowly improving such as the unemployment rate, which has decreased from its peak of 10% in 2009 to 7.9% this year. It is likely to decrease further as the US economy improves. REITs will continue to do well as property prices rise as a result of the increasing supply of money. Until 2015, it is anticipated that there will be a flow of funds into REITs as a result of investors who are starved for yields, which will cause a rise in the price of current undervalued REITs.  Analysts' currently target higher prices for REITs, such as $22.33 for IVR, which, combined with a high payout ratio, could return up to 15% for investors. This promises to attract investors hungry for yields and drive REIT prices upwards.

The potential downsides to holding REITs are minimized as long as the US economic fundamental remain strong and interest rates remain unchanged until 2015.

Why is the market underpricing stocks?

Some investors still have an aversion to moving their funds from bonds into stocks and would rather have their funds stay in high-yield bonds that have so far been producing higher returns with less volatility than stocks. As credit spreads narrow, bond returns will decrease and investors searching for greater returns will seek stocks with more risks and push the price of stocks upwards.

Upsides and Downsides of Stocks

Current stock valuations are well-supported by their fundamentals and are likely to reach 1,615 in 2013 according to analyst predictions6. About 72% of companies in the S&P 500 reported earnings that beat estimates. Analysts estimate that companies within the S&P500 will continue to report increasing EPS growth in 2013 and 2014 at $107.9 and $115.8. Current stock prices are well-supported by more accurate forward-looking fundamentals. Furthermore, strong earnings are supported by central banks' monetary policies of near zero interest rates. Hence, firms have access to cheap debt to expand and grow earnings.

The only possible downside is if European economies suffer setbacks and S&P500 exposed to Europe will suffer as a result. S&P500 companies should have operations diversified in non-European markets to offset another potential European crisis.

Future Outlook for REITs and Stocks

Stocks and REITs are undervalued compared to other assets as investors have been wary of the risks these assets carried during the last recession. This aversion is one of the main reasons why the current prices for REITs and stocks are underpriced.

As central banks continue to stimulate economies through expansionary monetary policies and unconventional monetary policies, investors will overcome their aversion to these assets and will buy them in search of greater returns. REITs and stocks are underpriced for now. As investors move their money into these assets, the prices of REITs and stocks are likely to rise because of their strong fundamentals through to 2015 when expansionary monetary policies end.



1. Petra Gerlach-Kristen, Robert N McCauley, Kazuo Ueda (2012). BIS Working Papers No 389 Currency intervention and the global portfolio balance effect: Japanese lessons. Bank for International Settlements. Retrieved from

2. (2013). Quarterly Inflation Report Q&A 13th February 2013. Bank of England. Retrieved from

3. Jana Randow, Jeff Black (2013). Weidmann Warns Governments Against Trying to Weaken Euro. Retrieved from

4. Philipp Hildebrand (2013) No Such Thing as a Global Currency War. Retrieved from

5. John Maynard Keynes (1936). The General Theory of Employment, Interest, and Money, pp. 382-3. Palgrave Macmillan.