Thursday, March 14, 2019

REITs III: Exchange Rates

This is Part III of my series on REITs. Please refer to Part I and Part II.

My series on REITs will not be complete without touching on exchange rate, given the internationalisation of the SGX as a major listing hub for REITs all over the world. Even blue chip REITs which were pure-plays in the Singapore space, such as Capitaland Commercial Trust, have gone abroad in hunt of fresh assets. As such, this introduces a new risk that investors cannot afford to ignore, or even take as a trivial risk. Given that the vast majority of REITs are listed in SGD but have exposure to various currencies globally, we have to study the SGD itself. As all Singaporean investors would be acutely aware, the SGD has been on a long term uptrend against most major currencies globally.

Central Bank Policy

At present, conventional monetary policy across the world usually revolves around setting interest rates to steer growth and inflation rates. Some smaller countries prefer to outsource this task to major central banks by pegging their currencies to that of their major trading partners, e.g. Hong Kong and the petro-states of the Middle East to the USD. The downside of maintaining a rigid currency peg (known as a ‘hard peg’) is that the central bank loses all control over its domestic interest rates, and is required to have ample reserves to maintain the credibility of a peg. This is because a peg means that the central bank is playing the role of a money changer for all participants in the economy. It must be able to satisfy all demand and supply for currency at the prevailing rate. A good case study is Thailand in the 1990s, which precipitated the Asian Financial Crisis. Basically, as foreign investors sold their THB to exit the market, the central bank saw its reserves deplete as it sought to defend the peg. 

To maintain a currency peg, the Central Bank has to act as the ultimate money changer, buying and selling the local currency at the pegged rate. For example, let us assume that the Monetary Authority of Singapore (MAS) were to suddenly peg the SGD to say, 1.30 against the USD. In this scenario, MAS would buy USD from exporters, inward bound investors and tourists, in exchange for SGD. This is an easy thing to do, as MAS can just ‘print’ the additional SGD in exchange for the USD received. The SGD enters into circulation for use in the broader economy, and MAS keeps the USD received as part of its foreign reserves. This is essentially what a central bank’s foreign reserves are- a hoard of foreign currencies accumulated through the course of action of a central bank’s attempt to control its currency.

On the other hand, let us consider what happen when an importer brings goods in, or a Singaporean investor buys US stocks. That person is basically offering to sell his SGD in exchange for foreign currency in order to fund his purchase or investment. MAS will therefore dip into its reserves, take the USD out in exchange for the SGD.

In the former transaction, MAS is able to print an infinite amount of SGD when exporters or inward bound investors demand for the local currency at 1.30. However, in the latter scenario, when importers or outward bound investors want to dispose of their SGD, MAS has a finite supply of foreign reserves that it can use to meet the demand for foreign currency.

Should the selling of local currency in exchange for foreign currency overwhelm the central bank’s reserves, the central bank will be unable to defend the currency at that level, and will be force to devalue the currency. This happened to the Thai Baht (THB) in 1997, when the Central Bank, the Bank of Thailand, depleted its reserves defending its currency peg then. The government was forced to allow the THB to float as it did not have the reserves to meet the flood of THB sellers. The breaking of the currency peg led to the THB going into freefall and this was the opening chapter of the crisis that ravaged Asia.

Macroeconomic Environment of Singapore

Singapore runs a massive Current Account Surplus, as a result of its strong net exports position and high national savings rate. A high national savings rate is due to household savings and government savings (fiscal surplus). Further reading on this issue (which is rather academic) can be found here. As explained above, this implies that there is a net inflow of foreign currencies into Singapore, which allows MAS to accumulate foreign currencies if it wishes to prevent the currency from appreciating sharply.

The result of the Current Account Surplus above has translated into the chart below, which demonstrates Singapore's long term uptrend of foreign reserves. We will explore further below the relationship between the current account surplus, reserves and the SGD.

Monetary Authority of Singapore (MAS) Policy

MAS has adopted a ‘soft peg’ regiment for the SGD. The SGD is permitted to fluctuate within a narrow band against a trade-weighted basket of currencies. MAS effects it monetary policy through controlling the position of the center, slope and width of the currency band. While it does not disclose the precise nature of these details, many large banks have reversed engineered the basket. The basket generally reflects the trade partners of Singapore, with the USD, MYR and CNH constituting the bulk of the basket. The following is the currency pathway of the SGD as set by MAS over the years, with the center and bands estimated by Morgan Stanley. The black bands are the 'guard rails' that MAS permits the SGD to drift within.

MAS intervenes in a similar manner as described in the 'hard peg' scenario earlier. It buys foreign currencies in exchange for SGD when the SGD presses against the ceiling of the band, and supports the SGD by selling its foreign reserves when the currency approaches the floor. It is this process of keeping the SGD within this band, that MAS accumulates its foreign reserves. This is because as demand for SGD exceeds supply due to the strong current account surplus, this will naturally lead to an appreciation of the SGD. MAS intervenes to limit the degree of intervention by selling SGD that it 'prints', in exchange for foreign currency that becomes part of MAS' reserves.

Reading the MAS semi-annual monetary policy statements will give you an insight into how MAS steers the currency. The following is extracted from MAS’ October 2018 statement, when the central bank decided to increase the slope of the currency policy band.

14.   MAS has therefore decided to increase slightly the slope of the S$NEER policy band. The width of the policy band and the level at which it is centred will be unchanged. This measured adjustment follows the slight increase in the slope of the policy band in April 2018 from zero percent previously, and is consistent with a modest and gradual appreciation path of the S$NEER policy band that will ensure medium-term price stability.

We can easily conclude from the chart above that MAS has deliberately kept the SGD on a steady and controlled upward or appreciating pathway in the long run. Even in times of economic weakness, MAS kept the slope flat, implying that the SGD remained flat against the major currencies. Historically, MAS has kept the currency on an upward slope of 2% in times of strong economic growth, and flat or 0% during periods of economic weakness. The current slope is estimated to be 1%, or in other words, the SGD is expected to strengthen at a rate of 1% per annum against the basket of currencies.

We can see below how the SGD has generally appreciated against the major currencies globally.

The SGD has held up well against other Asian currencies as well, though the RMB stands out for holding up against the SGD. This is somewhat expected as China has been an export powerhouse and has amassed the largest foreign reserves in the world (north of USD 3 trillion as of early 2019). 

What are the implications for SREITs?

Since the SGD tends to be on an uptrend against major currencies for the vast majority of the majority of the time, REITs with exposure to foreign currencies will inevitably experience drag from a stronger SGD. The investor needs to factor this when considering a REIT with non-SGD exposure. In many cases, the growth prospects of the REIT may more than compensate the effect of the currency drag, more so in many emerging markets such as China, India and South East Asia. 

However, for REITs with Developed Market exposure, such as the US, Canada, Japan, European Union and Australia, growth prospects are more muted. The currency effect is likely to be a more significant component (either positive or negative) of total returns. As such, investors need to consider the currency drag, particularly when looking at REITs with minimal or zero rental reversion.

Hedging. While currency hedging provides some visibility in the short term, it is only delaying, not preventing the impact of currency changes. This is because the earnings are only hedged for the duration of the hedge, and when the hedges expire and have to be rolled over, the DPU will be exposed to the prevailing exchange rate. 


In the long run, it is important to keep in mind that Singapore's strong current account surplus has been the major driver of SGD strength over the decades. Should these driver remain intact for the foreseeable future, MAS will continue to ensure that the SGD appreciates in a steady and gradual manner. As a result, investing in REITs with non-SGD will inevitably result in a currency drag of 1-2% per annum in the long run. While not a major issue, this could potentially affect REITs with stagnant or minimal DPU growth, and needs to be incorporated as a factor when making investment decisions. Hedging only delays the effect of exchange rates changes, not prevent it. 


Sunday, March 3, 2019

S-REITs Jan-Feb 2019 Review

S-REITs have been on tear this year, outperforming the broader market by a wide margin. Economic and market conditions have been optimal for a REIT rally. These conditions include falling bond yields due to expectations of looser monetary policy by major central banks as compared to the last 2 years. Also, a weaker economic outlook, but not quite a recession, means that growth stocks which were in vogue over the last few years, have lost their shine. 

Instead, institutional investors have turned their attention to dividend stocks, since they anticipate lower capital gains from growth stocks. Also, appetite among global investors for Asian equities have returned in a very strong manner. These factors have been the driving force behind the stampede into S-REITs this year.

So how have S-REITs stacked up so far? 

The table below shows the total returns of the S-REIT sector for the first two months of the year. While no sub-sector has outperformed in particular, the Industrials have underperformed, despite their higher yields. This is likely due to the still-pessimistic outlook for this sub-sector, more so if economic growth worsens.

The higher beta REITs have outperformed, though they were also the most battered in the sell-off last year. In the top 10, the only REITs with a majority of assets based in Singapore is CapitaLand Commercial Trust and to a lesser extent, Keppel DC REIT. The other REITs are 100% offshore assets, with the exception of Ascendas Hospitality Trust holding a single Singaporean asset.

Also, the China plays have been stellar as a resolution on the trade war looks increasingly likely, notably Sasseur REIT (19.2%), Mapletree North Asia Commercial Trust (11.4%), CapitaRetail China Trust (11.0%) and EC World REIT (10.1%). I expect the Chinese REITs to continue to outperform should a trade deal materialise. This is largely due to aggressive monetary and fiscal policy stimulus that the government unleashed in late 2018. As government policies tend to take a few months to kick in, the Chinese economy will rebound as early as the 2nd Quarter of 2019.

Where do we go from here?

Any further rally in the REIT sector as a whole will hinge on Federal Reserve policy changes over the next few months. If the Federal Reserve does indeed pause its rate hikes for good and ends it balance sheet reduction (read 'money destruction'), we can expect bond yields to head lower once more and the S-REIT rally to resume. But for now, I believe that the rally is done, though I expect prices to move sideways, or even undergo a minor correction, pending further development from the Federal Reserve.