Impending volatility when FOMC meets, but S-Reits' valuation cheap now: OCBC

OCBC Investment Research said on Friday that the tactical paper it published in July this year, highlighting its belief that the risk-reward of the Singapore Reits (S-Reits) sector has turned unfavourable, has been proven right.

In July, it had said that investors may reap almost zero total returns from S-Reits now until end-2016, on the back of falling dividends and capital loss.

Rightly so, the FTSE ST Reit Index had subsequently fallen 11.5 per cent since the report was published, with its year-to-date trough coming in about one month after the report.

"Looking ahead, the S-Reits sector's market-cap weighted distribution per unit (DPU) growth is expected to come in at 3.3 per cent year-on-year for FY15/16, before easing to 2.6 per cent in FY16/17 and 1.8 per cent in FY17/18.

"This is due to declining rentals, rising operating costs and less favourable demand and supply dynamics within the various industries."

OCBC also noted the increasing possibility of a December rate hike, which would bring volatility to the asset class.

"The Fed funds futures market has priced in a 78 per cent probability of a Fed lift-off during the next FOMC (Federal Open Market Committee) meeting from Dec 15-16, a stark increase from the 41 per cent probability as at Sept 30, 2015.

"The Fed is likely to finally begin normalising its interest rates after an unprecedented period of near zero rates over the past seven years, and we find this unsurprising, given the recent solid October and November non-farm payrolls data, while the US unemployment rate stayed constant at 5 per cent, the lowest in more than seven years.

"In addition, the Fed Chairperson Janet Yellen also appears to have been preparing the markets for this imminent event, sounding more hawkish during her recent statements. We believe there may still be increased volatility ahead, even after the overhang of the Fed funds rate hike is lifted, as the attention of the market would then turn towards how aggressively the Fed would subsequently raise its benchmark rates."

That said, S-Reits' valuations look quite cheap right now, it said.

"Although our thesis of slowing DPU growth remains intact and we are cognisant of headwinds that will continue to plague the sector ahead, we opine that the market has priced in some of these negatives and current sector valuations are not demanding."

The FTSE ST Reit Index is trading at a forward yield spread of 4.7 percentage points against the Singapore government 10-year bond yield, as compared to the five-year average of 4.3 percentage points.

OCBC is thus keeping its "neutral" rating on the S-Reits sector, and recommending a bottom-up stock picking strategy.

It prefers S-Reits with solid execution capabilities, defensive attributes and good risk-reward profiles. CapitaLand Mall Trust, Frasers Centrepoint Trust and Keppel DC Reit rank among its favourites.